4What Is Liquidity Risk?» Liquidity is the ability to fund increases in assets and meet obligations whenthey come due.» Liquidity risk is the risk to a bank’s earnings and capital arising from its inabilityto timely meet obligations when they come due.» Liquidity Risk Management involves the processes, controls, andinfrastructures established to mitigate unacceptable exposure to liquidity risk.
5What is Liquidity Risk?In general, there are three central topics that must be effectively managed in order toeffectively address firm wide exposure to liquidity risk:» Market Liquidity Risk is oriented around price changes and P&L impacts» Funding Liquidity Risk addresses cash flow estimation (assets as well as liabilities)» Contingency Planning (including stress testing) considers how, in the absence of marketor funding liquidity, a bank can continue to meet obligations, particularly during periods ofstress.
Changed Economic Environment6.Systemic Liquidity Mismatches Compounded and Magnified theConsequences of Excess Leverage– Rapid growth in new funding vehicles– Rapid growth in new on-balance sheet products– Incentives not aligned with risk• Grow earnings to remain competitive (e.g., “volume” forvolume’s sake)• Over reliance on rating agencies– Increase in system leverage not transparent• For example, “shadow” system– Liquidity Risk Management did not foresee the extreme systemiccrises– Liquidity Risk was not embedded into business planning andmanagement• These challenges force banks to think about thebusiness model implications moving forward• How should financial institutions address liquidity risk inthe future?
Conclusion7“Measuring and managing bank liquidity risk is as important as capital/solvencyrisk management, but in the years running up to the crisis did not receiveadequate attention, either in the UK or internationally, where debates aboutbank regulation were dominated by the design of the Basel II capital adequacystandard. It is essential now to restore liquidity regulation and supervision to aposition of central importance.”The Turner Review: A regulatory response to the global banking crisis; March2009
Lessons Learned by Institutions» More central coordination and management of business line funding andliquidity risk profiles» Better integration of liquidity management and liquidity risk management intooverall enterprise-wide risk management process» Robust internal pricing of funding and liquidity risks, including the assignmentof liquidity risk premiums in product pricing and business line P&L attribution» Enhanced internal MIS» Enhanced contingency funding plans» More robust liquidity risk stress testing9
Lessons Learned by Supervisors» Clear articulation of supervisory expectations on liquidity risk management» Enhanced oversight and enforcement ensuring that supervisory expectations are met» Strengthening the consistency and robustness of liquidity risk supervision globallythrough:– Use of consistent supervisory metrics and benchmarks for monitoring the liquidity risk profiles ofinstitutions– Enhanced communication mechanisms among home and host supervisors on the liquidity riskprofiles of cross-border institutions– “Global framework for promoting stronger liquidity buffers at financial institutions” G-20, April 200910
Actions Taken by Supervisors» Clear articulation of supervisory expectations on liquidity risk management– BCBS -“Principles on Sound Liquidity Risk Management and Supervision”– CEBS - 30 Recommendations on Liquidity Risk Management» Enhanced oversight and enforcement that supervisory expectations are met– Heightened efforts by supervisors globally –US, UK, EU supervisors» Strengthening the consistency and robustness of liquidity risk supervision globally– Enhanced coordination -SSG, CEBS, supervisory colleges ..etc.– BCBS Working Group on Liquidity– CEBS efforts– Basel III Liquidity Requirements11
Common Elements of BCBS “Principles” & CEBS“Recommendations”» Established risk tolerances» Adequate “cushions” or “buffers” of unencumbered liquid assets» Incorporation of liquidity costs in product pricing, performance measurement, and newproduct approvals» Robust assessment of contingent liquidity risks –enhanced stress testing of marketscenarios and OBS exposures» More robust liquidity contingency planning» Management of intra-day liquidity risks» Active liquidity risk management both within and across legal entities, business lines andcurrencies» More robust public disclosure for promoting market discipline» Enhanced supervisory efforts surrounding liquidity risk management12
FinancialCreditReputationalOperationalBusiness-as-Usual EnvironmentFirm-SpecificScenariosStress-Test EnvironmentLiquidityRiskGovernanceInfrastructureMarketLiquidity RiskFundingLiquidity RiskContingentLiquidity RiskSource: Office of the Comptroller of CurrencyEffective liquidity riskmanagement begins with theestablishment of a thorough andstrong internal governanceprocess for identifying, measuringand controlling liquidity riskexposure. The LRM infrastructurenaturally considers business-as-usual, firm-specific scenarios andstress-test environments. TheLRM process considers not onlymarket and funding risks, but howrisks are interconnected and can“compound” in ways that createelevated levels of risk andpotential exposure. Measures ofliquidity risk must be based onboth structural condition andprospective (i.e., forward-looking)cash-flow measures.Effective Liquidity Risk Management Requires a HolisticPerspective
An Integrated Balance Sheet Management ApproachSource: Office of Thrift Supervision
Basel III major implementation challenges» Don’t underestimate the challenge of building a Basel III data warehouse– Basel III liquidity data requirements span multiple functional and organizational silos» Treasury» Risk management» Finance Relevant data is buried in multiple systems and units Base III framework hinges on integrated asset, capital, and funding management - ERM Framework» Internal organization challenges (risk versus finance)» Stress testing and forecasting practices are evolving– Internal and regulatory pressure, forward looking (including market and business forecast assumptions)– Holistic approach between credit and liquidity risk scenarios(e.g. how could a given counterparty downgrade impact my capital and liquidity ratios?)» Regulatory reporting burden– While liquidity is a global issue, host regulators have different requirements– Therefore, institutions need to be aware of the cost to implement a system that will satisfy multipleregulatory regimes» Timing and Market Signaling– Market pressure to comply with new ratios before dead line16
Basel III data gap analysisAdditional data sourcing required to meet Basel III new Liquidity Risk requirementsFrom an ALM project From a Basel II projectMarket Data OK To be sourcedAssetsOKAdd characteristics forCash flow generation(or import CFs)Liabilities OK To be sourcedOff balance Facilities/Counterparties OKCreditEnhancementTo be sourced OKCounterparties Entity types, country OKSecurities Issuers, repo security legs OKRatings To be sourced OK
Liquidity Risk Management Best Practices» The institution utilizes a proprietary or vendor liquidity simulation model that evaluatescash flows across time buckets for both assets and liabilities at a detailed level.» Cash flow modeling considers both contractual instrument features and optionalbehaviors.» Credit dominates liquidity concerns. Place reasonable prices on products within HFIbanking book, not just HFU and trading positions.» The institution models daily and weekly time buckets in the near term, monthly buckets inthe moderate term and more coarse time buckets in the long run» The institution uses a framework which consists of early warning indicators, ratioanalysis, a liquidity maturity ladder, liquidity gap analysis, and stress testing to quantifyliquidity risk exposure.» Stress testing should include both idiosyncratic and systemic scenarios.» The liquidity policy, liquidity contingency plan, and funding should be consistent withliquidity stress test scenarios.» The assumptions for liquidity stress scenarios, funds transfer pricing assumptions, NIIsimulation, and market value of portfolio equity calculations are consistent.18
Liquidity Risk Stress Testing Best Practices» Different types of stress testing and scenario analysis are performed on a weekly andmonthly basis. Assumptions are in real time.» Stress testing should include both idiosyncratic and systemic scenanrios.» The liquidity policy, liquidity contingency plan, and funding should be consistent withliquidity stress test scenarios.» Liquidity scenario assumptions are reviewed and approved by senior management andthe Board on a regular basis.» Liquidity stress scenarios aid in defining relevant risk metrics and their correspondinglimits.» There is a connection between liquidity stress scenarios, funds transfer pricingassumptions, NII simulation, and market value of portfolio equity calculations.19
Liquidity Transfer Pricing Best Practices» All assets and liabilities must be transfer priced including the investment. Reporting unitscannot simply transfer price net positions.» In order to avoid the build up of long term illiquid trading assets and short-term volatilefunding, consider the application of higher funding charges to trading positions that aremore likely to become “stale”.» Better LTP practices require that banks define an LTP policy which set forth principles orrules to ensure LTP ensures its intended purposes.» Banks should charge TP rates based on their marginal cost of funds (“arm’s length cashmarket rates”). In addition, the FTP system should take into account the uniquecharacteristic of the funds. Strip-funding involves funding each cash flow.» Term liquidity should be applied to floating rate instruments. Many institutionsinappropriately assign short term cost of funds to floating rate products.» A consistent approach should be applied to interest rate risk measurement (both incomeand market value), risk adjusted performance measurement, and customer productpricing» Business activities creating the need for additional liquidity should be charged based ontheir expected usage of contingent liquidity.20
22Regulatory Emphasis on Contingent LiquidityBasel: “… the maintenance of a sufficient cushion of high quality liquid assets to meetcontingent liquidity needs…”FSA: “A Contingency Funding Plan should set out a firm’s strategy for addressing liquidityshortfalls in stressed conditions…”Fed: “… a cushion of liquid assets, and a formal well-developed contingency funding plan(CFP) as primary tools for measuring and managing liquidity risk…”Moody’s Analytics Enterprise Risk Management Solutions
23D. FTP Decomposition• Funds transfer pricing (FTP) is an increasingly centralcomponent of asset-liability management, as it facilitatesrisk transfer, profitability measurement, capitalallocation, and business unit incentive alignment• The components include a credit spread, whichcompensates the financial institution for bearing creditrisk associated with the exposure, as well as an optionspread, which is a premium that compensates the bankfor any embedded options in the contract (e.g.prepayment option)• The funding liquidity spread, which is the expected costof funds required to support the exposure to itsremaining life, and the contingent liquidity spread, whichrelates to the cost of maintaining a sufficient cushion ofhigh quality liquid assets to meet sudden or unexpectedobligationFundsTransferPriceCommercial MarginCredit SpreadOption SpreadFunding LiquiditySpreadContingent LiquiditySpreadReference Rate*The chart represents an schematic illustration of the components of an FTP
24A bank invests in a varietyof assetsExtends backup linesof credit to a pool ofborrowers: the futurecredit quality of themis uncertainFully-fundedinstruments withvarying degrees ofliquidity: the futureliquidity is uncertainThe bank funds the balancesheet using a combinationof long-term funds (aliquidity buffer), short-termcollateralized debt, andpossibly asset salesThe degree to whichassets can becollateralized isuncertainThe market price ofthe assets isuncertainThe bank’s funding costs,due in part to the value ofthe collateral, and theborrowers’ line usage arecorrelatedThe future correlationbehavior is uncertainBorrowers’ futuredemand for liquidity(line utilization) isuncertainAvailability of short-termfunds is limited in severemarket conditionsThe duration ofadverse fundingconditions areuncertainThe future fundingneeds are uncertainBasel 3 Contingent Liquidity Risk: Motivation• What amount of liquid assets should your bank hold inorder to absorb potential losses due to adverse fundingconditions?QuestionMoody’s Analytics Enterprise Risk Management Solutions
Bibliography» Results of the Comprehensive Quantitative Impact Study; Bank for InternationalSettlements; December 2010» Developments in Bank Supervision – a Canadian Perspective, Remarks by Ted Price,Assistant Superintendant, Office of the Superintendant of Financial Institutions Canada;May 2010» Basel III: International framework for liquidity risk measurement, standards andmonitoring; Bank for International Settlements; December 2010» Adoption of Bank Standards on Liquidity Risk Management; September 1, 2009;Financial Services Commission» Basel III Quantitative Impact Study and its Implications; December 17, 2010; FinancialServices Commission» The Basel III Liquidity Framework: Impacts and Recommendations; The Clearing House;November 2, 2011» The Impact of Sovereign credit risk on bank funding conditions; BIS; July 2011» Basel III: Long term impact on economic performance and fluctuations; February 2011;Bank for International Settlements30
Bibliography» Basel III and European Banking: Its impact, how banks might respond, and thechallenges of implementation; McKinsey and Company; November 2010» Senior Supervisors Group; Observations on Risk Management Practices during theRecent Market Turbulence; March 2008» Assessing the macroeconomic impact of the transition to stronger capital and liquidityrequirements; Bank For International Settlements; December 2010» Base III Implementation – Capital Adequacy and Liquidity Requirements; Office of theSuperintendant of Financial Institutions Canada; February 2011» Quantifying the Effects on Lending of Increased Capital Requirements; The BrookingsInstitute; September 2009» Remarks by Superintendant Julie Dickson, Office of the Superintendant of FinancialInstitutions Canada; December 2010» Basel III: balancing Risk and Regulation, Remarks by Mark White, AssistantSuperintendant, Office of the Superintendant of Financial Institutions Canada;December 2010» Mapping capital and liquidity requirements to bank lending spreads; Bank forInternational Settlements; November 201031
Bibliography» Adoption of Bank Standards on Liquidity Risk Management; Financial SupervisoryService; September 2009» Basel III Quantitative Impact Study and Its Implications; Financial Supervisory Service;December 2010» The Impact of Sovereign Credit Risk on Bank Funding Conditions; Bank ForInternational Settlements; July 2011» Basel III Liquidity Framework: Impacts and Recommendations; The Clearing House;November 2011» Basel III and Its Consequences: Confronting a New Regulatory Environment;Accenture; 201132