A New Regulation for Liquidity Risk - GARP

Copyright © 2011, SAS Institute Inc. All rights reserved.

A New Regulation for Liquidity Risk GARP, 1st December 2011 Jimmy Skoglund, SAS Institute Inc.

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Agenda

A New Regulation for Liquidity Risk A new regulation based on learnings in the recent crisis

New reporting and liquidity monitoring standards

» Short-term stress testing of liquidity coverage ratios

» Long-term structural liquidity mismatch measurement - net stable funding ratios

» Liquidity risk monitoring tools

Modeling Cash Flows for Liquidity Risk Traditional run-off liquidity gaps

Behavior modeling of net cash flows

Counterbalancing capacity of unencumbered assets

Stress testing and liquidity coverage ratios

Pricing Liquidity Risks Mismatch (term) liquidity risk

Contingency liquidity risk

Market liquidity risk

Funds transfer pricing of liquidity risk

Preparing for Liquidity Crisis – Contingency Funding Plans

A Note on Advanced Liquidity Risk Management Techniques Probabilistic measures and limits on liquidity risk

Optimising the counterbalancing capacity portfolio

Wrap Up and Summary

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Agenda

















Wrap Up and Summary

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A New Regulation for Liquidity Risk

The recent credit crisis compounded itself quickly into a major liquidity crisis (or

funding problem), leading to insolvency of major financial institutions

Many banks did not have a dedicated liquidity buffer or liquidity portfolio that

was managed

A key characteristic of the financial crisis was the inaccurate and

ineffective management of liquidity risk in many banks

Learnings from the recent crisis…..

The new [Basel III] liquidity risk regulation underscores the importance of

managing the liquidity contingency buffer in much the same way as capital

Focusing on maintaining a high quality liquidity portfolio that can hedge out

liquidity outflows under stress scenarios

And, integrate the liquidity pricing and hence incentive to raise liquidity as well as

price costly liquidity according to the opportunity cost of raising the needed buffer

Regulators response…..

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Guiding Principles

Basel (2008) ‘Principles for Sound Liquidity

Risk Management and Supervision’

Minimum Reporting

Basel (2009) ‘International Framework for Liquidity

Risk Measurement, Standards and Monitoring’

Liquidity Coverage Ratio (LCR)

Net Stable Funding Ratio (NSFR)

Regulatory Reporting Standards Monitoring Standards

Contractual Maturity Mismatch

Funding Concentration

Unencumbered Assets

Market Monitoring

Guiding Principles

Basel (2009) ‘Principles for Sound Stress Testing Practices and Supervision’

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Guiding Principles



Minimum Reporting








Unencumbered Assets

Market Monitoring

Guiding Principles


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Net Fund Requirements Modeling (market and behavioral risk)

a. Contingent withdrawal of funds (liability side liquidity risk),

b. Liquidity outflow due to off-balance sheet commitments that includes facilities, lines of credit, guarantees, letter of credit (asset side liquidity risk), and

c. Contingent liquidity impact due to derivatives collateral.

Counterbalancing (hedging) Capacity Modeling

a. Liquid asset value (cash, government bonds etc)

b. Haircut securities e.g., corporate bonds

Liquidity Coverage Ratio (LCR) Stock of Counterbalancing Capacity Assets

Net Cash Outflow under Stress Scenarios = > 100%

Short-term (30 day stress scenario)

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Guiding Principles



Minimum Reporting








Unencumbered Assets

Market Monitoring

Guiding Principles


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Net Stable Funding Ratio (NSFR) Available Stable Funding (ASF)

Required Stable Funding (RSF) = > 100%

Structural liquidity mismatch (1 year)

Assets

Unencumbered assets

Liabilities

Consumer loans

Short term funding

Non-core deposits

Core deposits

Long term funding

Equity

Corporate loans

Interbank loans

The NSFR is closely

related to Moody’s Cash

Capital Position (CCP)

100%

100%

85% – 100%

70%

0%– 50%%

0% - 50%

85% - 100%

50% - 100%

50% - 100%

RSF Factors ASF Factors

Long t

erm

assets

Long te

rm fu

ndin

g

Basic Idea:

Banks should avoid

excessive amount of

long-term assets being

funded short-term in

order to not run into

potential liquidity

issues in re-funding

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Guiding Principles



Minimum Reporting








Unencumbered Assets

Market Monitoring

Guiding Principles


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Complementary to NSFR reporting banks are required to monitor:

Counterparty concentration

Product concentration

Currency concentration

NSFR ratio promotes banks to steer part of their funding towards long term stable funding. However, the funding is not necessarily diversified

Contractual Maturity Mismatch Funding Concentration Unencumbered Assets Market Monitoring

Key Monitoring Items

Traditional run-off maturity mismatch.

Contractual maturity used as behavior model

Measures time to insolvency in extreme case of complete drying up of funding i.e., no short-term funding is rolled over

Report on available unencumbered assets that are (i) eligible for collateral, or, (ii) eligible for central bank facilities

Amount

Currency denomination

Estimated market haircut when used as collateral

Location/Business unit

Monitoring market wide information

Equity prices, debt markets, fx markets etc

Monitoring general information on the financial sector

Monitoring bank specific information

Bank’s equity, CDS prices, funding costs etc

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Agenda

















Wrap Up and Summary

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Modeling Cash Flows for Liquidity Risk

Traditional Liquidity Risk Management:

Run-off Liquidity Gaps

Tracking Liquidity Ratios

Now, focus on going concern behavioral modeling under stress scenarios!

a. Modeling Net Funding Requirements of Assets and Liabilities

b. Counterbalancing Capacity of Unencumbered Assets

Insolvency in run-off gap

Cumulative Net

Cash Flow Map

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Modeling Cash Flows for Liquidity Risk Going Concern Liquidity Risk Stress Scenario: Cumulative Net Cash Flow Map Should Not Be Negative!

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Modeling Net Funding Requirements: Example Scenarios

Behavioral Modeling of Consumer Cash Flows Consumer loans:

i. decreasing prepayment rates (cost of funds increase)

ii. Increased default rates

iii. Increase in loan stock (increased demand for funds)

Consumer deposits:

i. Increased withdrawal of funds (run on bank, need for funds)

Behavioral Modeling of Market Funding Sources Unsecured funding:

i. committed lines of credit not available

ii. Wholesale funding rolled over with reduced term and only with counterparties that have a strong relation with the bank

Difficulty maintaining secured funding. Repos are rolled over only if counterparty has strong relation with bank

Behavioral Modeling of Derivatives Margin Requirements Increased margin requirements for OTC derivatives (adverse market scenario)

Increased collateral posting due to reduced value of collateral (adverse market scenario)

Increased margin requirements due to downgrade i.e., rating triggers (bank-specific)

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Example: Deposit run-off stress scenarios

In both of the stress scenarios we see a marked increase in the withdrawal rate up to 1 month.

The depositors that are most sensitive to the stress scenario and rumors about the bank will withdraw early.

After the most sensitive customers have withdrawn the less sensitive customers remain and hence the withdrawal rate decreases significantly.

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Modeling Counterbalancing Capacity of Unencumbered Assets

A CBC scenario, for the unencumbered assets, is constructed by making assumptions about salability, price (haircut), repoability etc

Eligible assets:

Cash, central bank

reserves, government

debt, corporate and

covered bonds with

minimum A rating

(haircuts), securities

with claims on

sovereigns etc with 0%

risk weight

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Retail deposit run-off at

a minimum of 7.5% or 15%

Unsecured wholesale deposit run-off

by small business at

a minimum of 7.5% or 15%

Unsecured wholesale funding run-off

Provided by other legal entity customers at

100%


By non-financial corporates at

75%


By non-financial customers, sovereigns, banks

and public sector enterprises (PSEs) at a minimum of

25%

Cash Outflows

100% of retail contractual inflows from performing assets

0% cash flows from reverse repos and 100% cash flows from

reverse repos of illuiqid securities

0% cash inflow from committed lines of credit

100% contractual inflows from derivatives

100% of wholesale contractual inflows from fully performing

assets

Cash Inflows - - Increased liquidity needs due to valuation changes on

derivative transactions

Increased liquidity needs related to downgrade triggers

Increases liquidity needs related to potential for valution

changes on collateral posted for securing derivative transactions

20%

Loss of funding on asset-backed securities, covered bonds and

other structured finance products

Draws on committed credit and liquidity lines and other contingent

funding liabilities

Additional Components of

Cash Outflows + CBC

Cash

Central bank reserves

Government debt

Sovereign securities

with 0% risk weight

Minimum A rated corporate bonds

(20%-40% haircuts)

Net Funding Requirements

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Cash Outflows Cash Inflows - - Additional Components of

Cash Outflows + CBC

Net Funding Requirements

Insolvency measurement period for LCR

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Agenda

















Wrap Up and Summary

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Pricing Liquidity Risk

Term Liquidity Charge*

Liquidity is a scarce resource and liquidity pricing

should be instituted in a way that rewards

providers of liquidity and penalize its users

Contingency Liquidity Charge Market Liquidity Charge

Credit providers of long-term funds

with term funding spread

Charge long-term illiquid loans

with term funding spread

**Charge opportunity cost of stand-by

unsecured funded liquidity reserves Term liquidity charge

Liquefiability / repoability credit

Assets and liabilities Unencumbered assets

Used in bank’s FTP system to provide

incentives to branches

Accounting for liquidity explicitly in MtM

promotes assets that have short-term

liquidity – by maturity or liquefiability

*Term liquidity charge is

based on the funding

spread vs. swap rates

**Opportunity cost

charge is based on the

spread between

secured and unsecured

funding

Risk premium for offering contingency

liquidity at some pre-defined rate***

***Customer spread

guarantee is an option

on the funding spread

with strike the

guaranteed spread

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Treasury Investors

4% Coupon rate

Cash liquidity

Interbank

Market Swap rate + 30 bps

4% Fixed

Swap deal 5 Y bond funding

Measuring bank’s term liquidity costs

Treasury Investors

4.5% Coupon rate

Cash liquidity

Interbank

Market Swap rate + 45 bps

4.5 % Fixed

Swap deal 10 Y bond funding

5 Year 10 Year

Term funding

liquidity costs

curve

30 bps

45 bps

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Swap rate

Liquidity spread

Maturity 1 Year 2 Years 3 Years 4 Years

3.80% 3.90% 4.20% 4.40%

5 Years

4.50%

0 bps 13 bps 27 bps 35 bps 40 bps

Example: Term liquidity spread for a 5 year loan

Loan

cash flo

w s

ize

Loan maturity term

The loan cash flows are discounted with term liquidity spread.

Hence, pricing should account for the same spread

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Swap rate

Liquidity spread

Maturity 1 Year 2 Years 3 Years 4 Years

3.80% 3.90% 4.20% 4.40%

5 Years

4.50%

0 bps 13 bps 27 bps 35 bps 40 bps

Funds transfer pricing with liquidity risk

Credit spread 5 bps 19 bps 38 bps 47 bps 59 bps

Other spreads* 3 bps 7 bps 11 bps 17 bps 22 bps

Capital allocation 0.5% 0.5% 0.5% 0.5% 0.5%

Capital cost** 6% 6% 6% 6% 6%

FTP

*E.g., costs and charges

= FTP (swap) Capital allocation 100% - ( ) + * Capital allocation * Capital cost

+ FTP (spread)

Note: Liquidity contingency (CBC) costs are not in capital. How account

for opportunity cost of holding CBC similar to capital?

** Cost is the opportunity

cost of holding capital

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Example: Contingency liquidity pricing of a facility

Te

rm liq

uid

ity

co

sts

co

re

part

= 40 bps x 25% = 10 bps

Te

rm liq

uid

ity

costs

unused

port

ion

(dra

wdow

n)

= 40 bps x 70% x 20% = 5.6 bps

Opport

unity

costs

of

unsecure

d

fundin

g

= 8 bps x 70% x 20% = 1.12 bps

Ris

k p

rem

ia

for

fundin

g

spre

ad

vola

tilit

y

= 40 bps x 5% x 70% = 1.4 bps

= 18.12 bps (e.g., 18,120 in currency amount for a 10 million facility)

Liquidity spread

Unsecured funding spread

Current usage

Core part

Drawdown factor

Liquidity spread volatility

40 bps

5 bps

8 bps

30%

25 %

20 %

Market and facility information

Funding spread

Undrawn part 70%

x Core part

Funding spread x Undrawn part x Drawdown factor

Unsecured funding spread x Undrawn part x Drawdown factor

Funding spread x x Funding spread volatility

To

tal

liquid

ity

charg

e

Simplified option risk premia calculation for fixed spread contingency funding*

Unsecured funding (Interbank)

Secured (repo) funding

Unsecured

funding spread

The opportunity cost for unsecured

funding measures the relative cost of

unsecured vs. unsecured funding.

That is the cost of not having a liquid

asset buffer (collateral) for

contingency. The contingency

funding costs is on par with capital

costs for other risks such as credit

risk. However, for liquidity the cost is

for holding liqudity contingency

(CBC) rather than capital

*ATM option approximation for a T

year option is approximately 0.4 x

funding spread x funding spread

volatility x sqrt(T)

Undrawn part

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Agenda

















Wrap Up and Summary

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Contingency Funding Plan (CFP) helps banks strategize its response to liquidity crises in advance.

Objective:

» A CFP contains procedures for (i) counteracting cash flow shortfalls and (ii) maintaining market goodwill of the bank

Content:

» A CFP take into consideration how a funding crisis evolves in different stages as a trigger (early warning actions)

» Large increase in credit spreads, banks funding rates increase compared to peer

banks,..

» A CFP specifies actions based on the triggers

» Action for CBC (sell, repo), project plan for execution of liquidity portfolio

» A CFP nominates crisis teams and committes

Market Monitoring

(Triggers)

Action Plans

Responsibility

Chen, W, and Skoglund, J, 2011. Building a Project

Plan for Liquidity Execution

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Agenda

















Wrap Up and Summary

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A Note on Advanced Liquidity Risk Management Techniques

Probabilistic measures and limits on liquidity risk Market models, behavior models

ALCO puts VaR limits on Maximum Cash Outflow (MCO) at cumulative horizon t=1,…,n

t=1

t=2

t=3

t=4 VaR(t) < MCO(t) for all t, else the

limit has been breached

D (Net Funding Requirements) = D (CBC) D (Net Cash Flow Map) +

VaR(t)

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A Note on Advanced Liquidity Risk Management Techniques

....

,0,,max,

min

t

CBCa

sa

CBCa

sCBCa

Ss

sh

SspstNFRstCBChf

Vhpa

Optimization of asset share

is conditional on CBC

liquidation, repo scenario for

the asset

- Cheapest CBC portfolio

- Absolute mismatch constraints

- … other constratints e.g., tail

mismatch constraints

Optimizing the counterbalancing capacity portfolio* Find the (cheapest) CBC portfolio holdings (cash flows) that best replicates the (negative) Net

Funding Requirements (NFR)

-max(-NFR,0)

Optimal CBC

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Agenda

















Wrap Up and Summary

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Wrap Up and Summary

The new [Basel III] liquidity risk regulation impose significant challenges to banks of enhancing existing liquidity measurement and management methods

Compliance requires

» banks to take a sophisticated scenario based approach to liquidity risk measurement and management

» The establishment of scenario and risk based limits on liquidity risk

» Continous management of the dedicated CBC portfolio

» Cost efficient portfolio

» Policies and procedures to be implemented/reviewed (e.g., monitoring, CFP)

» Best liquidity portfolio execution plan

» Implementation of a pricing system for liqudity risk that decentralizes the incentives for raising liquidity

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References Books and papers

Chen, W, and Skoglund, J, 2011. Cash Flow Replication with Mismatch Constraints. Forthcoming, Journal of Risk

Chen, W and Skoglund, J, 2011. Optimal Portfolio Strategy with Liquidity Capacity, Working paper

Chen, W, and Skoglund, J, 2011. Building a Project Plan for Liquidity Execution. Working Paper

Dev, A. and R, Vandana, 2006. Performance Measurement in Financial Institutions in an ERM Framework. Risk Books.

Matz, L. and P, Neu, ed. 2007. Liquidity Risk Measurement and Management. John Wiley

Moody’s . 2001. How Moody’s Evaluates US Bank and Bank Holding Company Liquidity.

Skoglund, J and Mathur, S, 2011. Liquidity Risk Management After the Crisis, a SAS white paper.

Skoglund, J., 2010. Funds Transfer Pricing and Risk-Adjusted Performance Measurement, a SAS white paper

Basel Committee 2008 ‘Principles for sound liquidity risk management and supervision’

2009 ‘Strengthening the resilience of the banking sector’

2009 ‘International framework for liquidity risk measurement, standards and monitoring’

2009 ’Principles for sound stress testing practices and supervision’

2011 ’Basel III: A global regulatory framework for more resilient banks and banking systems

Senior Supervisors Group 2008 ‘Observations on risk management practices during the recent market turbulence’

Financial Stability Forum 2008 ’Enhancing market and institutional resilience’

Institute of International Finance 2008 ’Final report of the IIF committee on market best practices’


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A New Regulation for Liquidity Risk - GARP

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