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Liquidity Risk
Measurement
Raja Abdar Rahman
Rab Nawaz Khan
Daniyal Malik
Haider Zia
Introduction
• Liquidity risk arises from a bank’s inability to meet its
obligations when they come due without incurring
considerable losses (Ouma, 2015).
• Negatively influences earnings and the capital of the bank.
• Liquidity risk is the potential for loss to an institution,
arising from either its inability to meet its obligations or to
fund increases in assets as they fall due without incurring
considerable costs.
• Inability of a bank to liquidate its position without
unacceptable losses.
• Liquidity risk can be categorized into two major segments:
 Funding liquidity concerns the ease with which a financial
institution can obtain funds.
 Market liquidity is the ease with which a company can sell its
assets to obtain the required liquidity. Market liquidity risk
occurs when the assets are priced below their value and the firm
incurs losses while selling them.
Significance of liquidity risk
• The global financial crisis of 2007 was the biggest financial
crisis since the 1930s.
• Became the reason for regulators to emphasize on the
importance of liquidity as a key determinant of
performance for all the financial institutions.
• Before the meltdown in 2007 , the financial markets used to
be flexible and funding was readily available at low costs.
• The transition of the financial environment brought the
banking system under severe stress.
• Following this, Basel III was introduced which emphasized
on the maintenance of liquidity of global liquidity through
the introduction of two new ratios (LCR and NSFR).
• These were considered as the new regulations for
measuring liquidity risk.
Liquidity Measures before
BASEL III
More frequently discussed
• Add-on model with bid-ask-spread (1999)
• Transaction regression model (2000)
• Volume-based price impact (2001)
• Liquidity Balance (2003)
• Current Ratio and Liquidity Ratio
Others
• Nonperforming assets ratio
• Government securities ratio
Add-On Model With Bid-Ask-Spread
(1999)
• Bangia, Diebold, Schuermann and Stroughair (1999)
developed a simple liquidity adjustment of a Value At
Risk (VaR) measure based on bid-ask-spread.
• Liquidity cost is measured with the bid-ask-spread. To
determine risk as the worst achievable transaction
price, the worst bid-ask-spread is added to the worst
mid-price.
• The results suggested that ignoring liquidity risk can
produce substantial underestimates of overall risk,
particularly in emerging market securities.
Contd.
• L−V*aR = 1−exp(zσr) + (µS + ˆ zSσS)
• σr is the variance of the continuous mid-price return
over the appropriate horizon
• µS – Mean
• σS - variance of the bid-ask-spread.
• z is the percentile of the normal distribution.
• ˆ zS is the empirical percentile of the spread distribution
in order to account for non-normality in spreads.
Transaction Regression Model
(2000)
• Berkowitz (2000)
Pmid,t+1 −Pmid,t = C + θNt + xt+1 + ɛt
• C= constant
• θ= regression coefficient
• xt+1= effect of risk factors
• ɛt= error term
Volume-based price impact
• Cosandey (2001) established a simple framework to
estimate price impact from volume data
• The net return is then incorporated into the liquidity
adjusted value at risk model as
Liquidity Balance Approach
• Dutch regulation (2003)
LB = Available Liquidity – Required Liquidity
• Available liquidity = Available stock of high-quality
liquid assets + Cash inflow scheduled within the coming
month
• Required Liquidity = Stock of liquid liabilities + Cash
outflow scheduled within the coming month
Continued
• Haan and End (2012)
• Panel research
• Liquidity balance as measure of independent variable
liquidity risk
• Impact on financial performance of banks
Current and Liquidity ratios
• Current ratio measures a financial institution’s
capability to meet its short-term and long-term
obligations
• Liquidity ratio estimates the ability of the bank to pay
off its obligations quickly
• Ouma (2015) constructed a linear regression model for
43 commercial banks from the year 2010 to 2014
Continued
• The established model was:
• Y = β0 + β1X1 + β2 X 2+β3 X 3+ β4 X4 + ẹ
• Where:
• Y= Net Interest Income ratio (Net Interest Income divided by Total
Income)
• β0 - Constant/Y intercept
• X1 –Current ratio (current assets/ Current liabilities) to measure
funding risk.
• X2 – Liquidity ratio (Net liquid assets divided by net deposits) to
measure CBK liquidity risk
• X3–Log of Deposits as a control variable to capture the differences
in banks sizes.
• X4 – Interest rate, as a control variable.
• ε - Error term
Continued
• The results stated that there was a significantly positive
relationship between current ratio
• net interest income ratio at 5% level of significance.
• A relation between liquidity ratio and net interest
income ratio was also observed at 5% level of
significance
Basel III
• Basel III (or the Third Basel Accord) is a global,
voluntary regulatory framework on bank capital
adequacy, stress testing, and market liquidity risk.
• Was scheduled to be introduced from 2013 until 2015;
however, changes from 1 April 2013 extended
implementation until 31 March 2018.
• The third installment of the Basel Accords was
developed in response to the deficiencies in financial
regulation revealed by the financial crisis of 2007–08.
• Basel III is intended to strengthen the financial system
by increasing bank liquidity and decreasing bank
leverage.
Liquidity Coverage Ratio
(LCR)
• The liquidity coverage ratio (LCR) subjugates on the point of unifying
the resilience of the financial institutions for the stress period of 30
days irrespective of the support of the Central Bank or The
Government.
• The LCR is a minimum requirement and pertains to large body of
internationally consolidated banks and financial institutions.
• The LCR builds on traditional liquidity “coverage” methodologies used
internally by banks to assess exposure to stress events.
• The LCR requires that a bank’s stock of unencumbered high-quality
liquid assets (HQLA) be larger than the projected net cash outflows
(NCOF) over a 30-day horizon under a stress scenario.
Continued…
LCR = Stock of unencumbered high-quality liquid assets
Total net cash outflows over the next 30 calendar days
• High-quality liquid assets can be divided onto two
levels.
• Level 1 includes cash and other assets that may be
easily converted to cash in a stressed situation.
• Level 2 includes assets that will likely fetch nearly
full value in a stressed situation, such as low-risk
corporate bonds, covered bonds and some securities
issued by some sovereign institutions.
Continued…
• Total expected cash outflows are calculated by multiplying the size of
various types of liabilities and off-balance sheet commitments by the
rates at which they are expected to run off or be drawn down in the
stress scenario.
• The denominator of the LCR is on a “net” basis, as inflows can be
deducted from outflows, subject to a cap (minimum stock of HQLAs
equal to 25% of cash outflow).
• The standard requires that under normal circumstances, the value of
the ratio be no lower than 100%.
• However, the ratio’s volatility is linked to the volatility of the
estimated net cash outflows, encouraging banks to maintain a margin
above the required 100% level.
Continued…
• If most banks satisfy the LCR requirement by a comfortable margin, the
regulation’s effect on their behavior will be fairly minor.
• Insofar as meeting the LCR requirement is costly for banks, it is conceivable that
some banks may not exceed the regulatory threshold by a considerable margin.
• The LCR may increase the steepness of the very short end of the yield curve by
introducing an additional premium for interbank loans that extend beyond 30 days.
• However, the Liquidity Coverage Ratio's highly disparate treatment of retail and
wholesale funding may instead undermine financial stability by increasing the
competition for the types of funding treated preferably under the rule.
• Also, the financial regulators must take care that competition for traditionally more
stable debt such as retail deposits does not erode the very stability that supports
maturity transformation and the modem financial system
Net Stable Funding (NSF)
• Basel III – New Set of Capital Requirement.
• Seeks to calculate the proportion of long-term assets
which are funded by long-term stable funding.
• Stable funding includes: customer deposits, long-
term wholesale, and equity.
• Stable funding excludes short-term wholesale funding.
Contd.
• NSFR = Available Amount of Stable Funding / Required
Amount of Stable Funding
• NSFR >= 100%
Sources and Uses of NSFR
Contd.
• Liquidity Risk and Financial Performance of Commercial
Banks in Kenya, by Jane Gathigia Muriithi & Kennedy
Munyua Waweru, they proposed a model where NSFR is
seen as an endogenous variable.
• Using the Cobb Douglas functional shown
• 𝑅𝑂𝐸 = 𝑓(𝐿𝐶𝑅,𝑁𝑆𝐹𝑅)
• Upon linearization and parameterization, the long run
model was specified as:
• 𝑅𝑂𝐸𝑖, 𝑡 = 𝜆0 +𝜆1𝐿𝐶𝑅𝑖, +𝜆2𝑁𝑆𝐹𝑅𝑖, +𝜃𝑖 +𝜀𝑖, 𝑡
• And the short run model as:
• 𝑅𝑂𝐸𝑖, = 𝜆0 +𝛽𝑅𝑂𝐸𝑖𝑡−1 +𝜆1𝐿𝐶𝑅𝑖, +𝜆2𝑁𝑆𝐹𝑅𝑖, 𝑡 +𝜃𝑖 +𝜀𝑖, 𝑡
Contd.
• After OLS - it was found that the results are in line with
the results of studies by Adolphus (2008) and Ahmed et
al. (2012), negative relationship between bank liquidity
and profitability.
• Banks hold liquid assets as an obligation - imposed by
the authorities.
• May lead to low bank profitability as low returns are
expected.
• When a bank has inadequate liquidity, it cannot obtain
sufficient funds, either by increasing liabilities or by
converting assets promptly, at a reasonable cost, thereby
affecting profitability.
Comparison
1997-2002 2003-2004 2005-2009 2010-2016
Bangia, Diebold,
Schuermann and
Stroughair (1999) -
Berkowitz (2000) -
Cosandey (2001)
Haitao Li, Junbo Wang,
Chunchi Wu and Yan He
(2003) - Ľuboš Pástor and
Robert F. Stambaugh (2003)
Jan Ericson, Olivier Renaule
(2006) - Cornelia Ernst,
Sebastian Stange, Christoph
Kaserer (2009)
Angela Romana, Alina
Camelia Sargu (2015) - Ioan
Trencaa , Nicolae Petria
and Amelia Anuta (2015) -
Morten Bech and Todd
Keister (2012) - Jeanne
Gobat, Mamoru Yanase,
and Joseph Maloney (2014)
Ask-bid variations
Liquidity Balance
Approach Current Ratio Liquidity Coverage Ratio
Transaction model Liquidity Ratio
Net Stable Funding
Ratio
Volume-based
Impact
Government Securities
Ratio
Non-performing assets
ratio
Conclusion
• The banks must use LCR and NSFR along with other
regulations
• The use of other ratios is also recommended
• An extensive depiction of liquidity scenario
• Better implementation of tools

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Measuring Liquidity Risk: Models Before and After Basel III

  • 1. Liquidity Risk Measurement Raja Abdar Rahman Rab Nawaz Khan Daniyal Malik Haider Zia
  • 2. Introduction • Liquidity risk arises from a bank’s inability to meet its obligations when they come due without incurring considerable losses (Ouma, 2015). • Negatively influences earnings and the capital of the bank. • Liquidity risk is the potential for loss to an institution, arising from either its inability to meet its obligations or to fund increases in assets as they fall due without incurring considerable costs. • Inability of a bank to liquidate its position without unacceptable losses. • Liquidity risk can be categorized into two major segments:  Funding liquidity concerns the ease with which a financial institution can obtain funds.  Market liquidity is the ease with which a company can sell its assets to obtain the required liquidity. Market liquidity risk occurs when the assets are priced below their value and the firm incurs losses while selling them.
  • 3. Significance of liquidity risk • The global financial crisis of 2007 was the biggest financial crisis since the 1930s. • Became the reason for regulators to emphasize on the importance of liquidity as a key determinant of performance for all the financial institutions. • Before the meltdown in 2007 , the financial markets used to be flexible and funding was readily available at low costs. • The transition of the financial environment brought the banking system under severe stress. • Following this, Basel III was introduced which emphasized on the maintenance of liquidity of global liquidity through the introduction of two new ratios (LCR and NSFR). • These were considered as the new regulations for measuring liquidity risk.
  • 4. Liquidity Measures before BASEL III More frequently discussed • Add-on model with bid-ask-spread (1999) • Transaction regression model (2000) • Volume-based price impact (2001) • Liquidity Balance (2003) • Current Ratio and Liquidity Ratio Others • Nonperforming assets ratio • Government securities ratio
  • 5. Add-On Model With Bid-Ask-Spread (1999) • Bangia, Diebold, Schuermann and Stroughair (1999) developed a simple liquidity adjustment of a Value At Risk (VaR) measure based on bid-ask-spread. • Liquidity cost is measured with the bid-ask-spread. To determine risk as the worst achievable transaction price, the worst bid-ask-spread is added to the worst mid-price. • The results suggested that ignoring liquidity risk can produce substantial underestimates of overall risk, particularly in emerging market securities.
  • 6. Contd. • L−V*aR = 1−exp(zσr) + (µS + ˆ zSσS) • σr is the variance of the continuous mid-price return over the appropriate horizon • µS – Mean • σS - variance of the bid-ask-spread. • z is the percentile of the normal distribution. • ˆ zS is the empirical percentile of the spread distribution in order to account for non-normality in spreads.
  • 7. Transaction Regression Model (2000) • Berkowitz (2000) Pmid,t+1 −Pmid,t = C + θNt + xt+1 + ɛt • C= constant • θ= regression coefficient • xt+1= effect of risk factors • ɛt= error term
  • 8. Volume-based price impact • Cosandey (2001) established a simple framework to estimate price impact from volume data • The net return is then incorporated into the liquidity adjusted value at risk model as
  • 9. Liquidity Balance Approach • Dutch regulation (2003) LB = Available Liquidity – Required Liquidity • Available liquidity = Available stock of high-quality liquid assets + Cash inflow scheduled within the coming month • Required Liquidity = Stock of liquid liabilities + Cash outflow scheduled within the coming month
  • 10. Continued • Haan and End (2012) • Panel research • Liquidity balance as measure of independent variable liquidity risk • Impact on financial performance of banks
  • 11. Current and Liquidity ratios • Current ratio measures a financial institution’s capability to meet its short-term and long-term obligations • Liquidity ratio estimates the ability of the bank to pay off its obligations quickly • Ouma (2015) constructed a linear regression model for 43 commercial banks from the year 2010 to 2014
  • 12. Continued • The established model was: • Y = β0 + β1X1 + β2 X 2+β3 X 3+ β4 X4 + ẹ • Where: • Y= Net Interest Income ratio (Net Interest Income divided by Total Income) • β0 - Constant/Y intercept • X1 –Current ratio (current assets/ Current liabilities) to measure funding risk. • X2 – Liquidity ratio (Net liquid assets divided by net deposits) to measure CBK liquidity risk • X3–Log of Deposits as a control variable to capture the differences in banks sizes. • X4 – Interest rate, as a control variable. • ε - Error term
  • 13. Continued • The results stated that there was a significantly positive relationship between current ratio • net interest income ratio at 5% level of significance. • A relation between liquidity ratio and net interest income ratio was also observed at 5% level of significance
  • 14. Basel III • Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. • Was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018. • The third installment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. • Basel III is intended to strengthen the financial system by increasing bank liquidity and decreasing bank leverage.
  • 15. Liquidity Coverage Ratio (LCR) • The liquidity coverage ratio (LCR) subjugates on the point of unifying the resilience of the financial institutions for the stress period of 30 days irrespective of the support of the Central Bank or The Government. • The LCR is a minimum requirement and pertains to large body of internationally consolidated banks and financial institutions. • The LCR builds on traditional liquidity “coverage” methodologies used internally by banks to assess exposure to stress events. • The LCR requires that a bank’s stock of unencumbered high-quality liquid assets (HQLA) be larger than the projected net cash outflows (NCOF) over a 30-day horizon under a stress scenario.
  • 16. Continued… LCR = Stock of unencumbered high-quality liquid assets Total net cash outflows over the next 30 calendar days • High-quality liquid assets can be divided onto two levels. • Level 1 includes cash and other assets that may be easily converted to cash in a stressed situation. • Level 2 includes assets that will likely fetch nearly full value in a stressed situation, such as low-risk corporate bonds, covered bonds and some securities issued by some sovereign institutions.
  • 17. Continued… • Total expected cash outflows are calculated by multiplying the size of various types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down in the stress scenario. • The denominator of the LCR is on a “net” basis, as inflows can be deducted from outflows, subject to a cap (minimum stock of HQLAs equal to 25% of cash outflow). • The standard requires that under normal circumstances, the value of the ratio be no lower than 100%. • However, the ratio’s volatility is linked to the volatility of the estimated net cash outflows, encouraging banks to maintain a margin above the required 100% level.
  • 18. Continued… • If most banks satisfy the LCR requirement by a comfortable margin, the regulation’s effect on their behavior will be fairly minor. • Insofar as meeting the LCR requirement is costly for banks, it is conceivable that some banks may not exceed the regulatory threshold by a considerable margin. • The LCR may increase the steepness of the very short end of the yield curve by introducing an additional premium for interbank loans that extend beyond 30 days. • However, the Liquidity Coverage Ratio's highly disparate treatment of retail and wholesale funding may instead undermine financial stability by increasing the competition for the types of funding treated preferably under the rule. • Also, the financial regulators must take care that competition for traditionally more stable debt such as retail deposits does not erode the very stability that supports maturity transformation and the modem financial system
  • 19. Net Stable Funding (NSF) • Basel III – New Set of Capital Requirement. • Seeks to calculate the proportion of long-term assets which are funded by long-term stable funding. • Stable funding includes: customer deposits, long- term wholesale, and equity. • Stable funding excludes short-term wholesale funding.
  • 20. Contd. • NSFR = Available Amount of Stable Funding / Required Amount of Stable Funding • NSFR >= 100%
  • 21. Sources and Uses of NSFR
  • 22. Contd. • Liquidity Risk and Financial Performance of Commercial Banks in Kenya, by Jane Gathigia Muriithi & Kennedy Munyua Waweru, they proposed a model where NSFR is seen as an endogenous variable. • Using the Cobb Douglas functional shown • 𝑅𝑂𝐸 = 𝑓(𝐿𝐶𝑅,𝑁𝑆𝐹𝑅) • Upon linearization and parameterization, the long run model was specified as: • 𝑅𝑂𝐸𝑖, 𝑡 = 𝜆0 +𝜆1𝐿𝐶𝑅𝑖, +𝜆2𝑁𝑆𝐹𝑅𝑖, +𝜃𝑖 +𝜀𝑖, 𝑡 • And the short run model as: • 𝑅𝑂𝐸𝑖, = 𝜆0 +𝛽𝑅𝑂𝐸𝑖𝑡−1 +𝜆1𝐿𝐶𝑅𝑖, +𝜆2𝑁𝑆𝐹𝑅𝑖, 𝑡 +𝜃𝑖 +𝜀𝑖, 𝑡
  • 23. Contd. • After OLS - it was found that the results are in line with the results of studies by Adolphus (2008) and Ahmed et al. (2012), negative relationship between bank liquidity and profitability. • Banks hold liquid assets as an obligation - imposed by the authorities. • May lead to low bank profitability as low returns are expected. • When a bank has inadequate liquidity, it cannot obtain sufficient funds, either by increasing liabilities or by converting assets promptly, at a reasonable cost, thereby affecting profitability.
  • 24. Comparison 1997-2002 2003-2004 2005-2009 2010-2016 Bangia, Diebold, Schuermann and Stroughair (1999) - Berkowitz (2000) - Cosandey (2001) Haitao Li, Junbo Wang, Chunchi Wu and Yan He (2003) - Ľuboš Pástor and Robert F. Stambaugh (2003) Jan Ericson, Olivier Renaule (2006) - Cornelia Ernst, Sebastian Stange, Christoph Kaserer (2009) Angela Romana, Alina Camelia Sargu (2015) - Ioan Trencaa , Nicolae Petria and Amelia Anuta (2015) - Morten Bech and Todd Keister (2012) - Jeanne Gobat, Mamoru Yanase, and Joseph Maloney (2014) Ask-bid variations Liquidity Balance Approach Current Ratio Liquidity Coverage Ratio Transaction model Liquidity Ratio Net Stable Funding Ratio Volume-based Impact Government Securities Ratio Non-performing assets ratio
  • 25. Conclusion • The banks must use LCR and NSFR along with other regulations • The use of other ratios is also recommended • An extensive depiction of liquidity scenario • Better implementation of tools