liquidity risk garp

8/12/2019 Liquidity Risk Garp

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Copyright 2011, SAS Institute Inc. All rights reserved.

A New Regulation for Liquidity RiskGARP, 1st December 2011Jimmy Skoglund, SAS Institute Inc.


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Agenda

A New Regulation for Liquidity Risk A new regulation based on learnings in the recent crisis

New reporting and liquidity monitoring standards

Short-term stress testing of liquidity coverage ratios

Long-term structural liquidity mismatch measurement - net stable funding ratios

Liquidity risk monitoring tools

Modeling Cash Flows for Liquidity Risk Traditional run-off liquidity gaps

Behavior modeling of net cash flows

Counterbalancing capacity of unencumbered assets

Stress testing and liquidity coverage ratios

Pricing Liquidity Risks Mismatch (term) liquidity risk

Contingency liquidity risk

Market liquidity risk

Funds transfer pricing of liquidity risk

Preparing for Liquidity CrisisContingency Funding Plans

A Note on Advanced Liquidity Risk Management Techniques Probabilistic measures and limits on liquidity risk

Optimising the counterbalancing capacity portfolio

Wrap Up and Summary


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Agenda

















Wrap Up and Summary


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A New Regulation for Liquidity Risk

The recent credit crisis compounded itself quickly into a major liquidity crisis (or

funding problem), leading to insolvency of major financial institutions

Many banks did not have a dedicated liquidity buffer or liquidity portfolio that

was managed

A key characteristic of the financial crisis was the inaccurate and

ineffective management of liquidity risk in many banks

Learnings from the recent crisis..

The new [Basel III] liquidity risk regulation underscores the importance ofmanaging the liquidity contingency buffer in much the same way as capital

Focusing on maintaining a high quality liquidity portfolio that can hedge out

liquidity outflows under stress scenarios

And, integrate the liquidity pricing and hence incentive to raise liquidity as well as

price costly liquidity according to the opportunity cost of raising the needed buffer

Regulators response..


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Guiding Principles

Basel (2008) Principles for Sound Liquidity

Risk Management and Supervision

Minimum Reporting

Basel (2009) International Framework for Liquidity

Risk Measurement, Standards and Monitoring

Liquidity Coverage Ratio (LCR)

Net Stable Funding Ratio (NSFR)

Regulatory Reporting Standards Monitoring Standards

Contractual Maturity Mismatch

Funding Concentration

Unencumbered Assets

Market Monitoring

Guiding Principles

Basel (2009) Principles for Sound Stress Testing Practices and Supervision


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Guiding Principles



Minimum Reporting








Unencumbered Assets

Market Monitoring

Guiding Principles



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Net Fund Requirements Modeling (market and behavioral risk)

a. Contingent withdrawal of funds (liability side liquidity risk),b. Liquidity outflow due to off-balance sheet commitments that

includes facilities, lines of credit, guarantees, letter of credit (assetside liquidity risk), and

c. Contingent liquidity impact due to derivatives collateral.

Counterbalancing (hedging) Capacity Modeling

a. Liquid asset value (cash, government bonds etc)

b. Haircut securities e.g., corporate bonds

Liquidity Coverage Ratio (LCR)Stock of Counterbalancing Capacity Assets

Net Cash Outflow under Stress Scenarios= > 100%

Short-term (30 day stress scenario)


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Guiding Principles



Minimum Reporting








Unencumbered Assets

Market Monitoring

Guiding Principles



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Net Stable Funding Ratio (NSFR)Available Stable Funding (ASF)

Required Stable Funding (RSF)= > 100%

Structural liquidity mismatch (1 year)

Assets

Unencumbered assets

Liabilities

Consumer loans

Short term funding

Non-core deposits

Core deposits

Long term funding

Equity

Corporate loans

Interbank loans

The NSFR is closely

related to MoodysCash

Capital Position (CCP)

100%

100%

85%100%

70%

0%50%%

0% - 50%

85% - 100%

50% - 100%

50% - 100%

RSF Factors ASF Factors

Longtermassets

Longtermfunding

Basic Idea:

Banks should avoid

excessive amount of

long-term assets being

funded short-term in

order to not run into

potential liquidity

issues in re-funding


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Guiding Principles



Minimum Reporting








Unencumbered Assets

Market Monitoring

Guiding Principles



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Complementary to NSFRreporting banks arerequired to monitor:

Counterpartyconcentration

Product concentration

Currencyconcentration

NSFR ratio promotes banksto steer part of their fundingtowards long term stablefunding. However, thefunding is not necessarily

diversified

Contractual Maturity Mismatch Funding Concentration Unencumbered Assets Market Monitoring

Key Monitoring Items

Traditional run-off maturitymismatch.

Contractual maturityused as behavior

model Measures time to

insolvency inextreme case ofcomplete drying upof funding i.e., noshort-term funding isrolled over

Report on availableunencumbered assets thatare (i) eligible for collateral,or, (ii) eligible for centralbank facilities

Amount

Currencydenomination

Estimated markethaircut when used ascollateral

Location/Business unit

Monitoring market wideinformation

Equity prices, debtmarkets, fx markets

etc Monitoring general

information on the financialsector

Monitoring bank specificinformation

Banks equity, CDSprices, funding costsetc


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Agenda


New reporting and liquidity monitoring standards Short-term stress testing of liquidity coverage ratios














Wrap Up and Summary


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Modeling Cash Flows for Liquidity Risk

Traditional Liquidity Risk Management:

Run-off Liquidity Gaps

Tracking Liquidity Ratios

Now, focus on going concern behavioral modeling under stressscenarios!

a. Modeling Net Funding Requirements of Assets and Liabilities

b. Counterbalancing Capacity of Unencumbered Assets

Insolvency in run-off gap

Cumulative Net

Cash Flow Map


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Modeling Cash Flows for Liquidity RiskGoing Concern Liquidity Risk Stress Scenario: Cumulative Net Cash Flow Map Should Not Be Negative!


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Modeling Net Funding Requirements: Example Scenarios

Behavioral Modeling of Consumer Cash Flows Consumer loans:

i. decreasing prepayment rates (cost of funds increase)

ii. Increased default rates

iii. Increase in loan stock (increased demand for funds)

Consumer deposits:

i. Increased withdrawal of funds (run on bank, need for funds) Behavioral Modeling of Market Funding Sources

Unsecured funding:

i. committed lines of credit not available

ii. Wholesale funding rolled over with reduced term and only with counterparties that have astrong relation with the bank

Difficulty maintaining secured funding. Repos are rolled over only if counterparty has strongrelation with bank

Behavioral Modeling of Derivatives Margin Requirements Increased margin requirements for OTC derivatives (adverse market scenario)

Increased collateral posting due to reduced value of collateral (adverse market scenario)

Increased margin requirements due to downgrade i.e., rating triggers (bank-specific)


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Example: Deposit run-off stress scenarios

In both of the stress scenarios we see a marked increase in the withdrawal rate up to 1 month.

The depositors that are most sensitive to the stress scenario and rumors about the bank will withdrawearly.

After the most sensitive customers have withdrawn the less sensitive customers remain and hencethe withdrawal rate decreases significantly.


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Modeling Counterbalancing Capacity of Unencumbered Assets

A CBC scenario, for the unencumbered assets, is constructed by makingassumptions about salability, price (haircut), repoability etc

Eligible assets:

Cash, central bank

reserves, government

debt, corporate and

covered bonds with

minimum A rating

(haircuts), securities

with claims on

sovereigns etc with 0%

risk weight


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Retail deposit run-off at

a minimum of 7.5% or 15%

Unsecured wholesale deposit run-off

by small business at

a minimum of 7.5% or 15%

Unsecured wholesale funding run-off

Provided by other legal entity customers at

100%

Unsecured wholesale funding run-off

By non-financial corporates at

75%

Unsecuredwholesale funding run-off

By non-financial customers, sovereigns, banks

and public sector enterprises (PSEs) at a minimum of

25%

Cash Outflows

100% of retail contractual inflows from performing assets

0% cash flows from reverse repos and 100% cash flows from

reverse repos of illuiqid securities

0% cash inflow from committed lines of credit

100% contractual inflows from derivatives

100% of wholesale contractual inflows from fully performing

assets

Cash Inflows

- -Increased liquidity needs due to valuation changes on

derivative transactions

Increased liquidity needs related to downgrade triggers

Increases liquidity needs related to potential for valution

changes on collateral posted for securing derivative transactions

20%

Loss of funding on asset-backed securities, covered bonds and

other structured finance products

Draws on committed credit and liquidity lines and other contingent

funding liabilities

Additional Components of

Cash Outflows +CBC

Cash

Central bank reserves

Government debt

Sovereign securities

with 0% risk weight

Minimum A rated corporate bonds

(20%-40% haircuts)

Net Funding Requirements


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Cash OutflowsCash Inflows

- -

Additional Components of

Cash Outflows +CBC

Net Funding Requirements

Insolvency measurement period for LCR


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Agenda

















Wrap Up and Summary

*Term liquidity charge is


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Pricing Liquidity Risk

Term Liquidity Charge*

Liquidity is a scarce resource and liquidity pricing

should be instituted in a way that rewardsproviders of liquidity and penalize its users

Contingency Liquidity Charge Market Liquidity Charge

Credit providers of long-term funds

with term funding spread

Charge long-term illiquid loans

with term funding spread

**Charge opportunity cost of stand-by

unsecured funded liquidity reservesTerm liquidity charge

Liquefiability / repoability credit

Assets and liabilities Unencumbered assets

Used in banksFTP system to provide

incentives to branches

Accounting for liquidity explicitly in MtM

promotes assets that have short-term

liquidityby maturity or liquefiability

q y g

based on the funding

spread vs. swap rates

**Opportunity cost

charge is based on the

spread between

secured and unsecured

funding

Risk premium for offering contingency

liquidity at some pre-defined rate***

***Customer spreadguarantee is an option

on the funding spread

with strike the

guaranteed spread


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Treasury Investors

4% Coupon rate

Cash liquidity

Interbank

MarketSwap rate + 30 bps

4% Fixed

Swap deal 5 Y bond funding

Measuring banks term liquidity costs

Treasury Investors

4.5% Coupon rate

Cash liquidity

Interbank

MarketSwap rate + 45 bps

4.5 % Fixed

Swap deal 10 Y bond funding

5 Year 10 Year

Term funding

liquidity costs

curve

30 bps

45 bps


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Swap rate

Liquidity spread

Maturity 1 Year 2 Years 3 Years 4 Years

3.80% 3.90% 4.20% 4.40%

5 Years

4.50%

0 bps 13 bps 27 bps 35 bps 40 bps

Example: Term liquidity spread for a 5 year loan

Loancashflow

size

Loan maturity term

The loan cash flows are discounted with term liquidity spread.

Hence, pricing should account for the same spread

*E g costs and charges


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Swap rate

Liquidity spread

Maturity 1 Year 2 Years 3 Years 4 Years

3.80% 3.90% 4.20% 4.40%

5 Years

4.50%

0 bps 13 bps 27 bps 35 bps 40 bps

Funds transfer pricing with liquidity risk

Credit spread 5 bps 19 bps 38 bps 47 bps 59 bps

Other spreads* 3 bps 7 bps 11 bps 17 bps 22 bps

Capital allocation 0.5% 0.5% 0.5% 0.5% 0.5%

Capital cost** 6% 6% 6% 6% 6%

FTP

E.g., costs and charges

= FTP (swap) Capital allocation100% -( )+* Capital allocation * Capital cost

+ FTP (spread)

Note: Liquidity contingency (CBC) costs are not in capital. How account

for opportunity cost of holding CBC similar to capital?

** Cost is the opportunity

cost of holding capital

Unsecured funding (Interbank)


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Example: Contingency liquidity pricing of a facility

Termliquidity

costscore

part

= 40 bps x 25% = 10 bps

Termliquidity

costsunused

portion

(drawdown)

= 40 bps x 70% x 20% = 5.6 bps

Opportunity

costsof

unse

cured

funding

= 8 bps x 70% x 20% = 1.12 bps

Riskpremia

forfunding

spread

volatility

= 40 bps x 5% x 70% = 1.4 bps

= 18.12 bps (e.g., 18,120 in currency amount for a 10 million facility)

Liquidity spread

Unsecured funding spread

Current usage

Core part

Drawdown factor

Liquidity spread volatility

40 bps

5 bps

8 bps

30%

25 %

20 %

Market and facility information

Funding spread

Undrawn part 70%

x Core part

Funding spread x Undrawn part x Drawdown factor

Unsecured funding spread x Undrawn part x Drawdown factor

Funding spread x xFunding spread volatility

Total

liquidity

charge

Simplified option risk premia calculation for fixed spread contingency funding*

Secured (repo) funding

Unsecured

funding spread

The opportunity cost for unsecured

funding measures the relative cost of

unsecured vs. unsecured funding.

That is the cost of not having a liquidasset buffer (collateral) for

contingency. The contingency

funding costs is on par with capital

costs for other risks such as credit

risk. However, for liquidity the cost is

for holding liqudity contingency

(CBC) rather than capital

*ATM option approximation for a Tyear option is approximately 0.4 x

funding spread x funding spread

volatility x sqrt(T)

Undrawn part


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Agenda

















Wrap Up and Summary


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Preparing for Liquidity CrisisContingencyFunding Plans

Contingency Funding Plan (CFP) helps banks strategizeits response to liquidity crises in advance.

Objective:

A CFP contains procedures for (i) counteracting cash flow

shortfalls and (ii) maintaining market goodwill of the bank Content:

A CFP take into consideration how a funding crisis evolves indifferent stages as a trigger (early warning actions)

Large increase in credit spreads, banks funding rates increase compared to peer

banks,..A CFP specifies actions based on the triggers

Action for CBC (sell, repo), project plan for execution of liquidity portfolio

A CFP nominates crisis teams and committes

Market Monitoring

(Triggers)

Action Plans

Responsibility

Chen, W, and Skoglund, J, 2011. Building a Project

Plan for Liquidity Execution


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Agenda

















Wrap Up and Summary


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A Note on Advanced Liquidity RiskManagement Techniques

Probabilistic measures and limits on liquidity risk Market models, behavior models

ALCO puts VaR limits on Maximum Cash Outflow (MCO) at cumulative horizon t=1,,n

t=1

t=2

t=3

t=4VaR(t) < MCO(t) for all t, else the

limit has been breached

D (Net Funding Requirements)= D (CBC)D (Net Cash Flow Map) +

VaR(t)


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A Note on Advanced Liquidity RiskManagement Techniques

....

,0,,max,

min

t

CBCa

sa

CBCa

sCBCa

Ss

sh

SspstNFRstCBChf

Vhpa

Optimization of asset shareis conditional on CBCliquidation, repo scenario for

the asset

- Cheapest CBC portfolio

- Absolute mismatch constraints

- other constratints e.g., tail

mismatch constraints

Optimizing the counterbalancing capacity portfolio* Find the (cheapest) CBC portfolio holdings (cash flows) that best replicates the (negative) Net

Funding Requirements (NFR)

-max(-NFR,0)

Optimal CBC


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Agenda

















Wrap Up and Summary

W U d S


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Wrap Up and Summary

The new [Basel III] liquidity risk regulation imposesignificant challenges to banks of enhancing existingliquidity measurement and management methods

Compliance requires

banks to take a sophisticated scenario based approach to

liquidity risk measurement and management The establishment of scenario and risk based limits on

liquidity risk

Continous management of the dedicated CBC portfolio

Cost efficient portfolio

Policies and procedures to be implemented/reviewed (e.g.,monitoring, CFP)

Best liquidity portfolio execution plan

Implementation of a pricing system for liqudity risk thatdecentralizes the incentives for raising liquidity

R f


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References Books and papers

Chen, W, and Skoglund, J, 2011. Cash Flow Replication with Mismatch Constraints. Forthcoming, Journal of Risk

Chen, W and Skoglund, J, 2011. Optimal Portfolio Strategy with Liquidity Capacity, Working paper

Chen, W, and Skoglund, J, 2011. Building a Project Plan for Liquidity Execution. Working Paper Dev, A. and R, Vandana, 2006. Performance Measurement in Financial Institutions in an ERM Framework. Risk Books.

Matz, L. and P, Neu, ed. 2007. Liquidity Risk Measurement and Management. John Wiley

Moodys. 2001. How MoodysEvaluates US Bank and Bank Holding Company Liquidity.

Skoglund, J and Mathur, S, 2011. Liquidity Risk Management After the Crisis, a SAS white paper.

Skoglund, J., 2010. Funds Transfer Pricing and Risk-Adjusted Performance Measurement, a SAS white paper

Basel Committee 2008 Principles for sound liquidity risk management and supervision

2009 Strengthening the resilience of the banking sector

2009 International framework for liquidity risk measurement, standards and monitoring

2009 Principles for sound stress testing practices and supervision

2011 Basel III: A global regulatory framework for more resilient banks and banking systems

Senior Supervisors Group 2008 Observations on risk management practices during the recent market turbulence

Financial Stability Forum 2008 Enhancing market and institutional resilience

Institute of International Finance 2008 Final report of the IIF committee on market best practices


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