Eddielogic

– Thoughts on Strategy and Management

The interview – How a large US bank manages their liquidity risks.

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In mid September we published a short post with the title “the worse is yet to come“. Now, one month later, we can observe worst case scenarios becoming reality. Black swan effects test the survivability of financial institutions. Large banks on both sides of the ocean are in very serious trouble and need massive government support. Very strange market conditions challenge risk management systems to the max. A good time for raising questions how large banks manage their liquidity and liquidity risks. A large US bank agreed to participate in an interview –please see details at the end of this post – for eddielogic.com – the blog on strategy and management.

 

Q: Thank you very much for the opportunity to make this interview. Time is money; hence I would like to start with my first question right away. Liquidity has become one of the most important business aspects. How would you describe the current situation of your organization?

A: “We have achieved our best-ever geographic diversification, with half of the Firm’s revenues generated outside the Americas. The result of all this is that we have built a balanced global organization – able to withstand the stresses of rapid shifts in world liquidity flows.

Our Firm ranks #1 “Most Admired Securities Firm” by Fortune. The organization achieves record net revenues, net income and earnings per common share for the fourth consecutive year based on record results in all three business segments.”

 

Q: Could you please describe your general management approach?

A: “We effectively managed our risk, balance sheet, and expenses. Ultimately, our performance in 2007 was about our “One Firm” sense of shared responsibility and careful management of our liquidity, capital commitments, and balance sheet positions. We benefited from our senior level focus on risk management and, more importantly, from a culture of risk management at every level of the Firm.”

 

Q: Could you describe your general risk management approach?

A: “Our goal is to realize returns from our business commensurate with the risks assumed. Our business activities have inherent risks that we monitor, evaluate and manage through a comprehensive risk management structure. These risks include market, credit, liquidity, operational and reputational exposures, among others. The bases of our risk control processes are:

  • We establish policies to document our risk principles, our risk capacity and tolerance levels.
  • We monitor and enforce adherence to our risk policies.
  • We measure quantifiable risks using methodologies and models based on tested assumptions.
  • We identify emerging risks through monitoring our portfolios, new business development, unusual or complex transactions and external events and market influences.
  • We report risks to stakeholders.”

Q: Many people are confused that certain banks did obviously not manage their liquidity risks. What is your organizational structure to manage liquidity risks?

A: “Management’s Finance Committee is responsible for developing, implementing and enforcing our liquidity, funding and capital policies. These policies include recommendations for capital and balance sheet size as well as the allocation of capital to the business units. Management’s Finance Committee oversees compliance with policies and limits with the goal of ensuring we are not exposed to undue liquidity, funding or capital risk. Our liquidity strategy seeks to ensure that we maintain sufficient liquidity to meet all of our funding obligations in all market environments.

That strategy is centered on five principles:

  • Maintaining a liquidity pool that is of sufficient size to cover expected cash outflows for one year in a stressed liquidity environment.
  • Relying on secured funding only to the extent that we believe it would be available in all market environments.
  • Diversifying our funding sources to minimize reliance on any given provider.
  • Assessing our liquidity at the legal entity level. For example, because our legal entity structure can constrain liquidity available to Holdings, our liquidity pool excludes liquidity that is restricted from availability to Holdings.
  • Maintaining a comprehensive funding action plan to manage a stress liquidity event, including a communication plan for regulators, creditors, investors and clients.”

 

Q: Are there specific reserves or pools that your firm can use to protect their liquidity status? For which period of time can you ensure your liquidity in a stress situation?

A: “We maintain a liquidity pool available to Holdings that covers expected cash outflows for twelve months in a stressed liquidity environment. In assessing the required size of our liquidity pool, we assume that assets outside the liquidity pool cannot be sold to generate cash, unsecured debt cannot be issued, and any cash and unencumbered liquid collateral outside of the liquidity pool cannot be used to support the liquidity of Holdings.”

 

Q: Do you have some kind of emergency plan for stress situations?

A: “We have developed and regularly update a Funding Action Plan, which represents a detailed action plan to manage a stress liquidity event, including a communication plan for regulators, creditors, investors and clients. The Funding Action Plan considers two types of liquidity stress events—a Company-specific event, where there are no issues with overall market liquidity and a broader market-wide event, which affects not just our Company but the entire market. In a Company-specific event, we assume we would lose access to the unsecured funding market for a full year and have to rely on the liquidity pool available to Holdings to cover expected cash outflows over the next twelve months.

In a market liquidity event, in addition to the pressure of a Company specific event, we also assume that, because the event is market wide, additional counterparties to whom we have extended liquidity facilities draw on these facilities. To mitigate the effect of a market liquidity event, we have developed access to additional liquidity sources beyond the liquidity pool at Holdings, including unutilized funding capacity in our bank entities and unutilized capacity in our bank facilities. We perform regular assessments of our funding requirements in stress liquidity scenarios to best ensure we can meet all our funding obligations in all market environments.”

 

Q: Thank you very much for the interview. This a lot of excellent information about the risk management structure of your firm.

A: Not a told, it was a pleasure.

 

 

Resume

Everything does sound fine, doesn’t it? It might be that you are banker and interested to join this bank? This bank manages its liquidity situation and can cover expected cash outflows for 12 months. Those aspects have gained a major meaning for bank management.

 

Well, I have very bad news for you. This was a fictitious interview with a US bank. What is the name of the bank? Lehman Brothers; hence an application for a job interview is not an option. The idea for this post was to find relevant statements how a bank manages its liquidity needs and how appropriate approaches and tools have worked in real life stress situations. The organization describes this system in details. Considering all the statements above, everything is fine. The core question for the risk management of your organization: How does your firm manages black swan effects? Do you have a plan B?

Note: All statements have been extracted from Lehman Brothers Annual reports 2007 or the firm’s website. Specific words and terms (e.g. Investment bank) have been replaced with the term “organization” or “firm” in order not to disclose the source of answers to early.

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3 Comments

  1. Pingback: Diversify Our Income. | 7Wins.eu

  2. Pingback: Lehman Brothers and its approach to look better | Eddielogic

  3. nice posting
    thank you

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