Managing Liquidity Risk: Preparing for  Extreme Events Leonard Matz
Why Stress Test? <ul><li>“ The liquidity strategy should set out the general approach the bank will have to liquidity, inc...
Why  Stress Test? <ul><li>Stress testing is an important element for sound risk management and contingency planning: </li>...
What’s Normal / Extreme ? <ul><li>Market Risk ‘normally’ is about  ‘Normal Scenarios’ </li></ul><ul><li>What is  normal ? ...
Volatility of Savings Deposits  The good news:   The bank has not experienced a severe loss of deposits. The bad news:   T...
Measurement and Quantification Processes Stress testing typically applies statistical tools to provide more information ab...
Measurement and Quantification Processes We can’t apply the usual statistical tools to liquidity risk stress testing! <ul>...
Measurement and Quantification  Conclusions <ul><li>Historical observation does not necessarily reflect what might happen ...
Stress Testing Should Reflect Both Internal and External Scenarios <ul><li>Capital markets disruptions </li></ul><ul><li>S...
Stress Environments Affect Both Cash Availability And Needs <ul><li>Cash availability: </li></ul><ul><ul><li>asset liquidi...
Systemic Crises – A Wide Variety 1987 1990 1991 1992 1994 1995 1997 1998 1999 2000 2001 2002 U.S. stock market crash colla...
<ul><li>Normal course of business, including any seasonal fluctuations:  </li></ul><ul><ul><li>VaR Works here, but who car...
It is imperative to use multiple degrees of severity  (stress levels) for each need scenario!
Key Facts: <ul><li>The amount of contingent liquidity risk varies depending on the severity of crisis. </li></ul><ul><li>C...
Stages of a Funding Crisis
From Funding Liquidity Cash Flows to Contingent Liquidity Stress Tests Source:  Dr. Michael Reuther
Stress Test Process  Source:  Dr. Michael Reuther
Forecasting Cash Out-Flows  More than Just Contractual Claims <ul><li>Perception risk </li></ul><ul><li>Surviving a liquid...
Stress Test Process Source:  Dr. Michael Reuther
Liquidity From Assets Source:  Dr. Michael Reuther
Stress Test Process Source:  Dr. Michael Reuther
Stress Tests Detail
Stress Tests Detail
Should You Forecast Cash In-flows? <ul><li>If you are covering today’s risk with tomorrow’s promises, you are masking risk...
Assumption Relevanancy <ul><li>Is the scenario relevant to your bank?  (e.g. foreign exposure, equity exposure, etc.) </li...
Measurement is Not Management <ul><li>Evaluate stress tests to identify major contributors to risk exposures.  Requires th...
Liquidity Warehousing –  the Easy Stuff <ul><li>NOT cash or interbank deposits </li></ul><ul><li>net funds sales, repos an...
Adding Liquid Assets –  What Do We Accomplish? Core Assets Liquid Assets Volatile Liabilities Core Funding  +  Equity Stru...
No Bank Can Afford To Hold Enough Liquid Assets to Cover All Contingent Needs in The Worst Scenario at The Highest Stress ...
Too little liquidity may kill the bank suddenly but too much can kill it slowly. KEY ISSUE
Beyond Liquid Assets <ul><li>Loans can also provide liquidity value  </li></ul><ul><ul><li>Mortgages as collateral for FHL...
Planned Responses to A Crisis: Asset Management <ul><li>Rank all assets by how quickly and easily they can be sold </li></...
Most Common Contingency Plan <ul><li>OKAY, BUT  …   “Every banker knows that if he has to prove that he is worthy of credi...
Wholesale Funds Providers Are Brutal Arbiters of Creditworthiness <ul><li>Quickly recognize potential problems </li></ul><...
Segmenting the Propensity  to Withdraw Deposits   Insured or Secured Depositors' Reliance On Information Depositors' Relat...
Sensitivity of Funds Providers By Type Very Sensitive to Perceived Deterioration in Credit Quality or Safety money market ...
Diversification of Funding Sources Should this bank reduce retail deposits and increase fiduciary deposits to improve dive...
Applying Five Diversification Tools For Wholesale Funding Sources Source:  Michael Reuther, Deutsche Bank
Managing Funding Sources <ul><li>Rank, measure, manage for both current needs and for contingent needs. </li></ul><ul><li>...
Wrapping Up
Applying Stress Testing <ul><li>Stress testing is not an end unto itself.  Results have to be used in the risk management ...
Four Essential Liquidity Management Tools <ul><li>Always keep some asset liquidity reserves.  This is the insurance cost o...
For More Information    LIQUIDITY RISK MANAGEMENT and SELF PACED A/L MANAGEMENT published by:  Sheshunoff Information Serv...
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  • Not just undrawn credit facilities but all commitments
  • All processes for securitization have been put in place — systems, tracking, investor reporting etc. As you recall from our loan example, a loan was charged 41 bps for matched liquidity. Here, at a portfolio level, we should credit back 20 bps.
  • Breakdown retail deposits:
  • Short term wholesale funding is used to fund liquid assets! Diversification by counterpart across regions and products requires complex infrastructure We make no stability assumptions for wholesale funding, therefore the contractual maturities are all reflected in the MCO profile. The liquid assets serve as counterbalance as shown before. A considered approach allows a Bank to run a “controlled” liquidity risk at the short end. -&gt; asset saleability
  • download 553 kb PowerPoint presentation

    1. 1. Managing Liquidity Risk: Preparing for Extreme Events Leonard Matz
    2. 2. Why Stress Test? <ul><li>“ The liquidity strategy should set out the general approach the bank will have to liquidity, including various quantitative and qualitative targets. This strategy should address the bank's goal of protecting financial strength and the ability to withstand stressful events in the marketplace.” </li></ul>Source: paragraph 7, Sound Practices for Managing Liquidity in Banking Organizations Basel Committee on Banking Supervision, Basel February 2000 BIS Guidelines Require Stress Testing
    3. 3. Why Stress Test? <ul><li>Stress testing is an important element for sound risk management and contingency planning: </li></ul><ul><ul><li>Stress scenarios highlight potential problems </li></ul></ul><ul><ul><li>The untimely liquidation of assets can be costly </li></ul></ul><ul><ul><li>Good advance planning can, at least potentially, prevent insolvency </li></ul></ul>
    4. 4. What’s Normal / Extreme ? <ul><li>Market Risk ‘normally’ is about ‘Normal Scenarios’ </li></ul><ul><li>What is normal ? </li></ul><ul><ul><li>Quantitative tools are applicable. </li></ul></ul><ul><li>Liquidity Risk is concentrated in “Extreme Scenarios’ </li></ul><ul><li>What is extreme ? … </li></ul><ul><ul><li>There is no Canonical Answer </li></ul></ul><ul><ul><li>Distinctions are derived from everyday life; however as no consensus can be reached: </li></ul></ul><ul><ul><li>They are meaningless in a quantitative context </li></ul></ul>Adapted from material developed by Dr. Robert E Fiedler.
    5. 5. Volatility of Savings Deposits The good news: The bank has not experienced a severe loss of deposits. The bad news: The historical observations tell us NOTHING about a future stress environment. Red lines indicate 2 SD
    6. 6. Measurement and Quantification Processes Stress testing typically applies statistical tools to provide more information about the tail. <ul><li>VaR </li></ul><ul><li>Extreme Value Theory </li></ul><ul><li>Other tools </li></ul>14 Probability Severity of loss
    7. 7. Measurement and Quantification Processes We can’t apply the usual statistical tools to liquidity risk stress testing! <ul><li>Very few banks have had the unfortunate experience of a “near death” experience. </li></ul><ul><li>Those that have don’t have any recent experience. </li></ul><ul><li>The tail in any one bank’s data simply doesn’t include the sorts of stress experiences that keep liquidity risk managers awake. </li></ul>KEY ISSUE 15 Probability Severity of loss
    8. 8. Measurement and Quantification Conclusions <ul><li>Historical observation does not necessarily reflect what might happen (future events) </li></ul><ul><li>Modelling a (fat tail) distribution does not solve the problem either: </li></ul><ul><ul><li>Outlying point or fat tail? </li></ul></ul><ul><ul><li>Risk is not linear in extreme events </li></ul></ul><ul><li>The Question is not: ‘What Risk will we get if we push out the quantiles?’ – The answer to that question is only a matter of scaling and is therefore meaningless! </li></ul><ul><li>Instead, the question is: ‘ Is there a structural change that the bank should model? ’ </li></ul>Adapted from material developed by Dr. Robert E Fiedler
    9. 9. Stress Testing Should Reflect Both Internal and External Scenarios <ul><li>Capital markets disruptions </li></ul><ul><li>Systemic shocks </li></ul><ul><li>Payment system disruptions </li></ul><ul><li>Prolonged global recession </li></ul>External <ul><li>Credit losses </li></ul><ul><li>Operational losses </li></ul><ul><li>Problem merger or acquisition </li></ul>Internal
    10. 10. Stress Environments Affect Both Cash Availability And Needs <ul><li>Cash availability: </li></ul><ul><ul><li>asset liquidity </li></ul></ul><ul><ul><li>unused funding capacity </li></ul></ul><ul><ul><li>cost of borrowing </li></ul></ul><ul><li>Needs: </li></ul><ul><ul><li>deposit withdrawal </li></ul></ul><ul><ul><li>undrawn credit facility drawdown </li></ul></ul><ul><ul><li>collateral pledging </li></ul></ul>
    11. 11. Systemic Crises – A Wide Variety 1987 1990 1991 1992 1994 1995 1997 1998 1999 2000 2001 2002 U.S. stock market crash collapse of U.S. high yield (junk) bond market oil price surge ERM (European Exchange Rate Mechanism) crisis U.S. bond market crash Mexican Crisis Asian crisis Russian default, Ruble collapse. LTCM gold prices TMT (telecommunications, media & technology ) sector collapse September 11 payments system disruption Argentine crisis
    12. 12. <ul><li>Normal course of business, including any seasonal fluctuations: </li></ul><ul><ul><li>VaR Works here, but who cares? This is not a stress scenario. </li></ul></ul><ul><li>Bank specific funding crisis </li></ul><ul><li>Systemic liquidity crisis </li></ul>Use At Least Three Scenarios
    13. 13. It is imperative to use multiple degrees of severity (stress levels) for each need scenario!
    14. 14. Key Facts: <ul><li>The amount of contingent liquidity risk varies depending on the severity of crisis. </li></ul><ul><li>Crises rarely occur instantaneously. They usually develop in stages. </li></ul><ul><li>The duration of liquidity crises has ranged from days to over a year. </li></ul>
    15. 15. Stages of a Funding Crisis
    16. 16. From Funding Liquidity Cash Flows to Contingent Liquidity Stress Tests Source: Dr. Michael Reuther
    17. 17. Stress Test Process Source: Dr. Michael Reuther
    18. 18. Forecasting Cash Out-Flows More than Just Contractual Claims <ul><li>Perception risk </li></ul><ul><li>Surviving a liquidity crisis is not the same as successful liquidation. </li></ul>
    19. 19. Stress Test Process Source: Dr. Michael Reuther
    20. 20. Liquidity From Assets Source: Dr. Michael Reuther
    21. 21. Stress Test Process Source: Dr. Michael Reuther
    22. 22. Stress Tests Detail
    23. 23. Stress Tests Detail
    24. 24. Should You Forecast Cash In-flows? <ul><li>If you are covering today’s risk with tomorrow’s promises, you are masking risk. </li></ul><ul><li>But if you fail to include future cash in flows, your projection is incomplete and your forecasted quantity of liquidity need is unrealistically large. </li></ul>
    25. 25. Assumption Relevanancy <ul><li>Is the scenario relevant to your bank? (e.g. foreign exposure, equity exposure, etc.) </li></ul><ul><li>Is the scenario relevant to your balance sheet? (e.g. core funding versus wholesale funding) </li></ul><ul><li>Is the scenario relevant to your competitive environment? (e.g. ability to generate new deposits) </li></ul><ul><li>Does the scenario capture relationships between changes in credit risk, interest rate risk and liquidity risk </li></ul>
    26. 26. Measurement is Not Management <ul><li>Evaluate stress tests to identify major contributors to risk exposures. Requires the ability to “drill down” into detail. </li></ul><ul><li>Reduce risk exposures if possible. (Topic for another day.) </li></ul><ul><li>Combine stress testing and limits. </li></ul><ul><li>Combine stress testing and liquidity contingency planning. </li></ul>
    27. 27. Liquidity Warehousing – the Easy Stuff <ul><li>NOT cash or interbank deposits </li></ul><ul><li>net funds sales, repos and borrowings – BY TIME PERIOD & SCENARIO </li></ul><ul><li>unpledged, AFS investment securities </li></ul><ul><li>loans or portions of loans that can sold quickly (government guaranteed, loan sale channels, securitizations in process) </li></ul>
    28. 28. Adding Liquid Assets – What Do We Accomplish? Core Assets Liquid Assets Volatile Liabilities Core Funding + Equity Structural Liquidity Deficit Core Assets Liquid Assets Volatile Liabilities Core Funding + Equity Structural Liquidity Deficit
    29. 29. No Bank Can Afford To Hold Enough Liquid Assets to Cover All Contingent Needs in The Worst Scenario at The Highest Stress Level Liquid Assets Are Ideal, But …
    30. 30. Too little liquidity may kill the bank suddenly but too much can kill it slowly. KEY ISSUE
    31. 31. Beyond Liquid Assets <ul><li>Loans can also provide liquidity value </li></ul><ul><ul><li>Mortgages as collateral for FHLB borrowings </li></ul></ul><ul><ul><li>Salable and securitizable assets where bonds have not yet been issued </li></ul></ul><ul><li>A $1 reduction in liquidity risk is just as good as a $1 increase in liquid assets holdings. </li></ul><ul><ul><li>Do not have to hold liquid assets, therefore saves the cost </li></ul></ul>In practice, it depends on the scenario and stress level. When is an asset liquid? When is a liability volatile?
    32. 32. Planned Responses to A Crisis: Asset Management <ul><li>Rank all assets by how quickly and easily they can be sold </li></ul><ul><li>Start preparations for loan sales or securitizations </li></ul><ul><li>Maintain primary and secondary liquidity from assets warehouses </li></ul><ul><li>Manage pledging to free up excess collateral </li></ul><ul><li>Manage pledging to use the least readily salable assets </li></ul>
    33. 33. Most Common Contingency Plan <ul><li>OKAY, BUT … “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.” Walter Bagehot </li></ul>THE WELL PREPARED NEED BETTER PLANS “ Our Plan is Draw Down Our Committed Lines”
    34. 34. Wholesale Funds Providers Are Brutal Arbiters of Creditworthiness <ul><li>Quickly recognize potential problems </li></ul><ul><li>Respond rapidly </li></ul>
    35. 35. Segmenting the Propensity to Withdraw Deposits   Insured or Secured Depositors' Reliance On Information Depositors' Relationship With the Bank Overall Assessment of Stability consumers yes low high high small business in part low high medium large commercial no medium medium low banks no high medium medium municipalities yes high medium high capital markets funds providers no high low low
    36. 36. Sensitivity of Funds Providers By Type Very Sensitive to Perceived Deterioration in Credit Quality or Safety money market mutual funds rating sensitive providers pension funds insurance companies other funds providers with fiduciary responsibility broker/dealers regional and money center banks in your country foreign banks large corporations community banks in your market area Only sensitive to credit quality and liquidity when problems are very bad and highly publicized. local, uninsured, unsecured depositors customers who are net borrowers (their loan balances exceed their deposit balances) local, secured funds providers insured depositors
    37. 37. Diversification of Funding Sources Should this bank reduce retail deposits and increase fiduciary deposits to improve diversification? 16% 4% 9% 15% 2% 20% 6% 28% Retail Deposits Fiduciary Deposits Capital Markets Small/Mid Cap CP-CD Bank Deposits Central Bank Deposits Other Non-Bank Deposits
    38. 38. Applying Five Diversification Tools For Wholesale Funding Sources Source: Michael Reuther, Deutsche Bank
    39. 39. Managing Funding Sources <ul><li>Rank, measure, manage for both current needs and for contingent needs. </li></ul><ul><li>Encourage funding from more sticky sources. </li></ul><ul><li>Monitor borrowing spreads – not unused borrowing commitments. </li></ul><ul><li>Take advantage of market conditions to lengthen maturities when possible. </li></ul><ul><li>Maintain an appropriate amount of time deposits and borrowing with remaining lives greater than 90 days, 180 days and one year. </li></ul>
    40. 40. Wrapping Up
    41. 41. Applying Stress Testing <ul><li>Stress testing is not an end unto itself. Results have to be used in the risk management process. </li></ul><ul><li>Results should be carefully considered when setting risk limits. </li></ul><ul><li>Contingency plans for actions such as asset liquidations should be based on stress test results. </li></ul>
    42. 42. Four Essential Liquidity Management Tools <ul><li>Always keep some asset liquidity reserves. This is the insurance cost of liquidity management. But recognize that you cannot and do not want to hold enough for a catastrophe. </li></ul><ul><li>Extend liability terms to reduce liquidity risk. </li></ul><ul><li>Be prepared to enhance liquidity quickly at the first signs of increased potential need. </li></ul><ul><li>Manage cash flow profiles. </li></ul>
    43. 43. For More Information LIQUIDITY RISK MANAGEMENT and SELF PACED A/L MANAGEMENT published by: Sheshunoff Information Services, Inc. 1-800-456-2340 www.sheshunoff.com written by: Leonard Matz, lmatz@kamakuraco.com

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