Liquidity Risk

1. MAFINRISK 2010Market Risk Liquidity Risk Session 4 Andrea Sironi

2. Agenda • Liquidity risk: what it is and where it comes from • Funding liquidity risk • Stock-based approach • Cash flow based approach • Hybrid approach • Stress tests and contingency funding plans • The Basel Committee framework • Principles for liquidity risk management and supervision • Liquidity coverage ratio • Net stable funding ratio • Market liquidity risk

3. Introduction • The role of liquidity risk in the financial crisis  “Throughout the global financial crisis which began in mid-2007, many banks struggled to maintain adequate liquidity. Unprecedented levels of liquidity support were required from central banks in order to sustain the financial system and even with such extensive support a number of banks failed, were forced into mergers or required resolution. These circumstances and events were preceded by several years of ample liquidity in the financial system, during which liquidity risk and its management did not receive the same level of scrutiny and priority as other risk areas. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy” • Basel Committee on Banking Supervision (2009)

4. Liquidity • Asset and liability mismatch generates not only interest rate risk  liquidity risk • Different meaning of “liquidity”: • Security ease with which it can be cashed back or traded, even in large amounts, on a secondary market • Market liquidity of the securities traded in the market  different proxies of liquidity (e.g. bid-ask spread, volume) • Affected by many factors: n. mkt participants, size & frequency of trades, degree of informational asymmetry, time needed to carry out a trade • Function of tightness (market’s ability to match supply and demand at low cost) and depth (ability to absorb large trades without significant price impact) • Financial institution  ability to fund increases in assets and meet obligations as they come due, without incurring high losses • Generally proxied by the difference between the average liquidity of assets and that of liabilities

5. Liquidity risk • Liquidity risk • risk that a financial institution may not be able to pay back its liabilities in a timely manner because of an unexpectedly large amount of claims • more realistically, it may be able to meet those requests only by quickly selling (fire sale) large amounts of assets, at a price that is below their current market value, thereby suffering a loss • The role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk • Liquidity risk depends not only on the final maturity of assets and liabilities, but also on the maturity of each intermediate cash flow, including the early pre-payment of loans or the unforeseen usage of credit lines

6. Liquidity risk 2 types of liquidity risk • Funding risk risk that a F.I. may not be able to face efficiently (i.e. without jeopardising its orderly operations and its financial balance) any expected or unexpected cash outflows • Market liquidity risk risk that a F.I., to liquidate a sizable amount of assets, will affect the price in a considerable (and unfavourable) manner, because of the limited depth of the market where the assets are traded The two risk types are connected  a F.I. wishing to face unexpected cash outflows may need to sell a large amount of securities  potential sharp fall in price

7. Funding liquidity risk Relevant factors • Contractual maturity of assets and liabilities • Optionality in bank products e.g. demand deposits, guarantees issued, irrevocable loan commitments (e.g. SPVs related to securitization or CP programs), derivatives involving margin requirements Two main type of events • Bank specific events events that distress the confidence of third parties  rating downgrades (especially relevant when covenants or triggers  minimum rating required) • Systemic events e.g. market disruption, liquidity dry up (e.g. recent financial crisis)

8. Funding liquidity risk Three main measurement approaches • Stock based approach • Measures the stock of financial assets that can promptly be liquidated to face a possible liquidity shock • Cash flow based approach • Compares expected cash inflows and outflows, grouping them in homogeneous maturity buckets and checking that cash inflows are large enough to cover cash outflows • Hybrid approach • Potential cash flows coming from the sale (or use as collateral) of financial assets are added to actual expected cash flows • Actual cash flows - adjusted to take into account expected counterparties’ behaviour – are used in all approaches (not contractual ones)

9. Stock based approach • Measures the stock of financial assets that can promptly be liquidated to face a liquidity shock • Requires the bank’s BS be re-stated  contribution each item gives to creating/hedging funding risks • Cashable assets (CA)all assets that can quickly be converted into cash • Volatile liabilities (VL) short term funds for which there is a risk that they may not be rolled over (wholesale funding and volatile portion of customer deposits) • Commitments to lend (CL) OBS items representing irrevocable commitment to issue funds upon request • Steadily available credit lines (AL) irrevocable commitments to lend issued to the bank by third parties (usually, other F.I.s)

10. Stock based approach Cashable assets (CA) • Short-term deposits • Loans  short-term credit lines (e.g., o/n and other interbank facilities) than can be easily and effectively claimed back without endangering the customer relationships • Securities  only unencumbered positions (not used as collateral against loans or derivative contracts)  may also include long term bonds or shares. Does not include securities not traded on a liquid market and not “eligible”  not accepted as collateral (e.g., shares in private companies held for merchant banking purposes, unrated bonds, etc.) • Need of a haircut for: • possible loss relative to the market price • difference between current value and value of the short-term loans that could be obtained by pledging them as collateral

11. Stock based approach Example of a reclassified B/S

12. Stock based approach Cash Capital Position (CCP) • Share of cashable assets not absorbed by volatile liabilities • Signals bank’s ability to withstand liquidity shortages due to: • greater-than-expected volatility in funding sources • unexpected difficulties in the mgmt of cashable assets (e.g. increase haircuts due to unfavourable fin. markets) • To control for bank’s size, CCP sometimes scaled by total assets Example previous slide • CCP = CA – VL = 390 = 9.75% TA • CCP = CA – VL – CL = 90 = 2.25% TA

13. Stock based approach • Long term funding ratios (LTFR)  alternative measure of liquidity based on stocks •  % of assets with a maturity > 5 years funded with liabilities with maturity > 5 years or with capital • Portion of assets with a maturity greater than n years which is being funded with liabilities having an equally great maturity • Banks transform ST liabilities into MTL term loans  LTFR usually below 100% • Low values (or a deterioration over time) may indicate unbalances/weaknesses in the maturity structure of assets & liabilities

14. Cash flow based approach • CCP based on simplified approach  assets and liabilities are either stable or unstable (binary approach) • In reality many different degrees of stability/liquidity exist • Underlying logic of CF based approaches: • restate BS items going beyond a binary logic  maturity ladder • also called “mismatch based approach” • Cash flows are sorted across the different maturities based on: • contractual maturities (including intermediate cash flows) • bank’s expectations • past experience • Mismatch or liquidity gap (Gt)  net unbalance inflows and outflows

15. Cash flow based approach Example of expected cash flows As in the stock-based approaches, demand deposits and loans are dealt with based on their expected actual maturity

16. Cash flow based approach Two type of indicators • Cumulative liquidity gap unbalance between flows associated with a given band and all shorter maturities • Marginal liquidity gaps Gts related to one time band • Note that, when sorting assets and liabilities across time bands, we are considering: • cash flows – not stocks • their expected maturity, not their repricing period

17. Cash flow based approach • Negative cumulative liquidity gap  bank cannot cover foreseeable cash payments with expected inflows  severe warning of potential liquidity shortage • However, one weakness  cash flows associated with securities (including unencumbered assets) are based on contractual maturities and coupons  assets can be used as collateral to get new loans, also at a very short notice •  re-write the maturity ladder taking into account role of unencumbered assets in facing liquidity risks Hybrid approach

18. Hybrid approach • CF based approach  CFs from securities are sorted into maturity buckets based on contractual maturity  a 10-year ZC bond face value €10 mln entirely associated with “10 year” band • Bank’s treasurer can manage liquidity shortages by selling the bond or using it to get funded through a collateralised loan or repo • Haircut  funds raised would only be a share (e.g., 90%) of the bond’s mkt value (which would be less than face value)  e.g. €7 million  70% can be cashed quickly, rest (interest and haircut) available in 10 years • This only applies to unencumbered eligible assets assets the bank can freely sell or pledge as collateral

19. Hybrid approach Modified expected CFs taking into account unencumbered assets Net cash flows look much better using this approach

20. Hybrid approach • Liquidity gaps (marginal and cumulative) for shorter maturities are now positive • The bank looks immune to liquidity shortages for the shorter maturities

21. Hybrid approach • Results achieved so far are affected by assumptions on timing and amounts  uncertainty concerning: • Amount e.g. floating rate securities, IRS, European options • Timing e.g. long-term mortgages being pre-paid, demand deposits left with the bank for years • Both amount and timing cash flows associated to open credit lines or commitments to lend It is important to consider not only an “expected” scenario, but also check how the liquidity gaps would deteriorate in worst case scenarios  stress test

22. Stress test • Stress test  simulation exercise aimed at quantifying the effects of an especially adverse scenario • Three main approaches • Historical approach  historical scenarios (e.g., % of demand deposits unexpectedly withdrawn within 2 or 4 weeks) • Statistical approach  historical data to infer probability distribution of risk factors  reasonable estimate of potential shocks (e.g., on deposits, haircuts, interbank loans, etc.) • Judgement-based approach  subjective appraisals by the bank’s management (support of risk management, supervisors or consultants) • These approaches can be used to simulate individual risk factors separately or jointly (worst case scanarios) • “bank run” on demand deposits • increase in market volatility  increase haircuts on unencumbered assets • A+B jointly

23. Stress test • Stressed scenarios are rather intuitive in principle, but their practical implementation can prove difficult: • A stress exercise is usually limited to a number of selected B/S items (e.g. effect of an extreme scenario on the time profile of cash flows associated only with securities, ignoring other assets and liabilities)  a market turmoil may be accompanied by an increase in customer deposits as investors would postpone their asset allocation choices  indirect effects should also be included • When more risk factors are considered jointly (e.g., a bank run and an increase in market volatility) a simple “algebraic” summation of their effects may not be correct • pessimistic if risk factors are not strongly correlated (probability) • optimistic., if the two shocks are mutually reinforcing (impact)  e.g. confidence crisis hitting a bank in the midst of a market-wide currency crisis  the pressure on deposits might be stronger than it would be in a “quiet” macroeconomic environment

24. Contingency funding plans (CFP) • Stressed scenarios can prove useful in building “contingency funding plans” (CFP) to be triggered in case of extreme scenario • CFP surveys all possible sources of extra funds in the event of a liquidity shock (e.g. temporary withdrawals of compulsory reserves, repos with CB, secured or unsecured interbank loans) • CFP sets priority order (ranking) in which they should be tapped  cost and flexibility of the sources and type of liquidity shock (e.g. interbank loans in case of an institution-specific shock vs. intervention of Central Bank in case of a market-wide crisis • CFP describes people and structures responsible for implementing emergency policies and actions to be taken • A credible CFP can quickly bring panic under control, limiting the duration and breadth of the liquidity shortage

25. Non-maturing assets & liabilities (NOMAL) • Demand deposit  cash flow uncertainty due to: • market interest rates (attractiveness of substitute products) • interest rate applied by the bank (clients’ demand for deposits) • exogenous factors (e.g., the customer’s cash needs) • Possibility to withdraw funds from a bank account or to pay back an overdraft  option held by the customer • Evaluation of these options is complex • Value depends on the entire term structure of interest rates • American option but the client does not exercise it as soon as it is ITM  stickiness of bank interest rates when changes in market rates • Bank can influence probability of exercise by adapting customers’ interest rates to the new market conditions • Options on both sides of B/S are affected by same underlying factors (market rates) but do not hedge each other  tend to be exercised at different times (e.g., liquidity crisis could trigger a reduction in deposits but no early repayment of loans)

26. Non-maturing assets & liabilities (NOMAL) Two approaches • Replicating portfolio • An indefinite-maturity liability (asset) is invested in (funded by) a replicating portfolio consisting of instruments with explicit and predetermined maturities  generates cash flows matching the net outflows arising from the options embedded in the indefinite-maturity liability (asset) • Option based approach • Option value  difference between value of a straight bond and value of an identical bond with an early repayment option • Imperfect analogy  bond option may be exercised only at definite maturities and expires with the final maturity of the bond while products with indefinite maturity never expire and the prepayment option may be exercised at any time

27. Non-maturing assets & liabilities (NOMAL) Replicating portfolio • Static replication • Identifies replicating portfolio based on historical data and keeps constant the weights of the assets in the portfolio • Criterium  minimising tracking error between replicating portfolio and Nomal portfolio • Weights derived from the optimization process are then left constant over time (or rather, are reviewed at discrete, wide time intervals) • Dynamic replication • Weights of securities in replicating portfolio based on simulation models + continuous adjustments (very high-frequency) • Rather than historical data, future probability distribution of risk factors (scenarios)  portfolio weights chosen through some optimization criteria • Does not calibrate model on one set of historical factors (single scenario), but takes into account entire tree of mkt & customer rates and volumes

28. Funding liquidity risk Some peculiarities of funding liquidity risk vs other risks • Liquidity risk  not necessarily risk of losses • Assets & Liabilities mismatch does not need to be faced by capital  by high quality liquid (unencumbered) assets  more capital simply makes a liquidity crisis less likely • If the bank is made up of different legal entities, in the event of a liquidity crisis liquid funds cannot freely be moved from one entity to the other due to the opposition of some supervisory authorities

29. Organizational issues • Liquidity risk management requires systematic approach with clear organizational rules  systematic approach also required by Basel • E.g. Liquidity risk management (LRM) • LRM policy  key role of board of directors • ensures liquidity risk is correctly identified, measured, monitored and controlled • defines risk tolerance and strategy for liquidity risk management • identifies roles and responsibilities of the LRM Unit • receives periodic reports on the liquidity situation • Examples of periodic reports • analysis of the flow of funds • contingency funding plan • list of largest providers of funds • funding gap and maturity structure • structure and composition of the bank's balance sheet • size and cost of more recent very short term funding

30. Organizational issues • Limits are generally imposed to risk-taking units  they may refer to different measures  examples: • Max absolute maturity gap • Max volume of overnight funding in relation to total assets • Max gap between liquid assets and ST liabilities • Min liquid assets net of expected erosion in case of stress • Max concentration of liabilities across counterparties • Key role internal audit in LRM process  e.g. consistency between policies set by senior mgmt and day-by-day risk mgmt, adequacy of processes and soundness of measures • Often an ALM Committee (ALCO)  representatives of all business areas that affect liquidity risk • responsible for development of specific policies for LRM • ensuring adequacy of measurement system

31. Organizational issues • Liquidity Risk Management unit responsible for: • identifying liquidity risks incurred by the bank • monitoring evolution of liquidity profile • developing policies for controlling and mitigating liquidity risk • developing appropriate rules for liquidity risk management  roles, responsibilities and organizational structure; limits; policies and formats for reporting to senior management • Developing liquidity contingency plan • Early warnings events signalling liquidity shortages in advance • Internal early warnings  e.g. increased concentration of assets or liabilities, increase of assets funded by volatile funding • External indicators  e.g. rating downgrades, decline in the bank’s stock price; increase in the bank’s CDS spread; increase in the trading volume of securities issued by the bank, increase in requests for guarantees, increase in the cost of funding, request for (additional) collateral by counterparties, reduction in the lines of credit by corresponding banks

32. Basel Committee: Principles for the management and supervision of liquidity risk Key elements of a robust framework for liquidity risk mgmt: • board and senior management oversight • establishment of policies and risk tolerance • use of liquidity risk management tools such as comprehensive cash flow forecasting, limits and liquidity scenario stress testing • development of robust and multifaceted contingency funding plans • maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs

33. Basel Committee: Principles for the management and supervision of liquidity risk Fundamental principle for the mgmt and supervision of liquidity risk • 1. A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Governance of liquidity risk management • 2: A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system. • 3: Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. • 4: A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet)

34. Basel Committee: Principles for the management and supervision of liquidity risk Measurement and management of liquidity risk • 5: A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk projecting cash flows arising from assets, liabilities and off-balance sheet items • 6: A bank should actively monitor and control liquidity risk and funding needs within and across legal entities, business lines and currencies • 7: A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. • 8: A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions • 9: A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets • 10: A bank should conduct stress tests on a regular basis and use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions • 11: A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations • 12: A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against liquidity stress scenarios

35. Basel Committee: Principles for the management and supervision of liquidity risk Public disclosure • 13: A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgement about the soundness of its liquidity risk management framework and liquidity position The role of supervisors • 14: Supervisors should regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework and liquidity position • 15: Supervisors should supplement their regular assessments of a bank’s liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports and market information • 16: Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position. • 17: Supervisors should communicate with other supervisors and public authorities, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management

36. Basel Committee recent proposals (Dec. 2009) Two internationally consistent regulatory standards • Liquidity coverage ratio • Aimed at ensuring that a bank maintains an adequate level of high quality assets that can be converted into cash to meet its liquidity needs for a 30-day horizon under a liquidity stress scenario • Stock of high quality liquid assets/Net cash outflows over a 30-day time period ≥ 100% • Net stable funding ratio • Aimed at promoting more medium and long-term funding of the assets and activities of banking organisations • Minimum acceptable amount of stable funding based on the liquidity of a bank’s assets and activities over a 1 year horizon • Available amount of stable funding/Required amount of stable funding > 100%

37. Liquidity coverage ratio High quality assets • Unencumbered not pledged either explicitly or implicitly in any way to secure, collateralise or credit enhance any transaction (e.g. covered bonds) and not held as a hedge for any other exposure • Liquid during a time of stress and, ideally, central bank eligible • Fundamental characteristics • Low credit and market risk • 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

38. Liquidity coverage ratio • High quality assets  “unencumbered, high quality liquid assets” (ununcumbered: not pledged either explicitly or implicitly in any way to secure, collateralise or credit enhance any transaction and not held as a hedge for any other exposure)  examples: • Cash • CB reserves • Marketable securities representing claims guaranteed by sovereigns, CBs, non-central gov.t public sector entities (PSEs), BIS, IMF, or multilateral dev.t banks as long as all the following criteria are met: • 0% risk-weight under the Basel II standardised approach • deep repo-markets exist for these securities • the securities are not issued by banks or other financial services entities • Gov.t or CB debt issued in domestic currencies by the country in which the liquidity risk is being taken or the bank’s home country

39. Liquidity coverage ratio High quality assets  some general characteristics Fundamental characteristics • Low credit and market risk • 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

40. Liquidity coverage ratio Net cash outflows • Cumulative expected cash outflows minus cumulative expected cash inflows arising in the specified stress scenario in the time period under consideration • Net cumulative liquidity mismatch position under the stress scenario measured at the test horizon • Cumulative expected cash outflows are calculated by multiplying outstanding balances of various categories of liabilities by assumed % that are expected to roll-off, and by multiplying specified draw-down amounts to various OBS commitments • Cumulative expected cash inflows are calculated by multiplying amounts receivable by a percentage that reflects expected inflow under the stress scenario

41. Liquidity coverage ratio Scenario  combined idiosyncratic & market-wide shock: • a three-notch downgrade in the institution’s public credit rating; • run-off of a proportion of retail deposits; • a loss of unsecured wholesale funding capacity and reductions of potential sources of secured funding on a term basis; • loss of secured, short-term financing transactions for all but high quality liquid assets; • increases in market volatilities that impact the quality of collateral or potential future exposure of derivatives positions and thus requiring larger collateral haircuts or additional collateral; • unscheduled draws on all of the institution’s committed but unused credit and liquidity facilities • need for the institution to fund balance sheet growth arising from non-contractual obligations honoured in the interest of mitigating reputational risk  many of the shocks actually experienced during the financial crisis

42. Net stable funding ratio • Available amount of stable funding/Required amount of stable funding > 100% • NSFR standard is structured to ensure that investment banking inventories, off-balance sheet exposures, securitisation pipelines and other assets and activities are funded with at least a minimum amount of stable liabilities in relation to their requirement as these inflows and outflows are assumed to off-set each other • The NSFR aims to limit over-reliance on wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on and off-balance sheet items

43. The Basel requirements LCR • Similar to a CCP minimum requirement where the denominator is substituted by a net cash outflow estimate • Combination of a stock based and a cash flow based measure NSFR • Similar to a long term funding ratio (LTFR) • More sophisticated as different items are assigned different weights

44. Net stable funding ratio Available amount of stable funding (ASF)

45. Net stable funding ratio Required Stable Funding (RSF): Asset Categories and Associated Factors

46. Market liquidity risk • Market liquidity risk risk that a F.I., to liquidate a sizable amount of assets, will end up affecting the price in a considerable (and unfavourable) manner, because of the limited depth of the market where the assets are traded • Market liquidity risk can be twofold • Exogenous  general market characteristics  outside control of bank • Endogenous  bank’s characteristics (e.g. composition and size of its portfolio) • Market liquidity is measured through the lack of it  transaction costs explicit and implicit incurred by investors to trade: • Bid-ask spread • Market impact  difference between actual transaction price and price that would have prevailed if the transaction had not taken place the higher the lower is market liquidity

47. Market liquidity risk • If no uncertainty on market impact  liquidation value is equal to bid price  transaction cost • If large sale  impact on spread  deviation from its mean value  s + k (increasing function of position size P and decreasing function of market size M) mid-quote at time t bid/ask spread

48. Market liquidity risk Traded volume and bid-ask spread – (Bangia, et al. 1999) Transaction costs can be expected to increase with the transaction size, or, namely, with its impact in relation to market depth

49. Market liquidity risk • The function linking k to P and M is not easy and tends to change over time • Transaction costs also depend on the time period (e.g. gradual liquidation vs. sudden fire sale) • Dowd (2002)  more sophisticated version of the function Hp is the time period the bank wants to liquidate its position (holding period) λ2is the elasticity of TC to hp Both λ need to be estimated empirically Relative size of the position to liquidate Elasticity of transaction costs to the relative position size

50. Conclusions • Liquidity risk has been overlooked in the recent past • As clearly shown by the financial crisis, liquidity risk is crucial for individual financial institutions and for the stability of the financial system as a whole • Liquidity risk measurement methodologies are still at an initial stage in the financial services industry • Some indicators are already used by most banks  cash capital position, liquidity gaps, long term funding ratios • It is more complex to deviate from expected future cash flows and take into account stress scenarios • The regulators are stepping in with some new requirements and general principles