1. Reform of liquidity risk
management after global
financial tsunami
Mr. Fai Y. LAM
Senior VP, CT Risks Solutions Ltd.
MSc in Financial Engineering
CFA, CAIA, FRM, PRM
PRIMA Award of Merit 2005
Monday 15
December 2010
5:00 am
to 5:30 pm
2
Outline
Revisions to Market Risk Framework
Regulatory Liquidity Risk
Capital Enhancement Program
3
Basel committee on liquidity risk
4
What happened during the period?
Basel new capital accord (Basel II)
Kicked off in January 2001
Finalized in May 2006
Glass–Steagall Act repealed on November 12, 1999
Commercial banks in US participated in investment banking activities
Paper On Default Correlation: A Copula Function Approach” by Dr. David X.
LI’s, RiskMetrics Group published in 2000
Acceleration of the CDO market
CDS market grew to US$ 45 tn notional in 2007
Subprime mortgage market grew to US$ 1.3 tn in 2007
Financial tsunami emerged in 2007
Basel Committee issued guideline “Principles for Sound Liquidity Risk
Management and Supervision” in Sep 2008
Basel Committee issued consultative paper “International framework for liquidity
risk measurement, standards and monitoring “ in Dec 2009

2. 5
Regulatory liquidity
Standards
Liquidity coverage ratio
Net stable funding ratio
Monitoring tools
Contractual maturity mismatch
Concentration of funding
Available unencumbered assets
Market-related monitoring tools
6
Liquidity coverage ratio
To ensure existing liquidity can support the
cash flows over a 30-day period under an
acute liquidity stress scenario
100%
30
30
30
Stock of high quality liquid assets
Net cash outflows over a day time period
Stock of high quality liquid assets Cash outflows over a day time period
Cash inflows over a day time period
≥
−
≥ −
− −
7
High quality liquid assets
Fundamental characteristics
Low credit and market risks
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
8
High quality liquid assets
Cash (100%)
Qualifying central bank receivables (100%)
Domestic sovereign or central bank debt in domestic currency
(100%)
Qualifying marketable securities from sovereigns, central
banks, public sector entities, and multi-lateral development
banks (100%)
Qualifying corporate bonds and covered bonds rated AA to
AAA (80%)
Qualifying corporate bonds and covered bonds rated A- to
AA- (60%)

3. 9
Cash inflows
Amounts receivable from retail counterparties
(100% of planned inflows from performing assets)
Amounts receivable from wholesale counterparties
(100% of planned inflows from performing
wholesale customers)
Receivables in respect of repo and reverse repo
transactions backed by illiquid assets and securities
lending/borrowing transactions where illiquid assets
are borrowed (100%)
Other cash inflows, including planned contractual
receivables from derivatives
10
Cash outflows (1)
Retail deposits
Stable deposits (minimum 7.5%)
Less stable retail deposits (minimum 15%)
Unsecured wholesale funding
Stable, small business customers (minimum 7.5%)
Less stable, small business customers (minimum 15%)
Non-financial corporates, sovereigns, central banks and public sector entities
with operational relationships (25% of deposits needed for operational
purposes)
Non-financial corporates, no operational relationship (75%)
Other legal entity customers and sovereigns, central banks, and PSEs without
operational relationships (100%)
Secured funding
Funding from repo of illiquid assets and securities lending/borrowing
transactions illiquid assets are lent out (100%)
11
Cash outflows (2)
Additional requirements
Liabilities related to derivative collateral calls related to a downgrade
of up to 3-notches (100% of collateral that would be required to cover
the contracts in case of up to a 3-notch downgrade)
Market valuation changes on derivatives transactions (amount to be
nationally determined)
Valuation changes on posted noncash or non-high quality sovereign
debt collateral securing derivative transactions (20%)
ABCP, SIVs, Conduits, etc:
Liabilities from maturing ABCP, SIVs, SPVs, etc (100% of maturing
amounts and 100% of returnable assets)
Term Asset Backed Securities (including covered bonds) (100% of
maturing amounts)
12
Cash outflows (3)
Currently undrawn portion of committed credit and liquidity facilities to:
Retail clients (10% of outstanding lines)
Non-financial corporates, credit facilities (10% of outstanding lines)
Non-financial corporates, liquidity facilities (100% of outstanding lines)
Other legal entity customers (100% of outstanding lines)
Other contingent funding liabilities (such as guarantees, letters of credit,
revocable credit and liquidity facilities, etc.) (to be determined by
supervisors, specific to needs at certain banks)
Planned outflows related to renewal or extension of new loans (retail or
wholesale) (100%)
Any other cash outflows (including planned derivative payables)

4. 13
Net stable funding ratio
A minimum acceptable amount of stable
funding based on the liquidity characteristics
of an institution’s assets and activities over a
one year horizon
Available amount of stable funding
quired amount of stable funding
100%
Re
Re
≥
≥
Available amount of stable funding quired amount of stable funding
Available amount of stable funding
14
Capital
Preferred stock with maturity of equal to or greater
than one year
Liabilities with effective maturities of one year or
greater
The portion of “stable” non-maturity deposits and/or
term deposits with maturities of less than one year
that would be expected to stay with the institution
for an extended period in an idiosyncratic stress
event
15
Required amount of stable funding
The value of assets held and funded by the
institution, multiplied by a specific required
stable funding factor assigned to each
particular asset type
The amount of off-balance sheet activity (or
potential liquidity exposure) multiplied by its
associated required stable funding factor
16
Required stable funding (RSF) factor
The RSF factors assigned to various types of assets are
parameters intended to approximate the amount of a
particular asset that could not be monetised through sale or
use as collateral in a secured borrowing on an extended basis
during a liquidity event lasting one year
The RSF factor applied to the reported values of each asset or
off-balance sheet exposure is the amount of that item that
supervisors believe should be supported with stable funding
Assets that are more liquid and more readily available to act
as a source of extended liquidity in the stressed environment
identified above receive lower RSF factors (and require less
stable funding) than assets considered less liquid in such
circumstances and, therefore, require more stable funding

5. 17
Regulatory effort (1)
A big step from the Basel Committee
guideline “Principles for Sound Liquidity
Risk Management and Supervision” (Sep
2008)
Formally define regulatory liquidity in a
consistent and a measurable framework
Relatively easy to calculate
Deterministic, snapshot, rating factor approach
18
Regulatory effort (2)
Recognition of government related entities as
the top funding sources
Appreciation of high quality covered bonds
Regulatory liquidity economic liquidity
Limited details on derivatives
19
Regulatory effort (3)
HKMA Viewpoint article 11 June 2009
http://www.info.gov.hk/hkma/eng/viewpt/
20090611e.htm
*Source : Reorganisation of Banking
Departments in April 2010, HKMA
20
Potential impacts to banking industry
Competition on high quality assets
= high cost of liquidity
Downward pressure on BBB rated corporate bonds
and covered bonds
Merge and acquisition of financial institutions
Political bias on funding to “too large to fail”
Acceleration of coverage to life insurance businesses
Stable and diversified funding from insurance premium
Mortality risk uncorrelated with credit market
More supervisory reporting, reviews and
examinations

6. 21
A simple question
What is my bank’s funding liquidity
risk?
22
Outstanding questions
1. How to set funding liquidity risk limits?
2. Is the funding liquidity risk increasing or decreasing during
the last 12 months?
3. Which branch contributes the most funding liquidity risk?
4. How to diversify the funding sources?
5. How to perform funding liquidity stress testing?
6. What will be the potential loss in the next funding liquidity
crisis?
7. How to plan for contingency funding?
8. How to incorporate funding liquidity risk into cost?
23
Modelling total cash inflow
Probability
Amount
Estimated total
cash inflow
Total cash inflow
Modelling total cash inflow
Lognormal total cash inflow model
μ σ
= +
dI Idt IdW
 
σ
=  μ − + σ
⋅ 
I I T T Normal
I0 : Total estimated cash inflow
IT : Total realized cash inflow
μ I
: Drift of total cash inflow
Calculated according to regulatory liquidity requirements
σ I
: Volatility of total cash inflow
Greater than or equal to 0
Asymmetric
Long right tail 24
( )
2
0 exp ( ) 0,1
2
I
I
T I I I I
 

7. 25
Modelling total cash outflow
Probability
Amount
Estimated total
cash outflow
Total cash outflow
Modelling total cash outflow
Lognormal total cash inflow model
 
σ
2
μ σ
= +
dO Odt OdW
O
μ σ
= − O
0 exp  ( ) + ⋅ 0,1

O O T T Normal
T O O O
2
 
O0 : Total estimated cash outflow
OT : Total realized cash outflow
μO : Drift of total cash outflow
σO : Volatility of total cash outflow
( )
Calculated according to regulatory liquidity requirements
Greater than or equal to 0
Asymmetric
Long right tail 26
27
Regulatory liquidity surplus
gulatory liquidity surplus
Stock of high quality liquid assets
inf month
Total cash low next
=
+
A random variable subject to
Estimated total cash inflow and estimated total cash
outflow
Volatilities of total cash inflow and total cash outflow
Correlation between total cash inflow and total cash
outflow
month
Re
Total cash outflow next
−
28
Regulatory liquidity surplus
A random variable following a multi-lognormal
distribution
No closed form solutions
To be realized easily with Monte Carlo simulation
gulatory liquidity surplus
Stock of high quality liquid assets
σ σ
2 2
( ) ( )
μ I σ μ O
σ
I T T Normal O T T Normal
0 0
I I I O O O
( ) ( )
Re
exp 0,1 - exp 0,1
2 2
Correlation 0,1 , 0,1
Normal Normal
I O
=
ρ
     
+  −  + ⋅   −  + ⋅ 
     
=  

8. 29
Liquidity risk measures
Probability of regulatory liquidity shortage
What is the chance of having net cash outflow not
covered by current stock of high quality liquidity
assets?
Pr
obability of regulatory liquidity shortage
[ 1
Re 0 ] = gulatory liquidity surplus E
30
Monte Carlo simulation in Excel
31
Regulatory liquidity shortage
32
Findings of common sense
Regulatory liquidity 0
== probability of regulatory liquidity shortage = 0
$1 mn high quality liquid assets $1 mn planned
cash inflow
$1 mn planned cash inflow $1 mn planned cash
outflow
Two small funding sources are better than one large
funding source
Two small lending customers are better than one
large lending customer

9. Applications of liquidity risk measures
33
Trend analysis
What is the change of liquidity risk during last year?
Peer analysis
Which branch is the outlier?
Which branch contributes the most liquidity risk?
Liquidity risk limit
Positive regulatory liquidity surplus at 99.9% confidence level
Diversification analysis
What is the benefit of adding more funding sources?
Scenario analysis
How much more regulatory liquidity is required if a new branch is
opened in Shanghai?
Stress testing
Manipulation of expected cash inflow level, cash outflow level,
Further extensions
Internal definition of liquidity and cash flows
Total cash inflow and total cash outflow
broken down by business line, funding source
and customer base
gulatory liquidity surplus
Stock of high quality liquid assets
M
Σ
=
k
Σ
=
+
inf month
Total cash low next
34
volatilities and correlation =
−
N
k
Total cash outflow next
1
k
1
k
month
Re
Your opinions
To download paper and simulation model
http://sites.google.com/site/quanrisk