17 Liquidity Risk Management Recommendations from The New Zealand Financial Market Authority (FMA)
Liquidity risk in managed funds has been a prominent and increasing concern of regulators globally, particularly in the past two years, in the wake of some high-profile liquidity events. The New Zealand Financial Market Authority (FMA), following a familiar trend we’ve seen recently from many regulators, has published a liquidity risk management report.
The report contains recommendations on liquidity risk management frameworks (with a focus on stress testing), processes, and procedures. The report follows the liquidity risk management good practice guide the FMA published last year, and also the survey the FMA issued last August asking Managed Investment Scheme managers (MIS managers) to self-assess their liquidity risk management capabilities.
Following the survey, the FMA found that MIS managers, in general, appear to have a positive view of their liquidity risk management capabilities, including stress testing. The FMA however, considered this positivity to be “overly optimistic” based on the responses to the survey.
The FMA have made the following recommendations within the report:
1. All MIS managers should define explicit internal investor concentration thresholds and targets, and report these regularly as an integral part of scheme structuring and risk management policy.
2. MIS managers, including those with modest investor concentrations, should undertake sensitivity analysis/stress-testing to gauge the potential impact of withdrawals by their or each fund’s largest investors.
Liquidity stress testing scope, extent and frequency
3. MIS managers should review and constructively challenge the adequacy of their liquidity risk management frameworks, policies, procedures and risk appetite against their obligations associated with their MIS Manager Licence. This includes taking account of the distinctive features of their funds: asset types, investor profiles, related concentrations and market conditions.
4. MIS managers should undertake liquidity stress testing for all the funds they manage (whether individually or collectively) at least annually and more frequently if their fund structure and/or market conditions warrant. If the stress testing is undertaken by a third party on behalf of the fund, this does not absolve MIS management and board members from taking responsibility for the tests and satisfying themselves that the results have been taken into account and factored into decision making.
Liquidity management tools (LMTs)
5. MIS managers should explicitly define the LMTs they have available for use, assess conditions under which they will be deployed (and withdrawn), and how their use ensures ‘fair treatment’. This will help provide more stability during uncertain times.
6. MIS managers should maintain a written chronological record of their use of LMTs, including the conditions when deployed (and withdrawn), decisions made, results and lessons learned. This information will inform their future use of LMTs. This will provide a great opportunity to identify improvement areas and trends in tool use, and to improve oversight of tool use by boards, senior management and supervisors.
7. MIS managers should review and expand their suite of available LMTs beyond those they currently use, with a particular focus on LMTs suited to the ‘pending’ phase in an emerging liquidity crisis, which could help avoid suspending redemptions in future.
8. MIS managers should consider the use of LMTs in conjunction with other complementary/related tools (e.g. early-warning metrics) to effect better outcomes.
9. Mortgage MIS managers should actively explore augmenting their LMTs across all groups described in this report.
Liquidity risk governance, frameworks, policies, procedures and metrics
10. LRM policies should be reviewed in accordance with good practice principles and implemented in a way that reflects the particular characteristics of each fund, which will help raise standards.
11. MIS managers should have an LRM policy endorsed by the board. A formal policy helps ensure accountability and consistency in application, provides a starting point during a crisis, and provides visibility to the board of levers available in a crisis.
12. MIS managers should have an asset valuation policy that includes ‘fair valuation’ rules, particularly when market valuations are unavailable. These policies should consider at what point a valuation becomes stale for a particular asset or equity type. This will not only help during times of liquidity and pricing issues but also provide a mechanism to measure performance in this area.
13. MIS managers should consider more training on liquidity risk and LRM. This should include tool use and stress testing, and how this reporting can positively impact decision making.
14. MIS managers should consider improving the measuring and reporting of all risk types against respective risk management policies, to provide greater insight into performance against risk appetite.
Fund of Funds Managers
15. All FOF MIS managers, in line their licence conditions, should have good oversight and proactively consider on an ongoing basis the liquidity stress testing and use of LMTs undertaken by their underlying MIS managers. MIS managers should form their own conclusions and responses from these tests, in order to determine whether they are effectively discharging their risk management oversight obligations, and have visibility of when and how their underlying managers use/might use LMTs (i.e. ‘no surprises’).
16. In general, managers should implement relevant liability liquidity metrics such as, but not limited to: investor types, investor concentrations, and projected (and stressed) redemptions. This could allow for better visibility of potential redemption factors that could impact on performance/liquidity of the fund.
17. MIS managers should have a definition of ‘illiquid assets’ suited to their funds’ asset composition (current and targeted). The definition should take account of policy statements of regulators and be used in conjunction with other measures to monitor and manage relative liquidity across a fund’s asset classes, as without a clear definition of what an ‘illiquid asset’ is, you cannot accurately monitor the asset for its liquidity. Incorporating a clear definition, with metrics to track the performance, could greatly enhance oversight of the assets at a board, executive manager and supervisor level.
How we can help?
The issue of illiquid assets and open-ended funds has gained heightened prominence and regulator focus, most recently since 2019 after the suspension of the high profile LF Woodford Equity Income Fund and the COVID-19 pandemic. Issues such as this are likely to grow in prominence as mutual funds increasingly seek out and/or rely upon illiquid assets to generate greater returns in the prevailing and foreseeable low interest rate environment. For this reason, it is paramount that managers have in place tools in place to monitor their liquidity.
The Funds-Axis Liquidity Risk Management Solution can reduce this burden and increased workload, and assist firms with meeting these liquidity requirements in both times of market normality and stress.
Our solution has been designed to meet international requirements in respect of Liquidity Risk Management and Liquidity Stress Testing. It is a holistic module which embeds Liquidity Risk Management Monitoring into product governance, throughout the product lifecycle.