A methodological approach to identify low probability paths with severe consequences applied to the management of Asset Liability Management ALM.
The problems resulting liquidity crisis of recent years highlighted the importance of adequate management of liquidity risks of financial institutions. In response, the Committee on Banking Supervision in 2008 published the Principles for the proper management and supervision of liquidity risk (“Sound Principles”) on how to manage and monitor funding liquidity risk in order to promote better risk management. To this end, financial institutions have to meet short-term (LCR Liquidity Coverage Ratio) rules on liquidity ratios and long-term (NSFR, Net Stable Funding Ratio). These coefficients correspond to the analysis of a static image of the balance sheet structure of the entity considering an adverse default scenario, very severe, but that not fits correctly to the idiosyncrasies of a particular entity.
What Basilea Committee recommends is using complementary methodologies for optimal decision making.
In the 60s, NASA began using advanced methodologies to analyze all possible paths derived from launching astronauts into space successfully to assess the risks. In the 80s, after the accident of Nuclear Power Three Mile Island in the USA, also the Nuclear Industry started the probabilistic study of the risks of a serious accident. Since then, these methods have shown the ability to manage the risks and make risk informed decisions to high risk industries.
We think that both experiences can be transferred and applied to financial institutions to assess the consequences of a severe accident, systematically analyzing the possible paths of any stress scenario and validate the applicability of the appropriate corrective measures.