Michael Derwael (ALRiM): Plumbing for liquidity crises

New insights into the multifaceted nature of liquidity risk were required when asset managers confronted the Covid-19 pandemic. However, Michael Derwael, Board Member at ARLiM and Global Independent Risk Management Officer at MFS Investment Management, says existing guidance and familiarity with a risk management toolbox allowed the industry to navigate a way through the crisis.

Has the Covid crisis transformed the job/focus of the risk manager?

The two main impacts of the crisis were the risks of creating a mostly remote workforce and a seizure in markets that reminded us that overlooking risks, because they have been mostly benign for so long, can be costly (I’m referring to liquidity risks). Paradoxically these brought to the fore the need for a more global stance to risk rather than the trend towards specialised compliance on which risk managers had been focussing. Risk managers needed to ensure that processes remained sound - highlighting the importance of ongoing controls and due diligence. Emphasis needed to be placed on managing the multi-faceted aspects of the possible re-emergence of liquidity risks. This requires a complete risk toolbox: an understanding of the interaction of the multiple risks and the stewardship of an organisation to use the most suitable mix of those tools to the best advantage.

“A seizure in markets that reminded us that overlooking risks, because they have been mostly benign for so long, can be costly.”

Michael Derwael, ALRiM Board Member, Global Independent Risk Management Officer, MFS Investment Management

How did financial markets’ reaction to this crisis differ from previous crises?

While you can draw parallels with historical financial events, every new crunch is unique and brings its own challenges. For example, in past crises, risk processes were thought out and tested for centralised, office-based organisations. Covid has created new and unassessed risks in the transition to remote working. These could have easily resulted in heightened operational risks with key process and communication not operating as efficiently as previously or even breaking down. We have also seen the decade long bull market with investors chasing returns and investing into less familiar assets. This has created uncertainty around valuations of specific asset segments and potential liquidity risks in the event of an attempted sell -off. Despite these challenges, Luxembourg’s financial industry proved immensely adaptable and resilient.

Has the crisis brought new insights or new problems regarding liquidity risk?

Although liquidity risk is a familiar concept, there is little consensus about how to best assess, manage and communicate the full range of risks it embraces. The regulators’ drive to frame and streamline approaches brings clear advantages as it facilitates a robust dialogue. There may be drawbacks in attempts to impose a single way of framing the discussion as, potentially, other pertinent views may end up being ignored. Initially, the industry challenged the usefulness and stringency of ESMA guidelines around liquidity stress-testing. However, with hindsight, I think we can agree that some of these concepts (comprehensive liquidity risk profile, reverse stress testing, use of LMTs (liquidity management tools) have been very useful. It has assisted the assessment of decisions about liquidity risk management as well as informing clients and regulators. Managers in other jurisdictions were not as fortunate as those in Luxembourg where the regulators allowed us to use a range of liquidity management tools, tools that facilitated the continuing flow of liquidity that helped preserve financial stability.