Best Practices for Liquidity Risk Management

May 2012Created by Product Management Group

Robert J. Wyle, CFASenior Director, ALM

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Outline

1. Introduction

2. Lessons Learned

3. Liquidity Risk Management Best Practices

4. Liquidity Transfer Pricing

INTRODUCTIONA Definition for Liquidity Risk

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What Is Liquidity Risk?

» Liquidity is the ability to fund increases in assets and meet obligations when they come due.

» Liquidity risk is the risk to a bank’s earnings and capital arising from its inability to timely meet obligations when they come due.

» Liquidity Risk Management involves the processes, controls, and infrastructures established to mitigate unacceptable exposure to liquidity risk.

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What is Liquidity Risk?

In general, there are three central topics that must be effectively managed in order to effectively address firm wide exposure to liquidity risk:

» Market Liquidity Risk is oriented around price changes and P&L impacts

» Funding Liquidity Risk addresses cash flow estimation (assets as well as liabilities)

» Contingency Planning (including stress testing) considers how, in the absence of market or funding liquidity, a bank can continue to meet obligations, particularly during periods of stress.

Changed Economic EnvironmentChanged Economic Environment

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.Systemic Liquidity Mismatches Compounded and Magnified the Consequences of Excess Leverage

– Rapid growth in new funding vehicles– Rapid growth in new on-balance sheet products – Incentives not aligned with risk

• Grow earnings to remain competitive (e.g., “volume” for volume’s sake)

• Over reliance on rating agencies– Increase in system leverage not transparent

• For example, “shadow” system– Liquidity Risk Management did not foresee the extreme systemic

crises– Liquidity Risk was not embedded into business planning and

management

• These challenges force banks to think about the business model implications moving forward

• How should financial institutions address liquidity risk in the future?

Conclusion

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“Measuring and managing bank liquidity risk is as important as capital/solvency risk management, but in the years running up to the crisis did not receive adequate attention, either in the UK or internationally, where debates about bank regulation were dominated by the design of the Basel II capital adequacy standard. It is essential now to restore liquidity regulation and supervision to a position of central importance.”

The Turner Review: A regulatory response to the global banking crisis; March 2009

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LESSONS LEARNED

Lessons Learned by Institutions

» More central coordination and management of business line funding and liquidity risk profiles

» Better integration of liquidity management and liquidity risk management into overall enterprise-wide risk management process

» Robust internal pricing of funding and liquidity risks, including the assignment of liquidity risk premiums in product pricing and business line P&L attribution

» Enhanced internal MIS

» Enhanced contingency funding plans

» More robust liquidity risk stress testing

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Lessons Learned by Supervisors

» Clear articulation of supervisory expectations on liquidity risk management

» Enhanced oversight and enforcement ensuring that supervisory expectations are met

» Strengthening the consistency and robustness of liquidity risk supervision globally through:– Use of consistent supervisory metrics and benchmarks for monitoring the liquidity risk profiles of

institutions

– Enhanced communication mechanisms among home and host supervisors on the liquidity risk profiles of cross-border institutions

– “Global framework for promoting stronger liquidity buffers at financial institutions” G-20, April 2009

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Actions Taken by Supervisors

» Clear articulation of supervisory expectations on liquidity risk management– BCBS -“Principles on Sound Liquidity Risk Management and Supervision”

– CEBS - 30 Recommendations on Liquidity Risk Management

» Enhanced oversight and enforcement that supervisory expectations are met– Heightened efforts by supervisors globally –US, UK, EU supervisors

» Strengthening the consistency and robustness of liquidity risk supervision globally– Enhanced coordination -SSG, CEBS, supervisory colleges ..etc.

– BCBS Working Group on Liquidity

– CEBS efforts

– Basel III Liquidity Requirements

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Common Elements of BCBS “Principles” & CEBS “Recommendations”

» Established risk tolerances

» Adequate “cushions” or “buffers” of unencumbered liquid assets

» Incorporation of liquidity costs in product pricing, performance measurement, and new product approvals

» Robust assessment of contingent liquidity risks –enhanced stress testing of market scenarios and OBS exposures

» More robust liquidity contingency planning

» Management of intra-day liquidity risks

» Active liquidity risk management both within and across legal entities, business lines and currencies

» More robust public disclosure for promoting market discipline

» Enhanced supervisory efforts surrounding liquidity risk management

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LIQUIDITY RISK BEST PRACTICES

Financial

Credit

Reputational

Ope

ratio

nal

Business-as-Usual Environment

Firm

-Specific S

cenarios

Stress-Test Environment

Liq

uid

ity

Ris

k G

ove

rnan

ce In

fras

tru

ctu

re

Market Liquidity Risk

Funding Liquidity Risk

Contingent Liquidity Risk

Source: Office of the Comptroller of Currency

Effective liquidity risk management begins with the establishment of a thorough and strong internal governance process for identifying, measuring and controlling liquidity risk exposure. The LRM infrastructure naturally considers business-as-usual, firm-specific scenarios and stress-test environments. The LRM process considers not only market and funding risks, but how risks are interconnected and can “compound” in ways that create elevated levels of risk and potential exposure. Measures of liquidity risk must be based on both structural condition and prospective (i.e., forward-looking) cash-flow measures.

Effective Liquidity Risk Management Requires a Holistic Perspective

An Integrated Balance Sheet Management Approach

Source: Office of Thrift Supervision

Basel III major implementation challenges» Don’t underestimate the challenge of building a Basel III data warehouse

– Basel III liquidity data requirements span multiple functional and organizational silos

» Treasury» Risk management» Finance

Relevant data is buried in multiple systems and units

Base III framework hinges on integrated asset, capital, and funding management - ERM Framework

» Internal organization challenges (risk versus finance)

» Stress testing and forecasting practices are evolving– Internal and regulatory pressure, forward looking (including market and business forecast assumptions)

– Holistic approach between credit and liquidity risk scenarios(e.g. how could a given counterparty downgrade impact my capital and liquidity ratios?)

» Regulatory reporting burden– While liquidity is a global issue, host regulators have different requirements

– Therefore, institutions need to be aware of the cost to implement a system that will satisfy multiple regulatory regimes

» Timing and Market Signaling– Market pressure to comply with new ratios before dead line

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Basel III data gap analysis

Additional data sourcing required to meet Basel III new Liquidity Risk requirements

From an ALM project From a Basel II project

Market Data OK To be sourced

AssetsOK

Add characteristics forCash flow generation

(or import CFs)

Liabilities OK To be sourced

Off balance Facilities/Counterparties OK

Credit Enhancement To be sourced OK

Counterparties Entity types, country OK

Securities Issuers, repo security legs OK

Ratings To be sourced OK

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Liquidity Risk Management Best Practices

» The institution utilizes a proprietary or vendor liquidity simulation model that evaluates cash flows across time buckets for both assets and liabilities at a detailed level.

» Cash flow modeling considers both contractual instrument features and optional behaviors.

» Credit dominates liquidity concerns. Place reasonable prices on products within HFI banking book, not just HFU and trading positions.

» The institution models daily and weekly time buckets in the near term, monthly buckets in the moderate term and more coarse time buckets in the long run

» The institution uses a framework which consists of early warning indicators, ratio analysis, a liquidity maturity ladder, liquidity gap analysis, and stress testing to quantify liquidity risk exposure.

» Stress testing should include both idiosyncratic and systemic scenarios.

» The liquidity policy, liquidity contingency plan, and funding should be consistent with liquidity stress test scenarios.

» The assumptions for liquidity stress scenarios, funds transfer pricing assumptions, NII simulation, and market value of portfolio equity calculations are consistent.

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Liquidity Risk Stress Testing Best Practices

» Different types of stress testing and scenario analysis are performed on a weekly and monthly basis. Assumptions are in real time.

» Stress testing should include both idiosyncratic and systemic scenanrios.

» The liquidity policy, liquidity contingency plan, and funding should be consistent with liquidity stress test scenarios.

» Liquidity scenario assumptions are reviewed and approved by senior management and the Board on a regular basis.

» Liquidity stress scenarios aid in defining relevant risk metrics and their corresponding limits.

» There is a connection between liquidity stress scenarios, funds transfer pricing assumptions, NII simulation, and market value of portfolio equity calculations.

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Liquidity Transfer Pricing Best Practices

» All assets and liabilities must be transfer priced including the investment. Reporting units cannot simply transfer price net positions.

» In order to avoid the build up of long term illiquid trading assets and short-term volatile funding, consider the application of higher funding charges to trading positions that are more likely to become “stale”.

» Better LTP practices require that banks define an LTP policy which set forth principles or rules to ensure LTP ensures its intended purposes.

» Banks should charge TP rates based on their marginal cost of funds (“arm’s length cash market rates”). In addition, the FTP system should take into account the unique characteristic of the funds. Strip-funding involves funding each cash flow.

» Term liquidity should be applied to floating rate instruments. Many institutions inappropriately assign short term cost of funds to floating rate products.

» A consistent approach should be applied to interest rate risk measurement (both income and market value), risk adjusted performance measurement, and customer product pricing

» Business activities creating the need for additional liquidity should be charged based on their expected usage of contingent liquidity.

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LIQUIDITY TRANSFER PRICING

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Regulatory Emphasis on Contingent Liquidity

Basel: “… the maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs…”

FSA: “A Contingency Funding Plan should set out a firm’s strategy for addressing liquidity shortfalls in stressed conditions…”

Fed: “… a cushion of liquid assets, and a formal well-developed contingency funding plan (CFP) as primary tools for measuring and managing liquidity risk…”

Moody’s Analytics Enterprise Risk Management Solutions

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D. FTP Decomposition

• Funds transfer pricing (FTP) is an increasingly central component of asset-liability management, as it facilitates risk transfer, profitability measurement, capital allocation, and business unit incentive alignment

• The components include a credit spread, which compensates the financial institution for bearing credit risk associated with the exposure, as well as an option spread, which is a premium that compensates the bank for any embedded options in the contract (e.g. prepayment option)

• The funding liquidity spread, which is the expected cost of funds required to support the exposure to its remaining life, and the contingent liquidity spread, which relates to the cost of maintaining a sufficient cushion of high quality liquid assets to meet sudden or unexpected obligation

Funds

Transf

er

Pri

ce

Commercial Margin

Credit Spread

Option Spread

Funding Liquidity Spread

Contingent Liquidity Spread

Reference Rate

*The chart represents an schematic illustration of the components of an FTP

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A bank invests in a variety of assets

Extends backup lines of credit to a pool of borrowers: the future credit quality of them

is uncertain

Fully-funded instruments with

varying degrees of liquidity: the future

liquidity is uncertain

The bank funds the balance sheet using a combination of long-term funds (a liquidity

buffer), short-term collateralized debt, and

possibly asset sales

The degree to which assets can be

collateralized is uncertain

The market price of the assets is uncertain

The bank’s funding costs, due in part to the value of the collateral, and the borrowers’

line usage are correlated

The future correlation behavior is uncertain

Borrowers’ future demand for liquidity (line utilization) is

uncertain

Availability of short-term funds is limited in severe

market conditions

The duration of adverse funding conditions are

uncertain

The future funding needs are uncertain

Basel 3 Contingent Liquidity Risk: Motivation

• What amount of liquid assets should your bank hold in order to absorb potential losses due to adverse funding conditions?

Question

Moody’s Analytics Enterprise Risk Management Solutions

20% 40% 60% 80%0%

4%

8%

12%

20% 40% 60% 80%0%

4%

8%

12%

20% 40% 60% 80%0%

4%

8%

12%

1bps 10bps 100bps 1000bps

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BorrowerUsage

-12% -8% -4% 0% 4% 8%

Bank Gains/Losses

Borrower Credit Migration

Collateral Asset Credit Migration

Market Risk Premium

Haircut/Asset Sale

Ba

nk

Line of credit

borrower

Ba

nk

Market Risk Premium

Ba

nk

Collateralizable Asset BorrowerBank

borrowingcost

Bank Funding Decision: Borrow or

Sell

Contingent Liquidity: Joint Dynamics

Moody’s Analytics Enterprise Risk Management Solutions

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Incorporating Contingent Liquidity Costs in Funds Transfer Pricing for ALM System Calibration

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Commercial Margin

Credit Spread201bps

Funding Liquidity Spread32bps

Contingent Liquidity Spread20bps

Reference Rate

Base Case: λ = 0.5, Corr(Bank,Borrower) = 16.5%

Stressed Scenario: λ = 0.9, Corr(Bank,Borrower) = 33%

FTP =

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3bps

FTP =

32

6bps

Credit Spread261bps

Funding Liquidity Spread32bps

Contingent Liquidity Spread33bpsC

ontr

act

ual Fe

e =

30

0bps

Reference Rate

Contr

act

ual Fe

e =

30

0bps

*Results based on Moody’s Analytics Liquidity Cost Model for a line of credit (bank PD 20bps/annual, borrower PD 1.2%/annual, LGD 50%)

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A Practical Approach for FTP and Spread Decomposition

Fun

ds

Tran

sfer

Pri

ce

Commercial Margin

Credit Spread

Option Spread

Funding Liquidity Spread

Contingent Liquidity Spread

Reference Rate

135 bps

23 bps

78 bps

64 bps

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Robert.Wyle@Moodys.com

BIBLIOGRAPHY

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Bibliography» Results of the Comprehensive Quantitative Impact Study; Bank for International

Settlements; December 2010

» Developments in Bank Supervision – a Canadian Perspective, Remarks by Ted Price, Assistant Superintendant, Office of the Superintendant of Financial Institutions Canada; May 2010

» Basel III: International framework for liquidity risk measurement, standards and monitoring; Bank for International Settlements; December 2010

» Adoption of Bank Standards on Liquidity Risk Management; September 1, 2009; Financial Services Commission

» Basel III Quantitative Impact Study and its Implications; December 17, 2010; Financial Services Commission

» The Basel III Liquidity Framework: Impacts and Recommendations; The Clearing House; November 2, 2011

» The Impact of Sovereign credit risk on bank funding conditions; BIS; July 2011

» Basel III: Long term impact on economic performance and fluctuations; February 2011; Bank for International Settlements

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Bibliography

» Basel III and European Banking: Its impact, how banks might respond, and the challenges of implementation; McKinsey and Company; November 2010

» Senior Supervisors Group; Observations on Risk Management Practices during the Recent Market Turbulence; March 2008

» Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements; Bank For International Settlements; December 2010

» Base III Implementation – Capital Adequacy and Liquidity Requirements; Office of the Superintendant of Financial Institutions Canada; February 2011

» Quantifying the Effects on Lending of Increased Capital Requirements; The Brookings Institute; September 2009

» Remarks by Superintendant Julie Dickson, Office of the Superintendant of Financial Institutions Canada; December 2010

» Basel III: balancing Risk and Regulation, Remarks by Mark White, Assistant Superintendant, Office of the Superintendant of Financial Institutions Canada; December 2010

» Mapping capital and liquidity requirements to bank lending spreads; Bank for International Settlements; November 2010

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Bibliography

» Adoption of Bank Standards on Liquidity Risk Management; Financial Supervisory Service; September 2009

» Basel III Quantitative Impact Study and Its Implications; Financial Supervisory Service; December 2010

» The Impact of Sovereign Credit Risk on Bank Funding Conditions; Bank For International Settlements; July 2011

» Basel III Liquidity Framework: Impacts and Recommendations; The Clearing House; November 2011

» Basel III and Its Consequences: Confronting a New Regulatory Environment; Accenture; 2011

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