Download - 8 Liquidity Risk
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Liquidity risk
Giampaolo Gabbi
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Agenda
Liquidity risk: what it is and where it comes from
Funding liquidity risk
Stock-based approach
Cash flow based approach
Hybrid approach
Stress tests and contingency funding plans
The Basel Committee framework
Principles for liquidity risk management and supervision Liquidity coverage ratio
Net stable funding ratio
Market liquidity risk
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One of the main reasons the economic and financial crisis became sosevere was that the banking sectors of many countries had built upexcessive on- and off-balance sheet leverage.
This was accompanied by a gradual erosion of the level and quality of thecapital base.
At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic
trading and credit losses nor could it cope with the re-intermediation oflarge off-balance sheet exposures that had built up in the shadow bankingsystem.
The crisis was further amplified by a procyclical deleveraging process andby the interconnectedness of systemic institutions through an array ofcomplex transactions
Basel Committee, Strengthening the resilience of the banking sector - consultative
document
The Basel Committee December 2009
proposals
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Some figures from the market:
Interbank Interest Rates
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Interbank Interest Rates Volatility
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Infra Day Interbank Interest Rates
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Interbank Volumes
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Interbank Trades
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Interbank Market Active Banks
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Liquidity
Asset and liability mismatch generates not only interest raterisk liquidity risk
Different meaning of liquidity:
Security ease with which it can be cashed back or traded, even
in large amounts, on a secondary market
Market liquidity of the securities traded in the market differentproxies of liquidity (e.g. bid-ask spread, volume)
Affected by many factors: n. mkt participants, size & frequency of trades,degree of informational asymmetry, time needed to carry out a trade
Function of tightness (markets ability to match supply and demand at lowcost) and depth (ability to absorb large trades without significant price impact)
Financial institutionability to fund increases in assets and meetobligations as they come due, without incurring high losses
Generally proxied by the difference between the average liquidity of assetsand that of liabilities
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Liquidity risk
Liquidity risk risk that a financial institution may not be able to pay back its
liabilities in a timely manner because of an unexpectedly largeamount of claims
more realistically, it may be able to meet those requests only byquickly selling (fire sale) large amounts of assets, at a price that isbelow their current market value, thereby suffering a loss
The role of banks in the maturity transformation of short-term deposits into long-term loans makes banks
inherently vulnerable to liquidity risk
Liquidity risk depends not only on the final maturity ofassets and liabilities, but also on the maturity of eachintermediate cash flow, including the early pre-payment
of loans or the unforeseen usage of credit lines
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Liquidity risk
2 types of liquidity risk
Funding risk risk that a F.I. may not be able to faceefficiently (i.e. without jeopardising its orderly operationsand its financial balance) any expected or unexpected
cash outflows Market liquidity risk risk that a F.I., to liquidate a sizable
amount of assets, will affect the price in a considerable(and unfavourable) manner, because of the limited depthof the market where the assets are traded
The two risk types are connected a F.I. wishing to faceunexpected cash outflows may need to sell a largeamount of securities potential sharp fall in price
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Funding liquidity risk
Relevant factors Contractual maturity of assets and liabilities Optionality in bank products e.g. demand deposits,
guarantees issued, irrevocable loan commitments (e.g.
SPVs related to securitization or CP programs),derivatives involving margin requirements
Two main type of events
Bank specific events events that distress the
confidence of third parties rating downgrades(especially relevant when covenants or triggers minimum rating required)
Systemic events e.g. market disruption, liquidity dry up(e.g. recent financial crisis)
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Funding liquidity risk
Three main measurement approaches Stock based approach
Measures the stock of financial assets that can promptly beliquidated to face a possible liquidity shock
Cash flow based approach Compares expected cash inflows and outflows, grouping them in
homogeneous maturity buckets and checking that cash inflowsare large enough to cover cash outflows
Hybrid approach Potential cash flows coming from the sale (or use as collateral) of
financial assets are added to actual expected cash flows
Actual cash flows - adjusted to take into account expectedcounterparties behaviour are used in all approaches(not contractual ones)
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Stock based approach
Measures the stock of financial assets that can promptlybe liquidated to face a liquidity shock
Requires the banks BS be re-stated contribution eachitem gives to creating/hedging funding risks
Cashable assets (CA) all assets that can quickly beconverted into cash
Volatile liabilities (VL) short term funds for which there isa risk that they may not be rolled over (wholesale fundingand volatile portion of customer deposits)
Commitments to lend (CL) OBS items representingirrevocable commitment to issue funds upon request
Steadily available credit lines (AL) irrevocablecommitments to lend issued to the bank by third parties(usually, other F.I.s)
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Stock based approach
Cashable assets (CA)
Short-term deposits
Loans short-term credit lines (e.g., o/n and other interbankfacilities) than can be easily and effectively claimed back
without endangering the customer relationships Securities only unencumbered positions (not used as
collateral against loans or derivative contracts) may alsoinclude long term bonds or shares. Does not include securitiesnot traded on a liquid market and not eligible not accepted
as collateral (e.g., shares in private companies held formerchant banking purposes, unrated bonds, etc.)
Need of a haircut for: possible loss relative to the market price
difference between current value and value of the short-term loans that
could be obtained by pledging them as collateral
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Stock based approach
Assets Liabilities
Cash & equivalent 10 Sort term deposits 100
Loans (cashable) Customer deposits
- O/n and similar int/bank fac.s, easily cashable 200 - volatile portion 600
Securities (unencumbered)
- Not used as collateral 1.000- Less haircut -120
Total cashable assets (CA) 1,090 Total volatile liabilities (VL) 700
Loans (others) Customer deposits
- Credit lines not easily cashable 580 - Stable portion 1,600
- Maturity loans 1,500 Medium to long term funding 1,000
Securities (others) Other long term funds 300
- used as collateral 400 Capital 400- Not cashable nor accepted as collateral 20
- haircut 120
Fixed fin. assets (minorities, participations, etc.) 150
Fixed real assets 100
Goodwill 40
Total per cassa 4,000 Total 4,000
Commitments to lend (CL) 300 Steadily available credit lines (AL) 80
Assets Liabilities
Cash & equivalent 10 Sort term deposits 100
Loans (cashable) Customer deposits
- O/n and similar int/bank fac.s, easily cashable 200 - volatile portion 600
Securities (unencumbered)
- Not used as collateral 1.000- Less haircut -120
Total cashable assets (CA) 1,090 Total volatile liabilities (VL) 700
Loans (others) Customer deposits
- Credit lines not easily cashable 580 - Stable portion 1,600
- Maturity loans 1,500 Medium to long term funding 1,000
Securities (others) Other long term funds 300
- used as collateral 400 Capital 400- Not cashable nor accepted as collateral 20
- haircut 120
Fixed fin. assets (minorities, participations, etc.) 150
Fixed real assets 100
Goodwill 40
Total per cassa 4,000 Total 4,000
Commitments to lend (CL) 300 Steadily available credit lines (AL) 80
Example of a reclassified B/S
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Stock based approach
Cash Capital Position (CCP)
Share of cashable assets not absorbed by volatile liabilities
Signals banks ability to withstand liquidity shortages due to:
greater-than-expected volatility in funding sources unexpected difficulties in the mgmt of cashable assets
(e.g. increase haircuts due to unfavourable fin. markets)
To control for banks size, CCP sometimes scaled by total
assets
Example previous slide
CCP = CA VL = 390 = 9.75% TA
CCP = CA VL CL = 90 = 2.25% TA
CCP CA VL CL
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Stock based approach
Long term funding ratios (LTFR) alternative measure ofliquidity based on stocks
% of assets with a maturity > 5 years funded with
liabilities with maturity > 5 years or with capital
Portion of assets with a maturity greater than n years
which is being funded with liabilities having an equally
great maturity
Banks transform ST liabilities into MTL term loans
LTFR usually below 100%
Low values (or a deterioration over time) may indicate
unbalances/weaknesses in the maturity structure of
assets & liabilities
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Cash flow based approach
CCP based on simplified approach assets and liabilitiesare either stable or unstable (binary approach)
In reality many different degrees of stability/liquidity exist
Underlying logic of CF based approaches: restate BS items going beyond a binary logic maturity ladder
also called mismatch based approach
Cash flows are sorted across the different maturitiesbased on:
contractual maturities (including intermediate cash flows)
banks expectations
past experience
Mismatch or liquidity gap (Gt) net unbalance inflowsand outflows
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Cash flow based approach
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows Net
flows
Net
cum.tive
flowsLoans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 10 -20 -20 -10 0 0
1 week 30 -50 -20 -15 -55 -55
2 weeks 80 -70 -15 -20 -25 -80
1 month 70 100 -200 -15 -50 -10 -105 -185
2 months 100 90 -330 -10 -50 -10 -210 -395
3 months 200 110 -300 -10 -100 -10 -110 -505
1 year 400 100 -400 -110 -100 -110 -615
3 years 400 200 -300 -200 -300 -200 -815
5 years 300 700 -650 -450 -100 -915
10 years 650 100 750 -165
Beyond 200 50 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows Net
flows
Net
cum.tive
flowsLoans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 10 -20 -20 -10 0 0
1 week 30 -50 -20 -15 -55 -55
2 weeks 80 -70 -15 -20 -25 -80
1 month 70 100 -200 -15 -50 -10 -105 -185
2 months 100 90 -330 -10 -50 -10 -210 -395
3 months 200 110 -300 -10 -100 -10 -110 -505
1 year 400 100 -400 -110 -100 -110 -615
3 years 400 200 -300 -200 -300 -200 -815
5 years 300 700 -650 -450 -100 -915
10 years 650 100 750 -165
Beyond 200 50 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Example of expected cash flows
As in the stock-based approaches, demand deposits and loans are dealt with based on
their expected actual maturity
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Cash flow based approach
Two type of indicators
Cumulative liquidity gap unbalance between flowsassociated with a given band and all shorter maturities
Marginal liquidity gaps Gts related to one time band
Note that, when sorting assets and liabilities across time
bands, we are considering: cash flows not stocks
their expected maturity, not their repricing period
titt GCG
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Cash flow based approach
Negative cumulative liquidity gap bank cannot cover
foreseeable cash payments with expected inflows
severe warning of potential liquidity shortage
However, one weakness cash flows associated with
securities (including unencumbered assets) are basedon contractual maturities and coupons assets can be
used as collateral to get new loans, also at a very short
notice
re-write the maturity ladder taking into account role ofunencumbered assetsin facing liquidity risks
Hybrid approach
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Hybrid approach
CF based approach CFs from securities are sorted
into maturity buckets based on contractual maturity a
10-year ZC bond face value10 mln entirely associated
with 10 year band
Banks treasurer can manage liquidity shortages by
selling the bond or using it to get funded through a
collateralised loan or repo
Haircut funds raised would only be a share (e.g.,
90%) of the bonds mkt value (which would be less thanface value) e.g. 7 million 70% can be cashed
quickly, rest (interest and haircut) available in 10 years
This only applies to unencumbered eligible assets
assets the bank can freely sell or pledge as collateral
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Hybrid approach
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows Net
flows
Net
cum.tive
flowsLoans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 600 10 -20 -20 -10 0 600
1 week 30 100 -50 -20 -15 -55 645
2 weeks 80 100 -70 -15 -20 -25 720
1 month 70 80 -200 -15 -50 -10 -105 595
2 months 100 -330 -10 -50 -10 -210 295
3 months 200 -300 -10 -100 -10 -110 75
1 year 400 -400 -110 -100 -110 -135
3 years 400 150 -300 -200 -300 -200 -385
5 years 300 300 -650 -450 -100 -885
10 years 650 120 750 -115
Beyond 200 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows Net
flows
Net
cum.tive
flowsLoans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 600 10 -20 -20 -10 0 600
1 week 30 100 -50 -20 -15 -55 645
2 weeks 80 100 -70 -15 -20 -25 720
1 month 70 80 -200 -15 -50 -10 -105 595
2 months 100 -330 -10 -50 -10 -210 295
3 months 200 -300 -10 -100 -10 -110 75
1 year 400 -400 -110 -100 -110 -135
3 years 400 150 -300 -200 -300 -200 -385
5 years 300 300 -650 -450 -100 -885
10 years 650 120 750 -115
Beyond 200 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Modified expected CFs taking into account unencumbered assets
Net cash flows look much better using this approach
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Hybrid approach
-1500
-1000
-500
0
500
1000
Loans
Securities
Cash and short-term
Customer deposits
Other deposits
Bonds
Commitments lo lend
Cumulative net flows
Liquidity gaps(marginal andcumulative) forshortermaturities are
now positive
The bank looksimmune toliquidity
shortages forthe shortermaturities
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Hybrid approach
Results achieved so far are affected by
assumptions on timing and amounts uncertainty
concerning:
Amount e.g. floating rate securities, IRS, European options Timing e.g. long-term mortgages being pre-paid, demand
deposits left with the bank for years
Both amount and timing cash flows associated to open
credit lines or commitments to lend
It is important to consider not only an expected scenario, but
also check how the liquidity gaps would deteriorate in worst
case scenarios stress test
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Stress test
Stress test simulation exercise aimed at quantifying the
effects of an especially adverse scenario
Three main approaches
Historical approach historical scenarios (e.g., % of demand deposits
unexpectedly withdrawn within 2 or 4 weeks) Statistical approach historical data to infer probability distribution of risk
factors reasonable estimate of potential shocks (e.g., on deposits,
haircuts, interbank loans, etc.)
Judgement-based approach subjective appraisals by the banks
management (support of risk management, supervisors or consultants)
These approaches can be used to simulate individual risk
factors separately or jointly (worst case scenarios)
A. bank run on demand deposits
B. increase in market volatility increase haircuts on unencumbered assets
C. A+B jointly
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Stress test
Stressed scenarios are rather intuitive in principle, but theirpractical implementation can prove difficult:1. A stress exercise is usually limited to a number of selected B/S
items (e.g. effect of an extreme scenario on the time profile of cash
flows associated only with securities, ignoring other assets andliabilities) a market turmoil may be accompanied by an increasein customer deposits as investors would postpone their assetallocation choices indirect effects should also be included
2. When more risk factors are considered jointly (e.g., a bank run andan increase in market volatility) a simple algebraic summation of
their effects may not be correct pessimistic if risk factors are not strongly correlated (probability)
optimistic., if the two shocks are mutually reinforcing (impact) e.g.confidence crisis hitting a bank in the midst of a market-wide currencycrisis the pressure on deposits might be stronger than it would be ina quiet macroeconomic environment
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Contingency funding plans (CFP)
Stressed scenarios can prove useful in building contingency
funding plans (CFP) to be triggered in case of extreme scenario
CFP surveys all possible sources of extra funds in the event of a
liquidity shock (e.g. temporary withdrawals of compulsory
reserves, repos with CB, secured or unsecured interbank loans)
CFP sets priority order (ranking) in which they should be tapped
cost and flexibility of the sources and type of liquidity shock
(e.g. interbank loans in case of an institution-specific shock vs.
intervention of Central Bank in case of a market-wide crisis CFP describes people and structures responsible for
implementing emergency policies and actions to be taken
A credible CFP can quickly bring panic under control, limiting
the duration and breadth of the liquidity shortage
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Funding liquidity risk
Some peculiarities of funding liquidity risk vs other risks
Liquidity risk not necessarily risk of losses
Assets & Liabilities mismatch does not need to be faced
by capital by high quality liquid (unencumbered)assets more capital simply makes a liquidity crisis
less likely
If the bank is made up of different legal entities, in the
event of a liquidity crisis liquid funds cannot freely bemoved from one entity to the other due to the opposition
of some supervisory authorities
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Organizational issues
Liquidity risk management requires systematic approach with clear
organizational rules systematic approach also required by Basel
E.g. Liquidity risk management (LRM)
LRM policy key role of board of directors
ensures liquidity risk is correctly identified, measured, monitored andcontrolled
defines risk tolerance and strategy for liquidity risk management
identifies roles and responsibilities of the LRM Unit
receives periodic reports on the liquidity situation
Examples of periodic reports
analysis of the flow of funds contingency funding plan
list of largest providers of funds
funding gap and maturity structure
structure and composition of the bank's balance sheet
size and cost of more recent very short term funding
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Organizational issues
Limits are generally imposed to risk-taking units they may
refer to different measures examples:
Max absolute maturity gap
Max volume of overnight funding in relation to total assets
Max gap between liquid assets and ST liabilities Min liquid assets net of expected erosion in case of stress
Max concentration of liabilities across counterparties
Key role internal audit in LRM process e.g. consistency
between policies set by senior mgmt and day-by-day risk mgmt,
adequacy of processes and soundness of measures Often an ALM Committee (ALCO) representatives of all
business areas that affect liquidity risk responsible for development of specific policies for LRM
ensuring adequacy of measurement system
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Organizational issues
Liquidity Risk Management unit responsible for:
identifying liquidity risks incurred by the bank
monitoring evolution of liquidity profile
developing policies for controlling and mitigating liquidity risk
developing appropriate rules for liquidity risk management
roles,responsibilities and organizational structure; limits; policies and formats for
reporting to senior management
Developing liquidity contingency plan
Early warnings events signalling liquidity shortages in
advance Internal early warnings e.g. increased concentration of assets orliabilities, increase of assets funded by volatile funding
External indicators e.g. rating downgrades, decline in the banks stock
price; increase in the banks CDS spread; increase in the trading volume
of securities issued by the bank, increase in requests for guarantees,
increase in the cost of funding, request for (additional) collateral by
Basel Committee: Principles for the
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Basel Committee: Principles for themanagement and supervision of liquidity
risk
Key elements of a robust framework for liquidity risk mgmt:
board and senior management oversight
establishment of policies and risk tolerance
use of liquidity risk management tools such ascomprehensive cash flow forecasting, limits and liquidity
scenario stress testing
development of robust and multifaceted contingency
funding plans maintenance of a sufficient cushion of high quality liquid
assets to meet contingent liquidity needs
ase omm ee: r nc p es or e
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ase omm ee: r nc p es or emanagement and supervision of
liquidity riskFundamental principle for the mgmt and supervision of liquidity risk 1. A bank is responsible for the sound management of liquidity risk. A
bank should establish a robust liquidity risk management frameworkthat ensures it maintains sufficient liquidity, including a cushion ofunencumbered, high quality liquid assets, to withstand a range ofstress events, including those involving the loss or impairment of both
unsecured and secured funding sources.Governance of liquidity risk management
2: A bank should clearly articulate a liquidity risk tolerance that isappropriate for its business strategy and its role in the financialsystem.
3: Senior management should develop a strategy, policies and
practices to manage liquidity risk in accordance with the risk toleranceand to ensure that the bank maintains sufficient liquidity.
4: A bank should incorporate liquidity costs, benefits and risks in theinternal pricing, performance measurement and new product approvalprocess for all significant business activities (both on- and off-balancesheet)
ase omm ee: r nc p es or e
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ase omm ee: r nc p es or emanagement and supervision of
liquidity riskMeasurement and management of liquidity risk 5: A bank should have a sound process for identifying, measuring, monitoring
and controlling liquidity risk projecting cash flows arising from assets,liabilities and off-balance sheet items
6: A bank should actively monitor and control liquidity risk and funding needswithin and across legal entities, business lines and currencies
7: A bank should establish a funding strategy that provides effectivediversification in the sources and tenor of funding.
8: A bank should actively manage its intraday liquidity positions and risks tomeet payment and settlement obligations on a timely basis under both normaland stressed conditions
9: A bank should actively manage its collateral positions, differentiatingbetween encumbered and unencumbered assets
10: A bank should conduct stress tests on a regular basis and use stress testoutcomes to adjust its liquidity risk management strategies, policies, andpositions
11: A bank should have a formal contingency funding plan (CFP) that clearlysets out the strategies for addressing liquidity shortfalls in emergencysituations
12: A bank should maintain a cushion of unencumbered, high quality liquidassets to be held as insurance against liquidity stress scenarios
ase omm ee: r nc p es or e
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ase omm ee: r nc p es or emanagement and supervision of
liquidity riskPublic disclosure 13: A bank should publicly disclose information on a regular basis that
enables market participants to make an informed judgement aboutthe soundness of its liquidity risk management framework and liquidityposition
The role of supervisors 14: Supervisors should regularly perform a comprehensive
assessment of a banks overall liquidity risk management frameworkand liquidity position
15: Supervisors should supplement their regular assessments of abanks liquidity risk management framework and liquidity position bymonitoring a combination of internal reports, prudential reports and
market information 16: Supervisors should intervene to require effective and timely
remedial action by a bank to address deficiencies in its liquidity riskmanagement processes or liquidity position.
17: Supervisors should communicate with other supervisors andpublic authorities, to facilitate effective cooperation regarding the
supervision and oversight of liquidity risk management
C
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Basel Committee recent proposals
(Dec. 2009)
Two internationally consistent regulatory standards
Liquidity coverage ratio
Aimed at ensuring that a bank maintains an adequate level of high
quality assets that can be converted into cash to meet its liquidity
needs for a 30-day horizon under a liquidity stress scenario Stock of high quality liquid assets/Net cash outflows over a 30-day
time period 100%
Net stable funding ratio
Aimed at promoting more medium and long-term funding of the
assets and activities of banking organisations
Minimum acceptable amount of stable funding based on the
liquidity of a banks assets and activities over a 1 year horizon
Available amount of stable funding/Required amount of stable
funding > 100%
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Liquidity coverage ratio
High quality assets
Net cash outflows over
30 days Andrea Resti
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Liquidity coverage ratio
High quality assets Unencumbered not pledged either explicitly or implicitly in any way to
secure, collateralise or credit enhance any transaction (e.g. covered bonds)
and not held as a hedge for any other exposure
Liquid during a time of stress and, ideally, central bank eligible
Fundamental characteristics
Low credit and market risk
Ease and certainty of valuation
Low correlation with risky assets
Listed on a developed and recognised exchange market
Market-related characteristics
Active and sizable market
Presence of committed market makers
Low market concentration
Flight to quality
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High quality assets unencumbered, high quality liquid assets
(ununcumbered: not pledged either explicitly or implicitly in any way tosecure, collateralise or credit enhance any transaction and not held as
a hedge for any other exposure) examples:
a) Cashb) CB reserves
c) Marketable securities representing claims guaranteed by sovereigns,
CBs, non-central gov.t public sector entities (PSEs), BIS, IMF, or
multilateral dev.t banks as long as all the following criteria are met:
i. 0% risk-weight under the Basel II standardised approachii. deep repo-markets exist for these securities
iii. the securities are not issued by banks or other financial services entities
d) Gov.t or CB debt issued in domestic currencies by the country in which
the liquidity risk is being taken or the banks home country
Liquidity coverage ratio
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Net cash outflows
Cumulative expected cash outflows minus cumulative
expected cash inflows arising in the specified stress
scenario in the time period under consideration
Net cumulative liquidity mismatch position under the
stress scenario measured at the test horizon
Cumulative expected cash outflows are calculated by multiplying
outstanding balances of various categories of liabilities by
assumed % that are expected to roll-off, and by multiplyingspecified draw-down amounts to various OBS commitments
Cumulative expected cash inflows are calculated by multiplying
amounts receivable by a percentage that reflects expected inflow
under the stress scenario
Liquidity coverage ratio
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Scenario combined idiosyncratic & market-wide shock:a) a three-notch downgrade in the institutions public credit rating;
b) run-off of a proportion of retail deposits;
c) a loss of unsecured wholesale funding capacity and reductions ofpotential sources of secured funding on a term basis;
d) loss of secured, short-term financing transactions for all but highquality liquid assets;
e) increases in market volatilities that impact the quality of collateral orpotential future exposure of derivatives positions and thus requiringlarger collateral haircuts or additional collateral;
f) unscheduled draws on all of the institutions committed but unused
credit and liquidity facilitiesg) need for the institution to fund balance sheet growth arising from
non-contractual obligations honoured in the interest of mitigatingreputational risk
many of the shocks actually experienced during the financialcrisis
Liquidity coverage ratio
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Available amount of stable funding/Required amount of
stable funding > 100%
NSFR standard is structured to ensure that investment
banking inventories, off-balance sheet exposures,
securitisation pipelines and other assets and activities are
funded with at least a minimum amount of stable liabilities
in relation to their requirement as these inflows and
outflows are assumed to off-set each other
The NSFR aims to limit over-reliance on wholesale fundingduring times of buoyant market liquidity and encourage
better assessment of liquidity risk across all on and off-
balance sheet items
Net stable funding ratio
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Net stable funding ratio
Goal:To reduce the
mismatching ofasset and liabilities
We could say banks
should drive a bikewhose liabilityturns over morerapidly than assetspeed
Stable asset must becovered by thesame volume ofstable liabilities
Assets
Liabilities
Andrea Resti
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Net stable funding ratio
ASF Factor Component of AFS Category
100% Capital (both Tier 1 and Tier 2) Preferred stock not included in Tier 2 (maturity > 1 year) Secured and unsecured borrowings and liabilities (including term deposits) with
maturities > 1year
85% Stable" non-maturity retail deposits and/or term retail deposits with residualmaturities < 1 year "Stable" unsecured wholesale funding, non-maturity deposits and/or term deposits
with a residual maturity < 1 year, provided by small business customers
70% "Less stable" non-maturity retail deposits and/or term retail deposits with residualmaturities of less than one year.
"Less stable" unsecured wholesale funding, nonmaturity deposits and/or termdeposits with a residual maturity of less than one year, provided by small businesscustomers
Less stabledeposits not covered by deposit insurance, high value-deposits,deposits of high net worth individuals, deposits which can be withdrawn quickly (eginternet deposits) and foreign currency ones
50% Unsecured wholesale funding, non-maturity deposits and/or term deposits with aresidual maturity < 1 year, provided by non-financial corporate customers
0% All other liabilities
Available amount of stable funding (ASF)
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Net stable funding ratio
Required Stable Funding (RSF): Asset Categories and Associated FactorsRSF Factor Summary Composition of Asset Categories RSF Factor
0% Cash, money market instruments Securities with effective remaining maturities of less than one year Outstanding loans to financial entities having effective maturities of less than one
year.
5% Unencumbered marketable securities with residual maturities one yearrepresentingclaims on sovereigns, central banks, BIS, IMF, EC, noncentral government PSEs ormultilateral development banks which are rated AA or higher and are assigned a 0%risk weight under the Basel II standardised approach, provided that active repo-markets exist for these securities.
20% Unencumbered corporate bonds (or covered bonds) rated at least AA with aneffective maturity of one year which are traded in deep, active and liquid marketsand which also have a demonstrated history of being a reliable liquidity source in astressed market environment.
50% Gold
Unencumbered equity securities listed on a major exchange and included in a largecapital market index and unencumbered corporate bonds (or covered bonds) ratedAA- to A- with an effective maturity of one yearwhich are traded in deep, active andliquid markets and which also have a demonstrated history of being a reliable liquiditysource in a stressed market environment.
Loans to non-financial corporate clients having a residual maturity of less than oneyear.
85% Loans to retail clients with a residual maturity < 1 year
100% All other assets
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LCR
Similar to a CCP minimum requirement where the
denominator is substituted by a net cash outflow
estimate Combination of a stock based and a cash flow based
measure
NSFR
Similar to a long term funding ratio (LTFR)
More sophisticated as different items are assigned
different weights
The Basel requirements
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Market liquidity risk risk that a F.I., to liquidate a sizable
amount of assets, will end up affecting the price in a
considerable (and unfavourable) manner, because of the limited
depth of the market where the assets are traded
Market liquidity risk can be twofold Exogenousgeneral market characteristics outside control of bank
Endogenousbanks characteristics (e.g. composition and size of itsportfolio)
Market liquidity is measured through the lack of it transaction
costs explicit and implicit incurred by investors to trade: Bid-ask spread
Market impact difference between actual transaction price and price that
would have prevailed if the transaction had not taken place the higher
the lower is market liquidity
Market liquidity risk
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Market liquidity risk
If no uncertainty on market impact liquidation value is
equal to bid price transaction cost
If large sale impact on spread deviation from its
mean value s + k(increasing function of position size
Pand decreasing function of market size M)
2
SPC
t
bid/ask spread
mid-quote at time t
,2
s k P M C P
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Market liquidity risk
askprice
mid price
price
s
bid price
Quote depth Sizeof the Position (P)
Transaction costs
can be expected toincrease with the
transaction size, or,
namely, with its
impact in relation to
market depth
Traded volume and bid-ask spread(Bangia, et al. 1999)
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Market liquidity risk
1
21 ( )
2
hpPS STC AL e
MS
The function linking kto Pand Mis not easy and tends to
change over time
Transaction costs also depend on the time period (e.g.
gradual liquidation vs. sudden fire sale)
Dowd (2002) more sophisticated version of the function
Relative size ofthe position to
liquidate
Hp is the time period thebank wants to liquidateits position (holding
period)2is the elasticity ofTCto hpBoth need to beestimated empirically
Elasticity oftransaction costs
to the relative
position size
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Liquidity risk has been overlooked in the recent past
As clearly shown by the financial crisis, liquidity risk is
crucial for individual financial institutions and for the
stability of the financial system as a whole
Liquidity risk measurement methodologies are still at an
initial stage in the financial services industry
Some indicators are already used by most banks cashcapital position, liquidity gaps, long term funding ratios
It is more complex to deviate from expected future cash
flows and take into account stress scenarios
The regulators are stepping in with some new
requirements and general principles
Conclusions