Liquidity risk in focus
Liquidity risk is emerging as a top priority amid concerns that a “tick the box” approach to liquidity risk management could leave funds ill-prepared to deal with sudden reversals in market or client sentiment. That’s a risky place to be at a time when macroeconomic conditions are tightening globally, and many asset valuations are comparatively high.
Deb Barnes, head of the risk management group at QIC in Brisbane said that market participants’ understanding, and management of liquidity risk has improved materially in the years since the global financial crisis. However, she said current conditions leave little room for complacency.
We are in a period of the cycle where things are about to change...It’s possible that if there was a market trigger elsewhere, liquidity could dry up quickly.
“We are in a period of the cycle where things are about to change. We have had central banks starting to raise rates and while the impact that has on the market is probably unknown at this point, the valuations of a number of equity markets are looking very stretched. It’s possible that if there was a market trigger elsewhere, liquidity could dry up quickly,” Barnes said.
While liquidity events can come on quickly, they can take a long time to resolve. At the height of the global financial crisis in November 2009, ASIC reported that 87 funds totalling $25 billion had been frozen, suspending the rights of members to transfer out their funds. At the last report by ASIC in June 2015, 47 of these funds remained frozen, retaining over $1 billion in funds under management including mortgage funds, property funds and cash-enhanced funds.
At the same time, while many superfunds’ understanding and management of liquidity risk has improved materially in recent years, experts are concerned it’s not yet at a level that inspires complete comfort should the next crisis hit.
This is not for lack of regulatory focus. Under the SIS Act, superfunds are required to consider the liquidity of investments when formulating and implementing investment strategies, while also considering the expected cash flow requirements of the registrable superannuation entity (RSE). Meanwhile, Superannuation Prudential Standard 530 Investment Governance, which was brought in in 2013 on the back of lessons learnt from the GFC, requires funds to develop liquidity risk management plans to monitor and manage liquidity on an ongoing basis.
Liquidity management plans, and a clear understanding of the actions that will be put in place to respond to a crisis, need to be in place and tested before, and not after, the next major liquidity crisis arises.
In essence, that requires funds to understand the sensitivity of their asset allocations to changes in market or member sentiments, including the possibility that previously liquid investments might becoming illiquid under stressed conditions. It also requires funds to think ahead and seek to identify emerging liquidity pressures, as part of their procedures to measure and manage liquidity on an ongoing basis.
Indeed, according to the Australian Prudential Regulation Authority (APRA), a prudent RSE licensee would have an awareness of the potential for an investment option to become illiquid in adverse circumstances, how this might affect the value of the investment option and the RSE licensee’s ability to meet portability and benefit payments obligations in such circumstances.
Understanding liquidity risk
While there has been significant progress in the way funds approach liquidity risk management since the introduction of SPS 530, there are still funds that treat having a liquidity risk management plan as a compliance exercise.
“The real liquidity of assets in particular is something many funds need to get a better grip on. If you’re merely treating it as a compliance exercise, it won’t provide you with valuable insights and as a result, you won’t be able to do much with that information,” one regulatory expert told Fund Business.
Cary Helenius, director at Lifetime Income in Melbourne, co-wrote a paper with Jules Gribble, now a senior policy advisor at the International Association of Insurance Supervisors, titled “Managing Liquidity in Superannuation” for the Institute of Actuaries in Australia in 2011. The paper urged funds to establish effective frameworks to manage liquidity. He agreed that while there have been definite moves on the part of industry funds putting liquidity risk management plans in place, progress has been slower than anticipated and some funds are merely ticking the box on compliance.
“Funds that simply apply a tick the box approach to liquidity risk management are not taking a holistic view of their funds’ liquidity exposures. A proper approach to liquidity risk management is about understanding what you’re invested in, understanding the cashflows of the assets within each of the investment options, understanding the demographics of your members and what is likely to happen in a stressed environment,” Helenius said.
That is easier said than done. For one, liquidity risk is non-linear. For another, market conditions can change very rapidly. While asset classes such as infrastructure, private equity and direct holdings in real estate would fall in the illiquid category by their very nature, the real problem arrives when asset classes that were previously considered liquid dry up, as was the case with the bond market during the global financial crisis, in particular mortgage funds. In that sense, it’s the assets that appear liquid, but that may not be under stress, that are most dangerous.
Liquidity risk also comes in many different guises. “It doesn’t have to be a market driven run, which are usually associated with unwinding positions within a reasonable timeframe. It could be a member or client driven liquidity event resulting in redemptions or switching, or unanticipated operational liquidity coinciding with a market driven run,” Jason Foo, director at Deloitte in Sydney said.
Helenius said that at a macro level, superannuation fund liquidity can be impacted by global investment market volatility, the ageing population of funds members leading to increasing industry wide outflows, and trends such as members transferring funds into the SMSF sector. These factors, which impact the liquidity of superannuation funds and need to be modelled and managed.
In addition, however, there are fund specific liquidity risks that relate to the management of illiquid assets, or asset classes, within the fund, and these should also be modelled and managed down to the investment option level.
“The test of a successful liquidity risk management plan is how effectively it deals with fund members impacted by illiquid assets, and importantly, how equitably do the consequences of the liquidity management actions impact on the other members in the fund,” Helenius said.
Changes in member preferences are another source of liquidity risk. “While large-scale switching is not an every day occurrence for most funds, during the global financial crisis there were sectors that were subject to significant transfers as members switched into lower investment risk options. When that happens, it clearly has a significant impact on the fund and its ability to do that,” Helenius said.
QIC’s Barnes said that having a solid understanding of the various types of liquidity risks that funds could be exposed to should form the basis of any risk management framework. “Any framework needs to start with an assessment of the key risks that funds are exposed to. Is it client redemption risk? Is it client subscription risk? Is it the ability to meet capital requirements and margin calls or is it replacement risk, the ability to replicate exposures as positions mature at a fair and reasonable price? It’s about understanding the most critical liquidity risks that your fund is exposed to and then stress testing your ability to wear those risks,” Barnes said.
Among the scenarios currently being stress tested by QIC are the impact of a sudden shock or market movement on margin calls and the reduction of liquidity in the key market segment relative to the investment teams’ mandates.
“If liquidity in a particular market suddenly dried up, what would that mean for our funds, their liquidity tiering and our ability to meet redemptions or subscription requests from clients? It’s about assessing how we would respond and what the action plan would be if there was a liquidity event within in a particular part of the market,” Barnes said.
“Liquidity management plans, and a clear understanding of the actions that will be put in place to respond to a crisis, need to be in place and tested before, and not after, the next major liquidity crisis arises,” Helenius said.
Getting a strong handle on the likely liquidity of your positions can also have advantages beyond merely being able to survive the next crisis. The advantage of developing an understanding of the likely liquidity in stressed conditions is that you can plan ahead and take advantage of new opportunities.
“Following a crisis, there’s typically a period in which assets are cheap. It’s worth thinking ahead to consider how the fund might be able to take advantage of those opportunities. For example, rather than immediately selling your most liquid assets during a downturn, you might want to take a loss and sell less liquid assets so that you can free up cash later on. We don’t see many funds taking their analysis to this next level, but understanding your liquidity will put you in a better position,” the regulatory expert said.