Global Financial Markets series

Global Financial Markets series

Global Financial Markets is a series of practical guides to the latest financial market tools, techniques and strategies. Written for practitioners across a range of disciplines it provides comprehensive but practical coverage of key topics in finance covering strategy, markets, financial products, tools and techniques and their implementation. This series will appeal to a broad readership, from new entrants to experienced prac-titioners across the financial services industry, including areas such as institutional investment; financial derivatives; investment strategy; private banking; risk manage-ment; corporate finance and M&A, financial accounting and governance, and many more.

Titles include:

Erik BanksLIQUIDITY RISKManaging Funding and Asset Risk

Daniel CapocciTHE COMPLETE GUIDE TO HEDGE FUNDS AND HEDGE FUND STRATEGIES

Sandy ChenINTEGRATED BANK ANALYSIS AND VALUATIONA Practical Guide to the ROIC Methodology

Frances CowellRISK-BASED INVESTMENT MANAGEMENT IN PRACTICE 2nd Edition

Jawwad FaridMODELS AT WORKA Practitioner’s Guide to Risk Management

Guy Fraser-SampsonINTELLIGENT INVESTINGA Guide to the Practical and Behavioural Aspects of Investment Strategy

Michael HünselerCREDIT PORTFOLIO MANAGEMENTA Practitioner’s Guide to the Active Management of Credit Risks

Ross K. McGillUS WITHHOLDING TAXPractical Implications of QI and FATCA

David MurphyOTC DERIVATIVES, BILATERAL TRADING AND CENTRAL CLEARINGAn Introduction to Regulatory Policy, Trading Impact and Systemic Risk

Gianluca OricchioPRIVATE COMPANY VALUATIONHow Credit Risk Reshaped Equity Markets and Corporate Finance Valuation Tools

Andrew Sutherland and Jason CourtTHE FRONT OFFICE MANUALThe Definitive Guide to Trading, Structuring and Sales

Michael C. S. Wong and Wilson F. C. Chan (editors)INVESTING IN ASIAN OFFSHORE CURRENCY MARKETSThe Shift from Dollars to Renminbi

Global Financial Markets seriesSeries Standing Order ISBN: 978–1–137–32734–5

You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above.

Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England.

Liquidity Risk Managing Funding and Asset Risk

Second Edition

Erik Banks

© Erik Banks 2014

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS.

Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988.

First edition 2005 Second edition published 2014 by PALGRAVE MACMILLAN

Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

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ISBN 978-1-349-47692-3 ISBN 978-1-137-37440-0 (eBook)DOI 10.1057/9781137374400

Softcover reprint of the hardcover 2nd edition 2014 978-1-137-37439-4

v

Contents

List of Figures xi

List of Tables xii

List of Boxes xiii

Preface to the 2nd Edition xiv

About the Author xvi

List of Abbreviations xvii

Part I Elements of Corporate Liquidity

1 Liquidity Risk Defined 3 Definitions of Liquidity Risk 3 Liquidity, Risk, and the Corporation 7 Market Risk, Credit Risk, and Liquidity Risk 13

Liquidity risk and the financial crisis of 2007–2008 14 The role of liquidity in the crisis 14 Lessons from the crisis 20

Overview of the Book 22

2 Liquidity and Financial Operations 24 Liquidity Operating Requirements 24 General Approaches to Liquidity Management 27 Financial Imperatives 28 External Requirements 29 The Liquidity Risk/Return Trade-Off 31 Liquidity Profiles Across Industries 33

Financial institutions 34 Non-financial service companies 40 Capital-intensive companies 41 Municipalities and sovereigns 42

Endogenous Versus Exogenous Liquidity 43

3 Sources of Liquidity 48 Sources of Asset Liquidity 49

Liquid assets 49 Cash and marketable securities 49

vi Contents

Receivables 52 Inventories 52

Fixed assets and intangibles 54 Fixed assets 54 Intangibles 55

Sources of Funding Liquidity 55 Short-term funding markets 57

Commercial paper, Euro commercial paper 57 Short-term bank facilities 57 Payables 58 Deposits and repurchase agreements 58

Medium/long-term funding markets 60 Medium-term notes and Euronote facilities 60 Funding agreements and GICs 60 Long-term bonds 61 Loans 62

Equity capital 63 Sources of Off-Balance Sheet Liquidity 64

Securitization 65 Contingent financings 66 Leases 67 Derivatives 68

Amalgamating Liquidity Sources 71

Part II Liquidity Problems

4 Funding Liquidity Risk 77 Sources of Funding Liquidity Risk 78

Unpredictable cash flows 78 Corporations 79 Financial institutions 81

Unfavourable legal or regulatory actions 83 Mismanagement 84 Negative perceptions/market actions 84

Exogenous Considerations 85 The Nature of Funding Problems 87

Rollover problems 87 Lack of market access 88 Commitment withdrawal 89 Excessive concentrations 90

The effects of funding liquidity risk 91

5 Asset Liquidity Risk 93 Sources of Asset Liquidity Risk 96

Contents vii

Exogenous Considerations 96 The Nature of Asset Problems 98

Lack of asset marketability 99 Lack of unencumbered assets 101 Excessive concentrations 102 Misvalued assets 103 Insufficient collateralization 105

The Effects of Asset Liquidity Risk 106

6 Liquidity Spirals and Financial Distress 108 Joint Asset and Funding Risks 108

Problems 109 Causes 112

The Liquidity Spiral 113 Problems 113 Causes 115

Debt investors and banks 116 Rating agencies 118 Management reaction 119

Financial Distress 119 Contagion 120

7 Case Studies in Liquidity Mismanagement 122 Drexel Burnham Lambert (1990) 123 Askin Capital (1994) 126 Orange County (1994) 129 Long Term Capital Management (1998) 131 General American (1999) 135 Swissair (2001) 136 Enron (2001) 140 Northern Rock (2008) 144 Lehman Brothers (2008) 148

Part III Managing Liquidity Risks

8 Measuring Liquidity Risk 155 Common Liquidity Measures 155

Liquidity ratios 157 Cash flow gaps 162 Financial instrument liquidity measures 168 Stress tests 173

Stress testing framework 175 Market parameters 176 Liquidation horizon 178

viii Contents

Cash flows 178 Asset disposals, secured funding and haircuts 179 Unsecured funding 182 Covenants and terminations 183 Collateral 184 Currency exposures 185 Event risks and joint scenarios 185

9 Controlling Liquidity Risk 188 Governance Structure 188

Liquidity risk mandate 191 Risk plan 191 Financial and human resources 192

Management Duties and Responsibilities 194 Liquidity Risk Controls 196

Asset liquidity controls 197 Liquid and fixed asset limits 198 Liquid asset limits 199 Collateral/pledging limits 202

Funding liquidity controls 204 Diversified funding limits 205 Committed facility limits 207

Joint liquidity controls 210 Cash flow gap limits 210 Balance sheet target limits 211 Hybrid ratio limits 212

Off-balance sheet controls 212 Forward commitments and contingencies 213

Other safeguards 215 Defensive interval (Minimum survival period) 215 Reserves 216 Mark and model verification 216 Penalties 217 External relationship management 218

Liquidity Risk Monitoring 219 Asset and funding portfolios 220 Off-balance sheet commitments and contingencies 221 Forward balance sheet 221 Stress scenarios 221 General indicators 222 Monitoring goals 224 Technical capabilities 225

Contents ix

10 Liquidity Crisis Management 227 Scope and Focus 227 Ex-Ante Market Access 231 Defensive Measures 232

Recentralization 232 Funding management 232

Prioritizing funding draw-downs 232 Extending liability maturities 233 Suspending cash flows 234

Asset management 235 Risk hedging 236

Communications 236 Invoking and Terminating the Program 237 Disaster Recovery 239 Testing the Plan 239

11 New Regulatory Initiatives 242 Basel III 243

New liquidity measures 243 Liquidity coverage ratio (LCR) 244 Net stable funding ratio (NSFR) 246

Monitoring liquidity risks 250 Dodd-Frank Act 252 Liquidity Consultation 253 Financial Services Authority’s Bipru 12 254 Solvency II and Other Insurance Regulations 257

12 Summary: The Future of Active Liquidity Risk Management 259 The Micro Role: Best Practices 260

Creating a sound governance framework 260 Implementing proper measures and reporting 261 Using tactical controls 262 Developing and implementing a crisis management process 263 Performing ongoing reviews 263

The Macro Role 263 Conducting regular inspections 265 Promoting competition 265 Avoiding fragmentation 266 Minimizing costs 266 Harmonizing accounting treatment 266 Reinforcing proper capital allocations 267 Providing selective lender of last resort support 267

x Contents

Appendix: A Primer on Gap Management 270

Notes 280

Selected References 294

Index 297

xi

List of Figures

1.1 A general taxonomy of risks 8 2.1 Corporate liquidity needs 27 2.2 Liquidity/return trade-off 33 2.3 Industry-based liquidity spectrum 43 3.1 Common sources of asset liquidity 56 3.2 Common sources of funding liquidity 63 3.3 Generic securitization 66 3.4 Common sources of off-balance sheet liquidity 69 3.5 Key sources of on- and off-balance sheet liquidity 70 3.6 Theoretical and actual liquidity sources for a

securities firm 72 4.1 Generic statement of cash flows and possible sources of

cash flow uncertainty 80 4.2 Funding liquidity risks 92 5.1 Sale price of concentrated position 103 5.2 Asset liquidity risks 107 6.1 The liquidity spiral 115 8.1 Common liquidity measurement techniques 157 8.2 Computation of the net funding requirement 163 8.3 Decomposition of the net funding requirement 164 8.4 Cash flow sources/uses by maturity bucket or duration 165 8.5 Net funding requirement 165 8.6 Generic stress test framework 177 9.1 Controlling liquidity risks 189 9.2 Fixed/liquid asset limits 199 9.3 Liquid asset limits 203 9.4 Collateral/pledging limits 204 9.5 Diversified funding limits 208 9.6 Committed facility limits 210 9.7 Forward commitment and contingency limits 214 9.8 Liquidity risk controls 218 9.9 Dimensions of liquidity monitoring 225 10.1 A liquidity crisis management program 240 11.1 Cash flows, CBC and the net liquidity position 251 12.1 Towards effective liquidity risk management 268 A1.1 Interest rates, rate measures, and banking activities 271A1.2 Sample interest rate scenario 279

xii

List of Tables

2.1 Costs and benefits to a firm under various liquidity scenarios 33

2.2 Examples of liability amount and timing variations 37 2.3 Examples of asset amount and timing variations 38 2.4 Examples of off-balance sheet amount and

timing variations 38 8.1 Corporate liquidity ratios 160 8.2 Financial institution liquidity ratios 162 8.3 RSAs, RSLs, and interest rates 167 8.4a Illustrative financial asset haircuts, normal market

conditions 181 8.4b Illustrative financial asset haircuts, extreme stress market

conditions 181 8.5 Summary stress testing grid 187 9.1 The liquidity buffer, net cash outflows and

the defensive interval 215 11.1 LCR HQLA factors 245 11.2 LCR cash outflow factors 247 11.3 LCR cash inflow factors 248 11.4 Available stable funding factors 249 11.5 Required stable funding factors 249 A1.1 Sample duration calculation 272A1.2 Sample European bank balance sheet 274A1.3 Sample European bank balance sheet 2 274A1.4 Sample European bank balance sheet 3 275A1.5 Relationships between gap, rates and net interest income 276A1.6 Solution to increase/decrease asset/liability sensitivity 276A1.7 Sample option-adjusted gap 279

xiii

List of Boxes

1.1 Sample definitions of liquidity and liquidity risk 6 10.1 Summary funding draw-down road map 234

xiv

Preface to the 2nd Edition

The world has undergone a fundamental transformation since the first edition of Liquidity Risk was published in 2005. The financial crisis of 2007–2008, which was so devastating in its reach and consequences, has transformed many aspects of the financial world and altered conven-tional wisdom regarding prudent risk management.

Much has rightly been written on the crisis and the “lessons learned”. Many “post mortems” have been performed on failed and rescued insti-tutions, new regulatory edicts and rules have been drafted and put into action, and new techniques of risk-taking and risk management have emerged. These are all important outcomes of any severe crisis. Perhaps most importantly, the financial crisis demonstrated that liquidity is the most vital component of a properly functioning financial system – it is the essential lifeblood of banks and other financial institutions and, by direct extension, the essential lifeblood of all other parts of the corporate and governmental world. The rapid disappearance of asset and funding liquidity during the crisis was extremely damaging: for many weeks, and even months, many of the traditional providers of liquidity were unable or unwilling to participate in their liquidity provision functions, mean-ing that sovereign authorities, primarily national central banks, were called on to be the true “liquidity providers of last resort”. It is largely because of their actions that a true financial collapse was avoided, but not before many large institutions failed or had to be rescued, and not before many non-financial stakeholders were financially damaged. Indeed, the list of liquidity-related “casualties” is nothing short of remarkable: Washington Mutual, IndyMac, Countrywide, Lehman Brothers, Bear Stearns, Wachovia, Merrill Lynch, Citigroup, AIG, Northern Rock, RBS, Bradford and Bingley, Dexia, IKB, and Sachsen Landesbank, to name but a few, all suffered from severe liquidity problems. Little wonder, then, that liquidity risk management has re-entered the spotlight.

Given the transformational qualities of the most recent crisis, it seems timely and appropriate to bring the original material in Liquidity Risk up to date and to further expand its scope. The new edition reflects current thinking and ideas and provides a ready roadmap on new rules, regula-tions and governance processes.

The new edition incorporates the following features: An introductory 1. overview of the financial crisis of 2007–2008, with a particular focus on the liquidity dimensions of the dislocation.

Preface to the 2nd Edition xv

Updates throughout the book to reflect “liquidity lessons learned” 2. from the crisis. Several new case studies drawn from the financial sector to illustrate 3. the sometimes devastating consequences of disappearing liquidity. Expanded sections on stress testing and cash flow gaps and their 4. importance in the risk management process. A new chapter dedicated to liquidity-related regulatory changes in the 5. financial sector that have been implemented (or which will be imple-mented over the coming years), with a particular focus on Basel III, Dodd-Frank, Solvency II and the FSA’s prudential liquidity rulebook. New concluding remarks on the future of liquidity risk management. 6. A new appendix on gap analysis and rate-sensitive assets and 7. liabilities.

xvi

About the Author

Erik Banks has held senior risk management positions at various glo-bal financial institutions in New York, London, Tokyo, Hong Kong and Munich over the past 27 years, including that of Managing Director and Chief Risk Officer at UniCredit Markets and Investment Banking, Partner and Chief Risk Officer of Bermuda reinsurer XL Capital’s derivatives sub-sidiary, and Managing Director of Corporate Risk Management at Merrill Lynch. He is the author of more than 20 books on risk management, emerging markets, derivatives, alternative risk transfer, merchant bank-ing, and electronic finance.

xvii

List of Abbreviations

ABCP asset backed commercial paper ALCO asset–liability committee BCBS Basel Committee on Banking Supervision BHC bank holding company BIS Bank for International Settlements bps basis points CAMEL S capital, asset quality, management, earnings, liquidity,

sensitivity to market risk CBC counterbalancing capability CEBS Committee of European Banking Supervisors CMO collateralized mortgage obligation CP commercial paper ECP Euro commercial paper ECU European Currency Unit EMR enhanced mismatch report EMTN Euro medium-term note EVT extreme value theory FINMA Swiss Financial Markets Supervisory Authority FRN floating rate note GAAP generally accepted account principle GIC guaranteed investment contract HQLA high-quality liquid assets IFRS International Financial Reporting Standards ILAS investment-linked assurance schemes IO interest only LAVAR liquidity-adjusted value-at-risk LBO leveraged buyout LC liquidity committee LCMT liquidity crisis management team LCR liquidity coverage ratio LR liquidity risk LTA long-term assets LTL long-term liabilities LTV loan-to-value MAC material adverse change MBS mortgage-backed security MTN medium-term note

xviii List of Abbreviations

NFR net funding requirement NIF note issuance facility NSFR net stable funding ratio OTC over-the-counter PD probability of default PO principal only RICO charges Racketeer Influenced and Corrupt Organization charges RMBS residential mortgage-backed securities RSA rate sensitive asset RSF required stable funding RSL rate sensitive liability RUF revolving underwriting facility SIV structured investment vehicle SPE special purpose entity SPV special purpose vehicle STA short-term assets STL short-term liabilities VAR value-at-risk

Part I

Elements of Corporate Liquidity

3

1 Liquidity Risk Defined

Liquidity, which we define broadly as the availability of cash or equiva-lent resources, is the lifeblood of every commercial and sovereign entity. Liquidity allows expected and unexpected obligations to be met when needed so that daily business affairs can proceed uninterrupted. In the absence of sufficient cash resources, activities may be jeopardized; more importantly, the probability of encountering severe financial distress increases. Indeed, as events of the past few years have demonstrated, the loss of liquidity and the onset of financial distress can often happen very quickly – in as little as 24 or 48 hours. Diligent and prudent management of liquidity is therefore a vital part of corporate financial management.

In this introductory chapter we begin our review of liquidity by exam-ining definitions of liquidity risk and considering liquidity risk in relation to general corporate operations and other dimensions of financial expo-sure. We then provide some background related to the liquidity charac-teristics of the financial crisis of 2007–2008 along with universal “lessons learned.” We finish by outlining the key themes we intend to explore in the balance of the text.

Definitions of Liquidity Risk

It is well understood that the modern corporation must cope with a broad range of risks in the pursuit of business. The same is true, though sometimes to a lesser degree, of municipal, quasi-governmental and gov-ernmental entities. Risk, which we define as any source of uncertainty impacting operations, comes in various forms. Although the taxonomy of risk is necessarily subjective, we begin by segregating risk into financial risk , or the risk of loss arising from financial variables that impact bal-ance sheet and off-balance sheet activities, and operating risk , or the risk of loss arising from variables that impact the physical characteristics and

E. Banks, Liquidity Risk© Erik Banks 2014

4 Liquidity Risk

operations of a business. While operating risks (including exposure to non-financial inputs/outputs, property and casualty losses, environmen-tal liability, fiduciary liability, other legal liability, workers’ health, safety, and compensation, and so forth) are crucial to understand and manage, we shall not consider them in further detail, except in the context of how they might lead to cash flow pressures. Instead, we focus on financial risks, decomposing them first into three broad classes: market risk, credit risk and liquidity risk.

Market risk is the risk of loss due to adverse changes in the market prices/variables of a transaction or business. Credit risk is the risk of loss due to failure by a counterparty to perform its contractual obligations. We can provide further granularity by considering financial exposure variables such as volatility risk, curve risk, directional risk, and basis risk (all subsets of market risk); and default risk, credit spread risk, contin-gent credit risk, sovereign risk, and settlement risk (subsets of credit risk). Both dimensions are essential to proper corporate risk management, but detailed discussion is out of the scope of this book; further descriptions and explanations on these topics can be found in several of the references listed at the end of the book. We shall therefore limit our discussion of market and credit risks to areas where they directly impact aspects of our main focus: liquidity risk, the last of the three broad classes of financial risk. Although liquidity risk is sometimes classified as a subset of market risk, we believe that it is more helpful to consider the category separately. This ultimately allows for more accurate identification, measurement, management and monitoring.

If liquidity is the availability of cash or equivalents, then we can define liquidity risk as the risk of loss arising from a lack of cash or equivalents or, more specifically, the risk of loss arising from an inability to obtain fund-ing at economically reasonable levels, or sell 1 or pledge an asset at carrying prices, in order to cover an expected or unexpected obligation. Liquidity risk can therefore be regarded as the risk of economic loss suffered in attempting to secure the cash that is so vital to business operations.

We can also consider further classes of liquidity risk. It is helpful, for instance, to distinguish between funding (or liability) liquidity, asset liquidity, and joint liquidity, as well as liquidity mismatches and liquidity contingencies.

Funding liquidity focuses on the availability of unsecured liabilities that can be drawn on to create cash, including short-term and long-term debt facilities. Funding liquidity risk is, therefore, the risk of loss stemming from an inability to access unsecured funding sources at an economically reasonable cost in order to meet obligations.

Liquidity Risk Defined 5

Asset liquidity, in contrast, centers on the availability of assets, such as marketable securities, inventories, receivables, and plant and equipment, which can be sold or pledged to generate cash. Asset liquidity risk is thus the risk of loss arising from an inability to convert assets into cash for some expected value in order to meet obligations.

In certain instances asset and funding liquidity join together to produce an incremental degree of risk, which we term joint asset/funding liquidity risk – the risk of loss that occurs when funding cannot be accessed and assets cannot be converted into cash in order to meet obligations.

We can also consider liquidity mismatches . It is common, particularly in financial services, for maturities of cash-sensitive assets and liabilities to be individually and/or collectively mismatched, leading to divergent cash inflows and outflows over time. Liquidity mismatch risk is therefore the risk of loss arising from the non-conformity of assets and liabilities.

Finally, it is important to mention the concept of liquidity contingencies . Future known or unknown events, as well as cash-sensitive contingent transactions that are carried off-balance sheet, can have a meaningful impact on future cash requirements. Liquidity contingency risk can thus be viewed as the risk of loss arising from future events or commitments which unfavorably reshape cash requirements.

We can also consider liquidity risk in the context of internal and exter-nal forces. Some aspects of liquidity are specific to an institution, its financial position, and its scope of operations, and are largely or entirely within its direct control. The liquidity features of the firm are not neces-sarily impacted by, nor do they impact, what happens in an industry or system context; this characteristic is commonly referred to as endogenous liquidity . In some cases, however, liquidity has a broader reach, affecting many institutions in a sector, or contracts in a marketplace; this exogenous liquidity is outside the direct control of any single institution, although in certain instances the actions of individual firms can contribute to the exogenous pressures. Whilst endogenous liquidity events can have a det-rimental effect on an institution, exogenous liquidity events can affect multiple institutions simultaneously, injecting an element of systemic risk into the concept of liquidity risk. The financial crisis of 2007–2008, which we shall consider later in the book, serves as in important example of this phenomenon.

For additional perspectives and definitions on liquidity and liquidity risk, we summarize in Box 1.1 sample definitions from a number of regu-lators and industry bodies. Some of these are specific to financial insti-tutions, and others are applicable more generally to the marketplace at large.

6 Liquidity Risk

Box 1.1 Sample definitions of liquidity and liquidity risk

American Academy of Actuaries (USA) Liquidity is the ability to meet expected and unexpected demands for cash. Specifically, it is a company’s ability to meet the cash demands of its policy and contract holders without suffering any (or a very minimal) loss. The liquidity profile of a company is a function of both its assets and liabilities. Liquidity risk is inherent in the financial services industry, and one must understand, measure, monitor, and manage this risk.

(AAA, 2000, p. 4)

Bank for International Settlements (Supranational) A liquid market is a market where participants can rapidly execute large volume transactions with a small impact on prices.

(BIS, 2000, p. 5)

Canadian Institute of Actuaries (Canada) Liquidity risk is the inability to meet financial commitments as they fall due through ongoing cash flow or asset sales at fair market value. Liquidation risk is the potential loss when the sale of an asset is urgently required, which may result in the proceeds being below fair market value. The loss is the difference between the fire sale price and the fair market value.

(CIA, 1996, p. 4)

Federal Deposit Insurance Corporation (USA) Liquidity represents the abil-ity to efficiently and economically accommodate a decrease in deposits and other liabilities, as well as fund increases in assets. A bank has liquidity poten-tial when it has the ability to obtain sufficient funds in a timely manner, at a reasonable cost.

(FDIC, 1998, p. 1)

Financial Services Authority (UK) Liquidity risk is the risk that a firm, though solvent, either does not have sufficient financial resources available to it to meet its obligations when they fall due, or can secure them only at excessive cost. It is a basic business risk faced to some degree by most (if not all) firms, though clearly it is more significant for some than others.

(FSA, 2003, p. 3)

HM Treasury (UK) Liquidity is the ease with which one financial claim can be exchanged for another as a result of the willingness of third parties to transact in the assets.

(HM Treasury, 1999)

International Association of Insurance Supervisors (Supranational) The risk emerging when the insurer fails to make investments (assets) liquid in a proper manner as its financial obligations fall due.

(IAIS, 2000)

International Organization of Securities Commissioners (Supranational) The risk to [an institution’s] ability to meet commitments in a timely and cost-effective manner while maintaining assets, and in the inability to pursue


profitable business opportunities and continue as a viable business due to a lack of access to sufficient cost-effective resources.

(IOSCO, 2002, p. 3)

Office of the Comptroller of the Currency (USA) Liquidity risk is the risk to a bank’s earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses.

(OCC, 2001, p.1)

Office of the Superintendent of Financial Institutions (Canada) Liquidity is the ability of an institution to generate or obtain sufficient cash or its equiva-lents in a timely manner at a reasonable price to meet its commitments as they fall due.

(OSFI, 1995, p. 2)

Federal Reserve Bank of San Francisco (US) Liquidity is generally defined as the ability of a financial firm to meet its debt obligations without incurring unacceptably large losses.

(FRBSF, 2008, p.1)

Bank for International Settlements (Supranational) Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses.

(BIS, 2008, p.1.)

Figure 1.1 summarizes the general taxonomy of risks we have outlined before.

Liquidity, Risk, and the Corporation

A company requires liquidity in order to operate successfully. Liquidity can be viewed as the essential resource that permits a company to replace its liabilities, meet contractual obligations, and fund growth, all at a reasonable price, as and when needed. Liquid resources allow planned principal and interest payments; supplier, customer or lease payments; committed capital investments; dividends; and other obligatory cash flows to be met on schedule. Equally important, liquidity allows unan-ticipated obligations to be met with ease and at a reasonable economic cost. This is important because cash flow surprises are quite common in the corporate world: a company might be called on to make emergency payments to suppliers, provide customer restitution in the event of prod-uct problems, acquire a competitor when a sudden opportunity arises, or quickly repay contingent obligations when a lender or investor exercises a repayment option. Since unanticipated obligations cannot, by definition, be predicted with any real precision, a company must maintain access to enough resources to cover such eventualities.

8 Liquidity Risk

Failure to meet expected or unexpected payments on a timely basis can have serious ramifications. In particular, when a company cannot cover its obligations, it might jeopardize access to external sources of funding and become a forced seller of assets at unfavorable prices; it might also dam-age its reputation in the marketplace, create investor and creditor unease, and attract unwanted scrutiny from regulators and rating agencies. Any of these events can lead to instances of financial distress, some of which can culminate in bankruptcy. A company might appear to be perfectly sound from a capitalization perspective (possessing sufficient capital and reasona-ble leverage), but if it lacks the cash to meet obligations, it might actually be forced into default. Preventing such an event through active management of liquid resources is thus powerful motivation for a firm’s leadership.

Corporate risks Systemicliquidity risks

Financial risks Operating risks

Market risks

Credit risks

Liquidity risks

Non-financialinput/output risks

Property andcasualty risks

Liability risks

Exogenous assetliquidity risks

Exogenous fundingliquidity risks

Asset liquidity risks (endogenous)

Funding liquidityrisks (endogenous)

Joint asset/fundingliquidity risks

Figure 1.1 A general taxonomy of risks


Liquidity is also necessary in order to fund asset growth. Although capital is the essential ingredient in long-term investment, expansion, and research and development, liquid resources make possible the ini-tial and periodic payments that are necessary to put plans into motion. Since companies depend on growth to build enterprise value, an ability to properly finance such expansion is imperative.

Endogenous liquidity risk can arise for a number of reasons, as we shall note in subsequent chapters. Broadly speaking, liquidity risks are induced by operating risks, credit and market risks, management/reputational problems, and legal/regulatory/compliance difficulties. Actual exposure and risk of loss can intensify dramatically when several of these forces are combined. Operating risks, including disruptions in daily business flows (such as sourcing, acquisition, extraction, transportation, and so forth) can impact cash flows and generate liquidity losses. Although the prudent company will typically have some type of pre-loss financing in place – through insurance, contingent capital or funding, or other forms of risk mitigation – access might be delayed, or coverage might prove inadequate. Those that lack any pre-loss financing at all can face even more severe problems.

Credit risks can lead to liquidity problems if a counterparty fails to perform on a contracted transaction, such as a derivative or loan. The party (perhaps a bank or another company) expecting its counterparty to supply a cash flow will not receive what it should and might experience a liquidity deficit as a result. Market risks can similarly create losses in a firm’s trading and investment portfolio, leading again to a cash flow short-fall. Although this mainly impacts companies following mark-to-market accounting policies, it can also affect companies that have experienced a permanent impairment in asset value. Management, reputational, regula-tory, and compliance problems can also cause, or intensify, liquidity risk. A firm that has damaged its reputation through particular behaviors (such as financial mismanagement, fraud, or product liability/recall) might lose customers and business revenues, causing investors and creditors to re-evaluate their willingness to supply funds. Regulatory sanctions, lawsuits, or other forms of legal action or penalty can exacerbate the situation and create even more pressures through forced compensatory payments.

Exogenous forces, such as a systemic market dislocation, a cyclical credit crunch, or a sovereign event (such as capital controls, asset expropriation, or a debt moratorium), can also play a role in firm-specific and sector liquidity pressures. The modern corporate world is not always defined by stable economic and financial conditions. Even in an era of sophis-ticated products, markets, and conduits, leading-edge computational processes, deregulation, competition, and external and self-regulatory

10 Liquidity Risk

oversight, market stability cannot be guaranteed – meaning that the influence of external forces on liquidity access must always be consid-ered. This becomes particularly critical during periods of economic weak-ness: regional or global economic slowdowns, credit deterioration, and real asset depreciation can intensify liquidity problems at the micro and macro levels.

Although certain regulations exist to help dampen the possibility of large-scale illiquidity, they are not foolproof – the financial crisis of 2007–2008 demonstrated that with resounding force. (In fact, we shall note later in the book instances where regulatory directives have actu-ally intensified liquidity risks.) We can consider several basic examples of external liquidity pressures. For instance, if the banking sector is suf-fering from an excess of bad loans and reducing its corporate lending, individual companies (including those that are good credits) might have difficulty accessing or renegotiating debt facilities on favorable terms, leading to an increase in the cost of funding and inducing liquidity-re-lated losses. If the global equity or fixed income markets are unstable, causing forced panic selling into thin trading volume, the prices of assets might plunge dramatically. Companies needing to sell or pledge assets in order to secure liquidity will be doing so under very unfavorable market circumstances, again suffering losses. Liquidity-related losses can there-fore come from external and internal sources. Although the degree of intensity can vary by firm, industry, country, and market, the specter of loss is always present.

The nature of liquidity risk and risk management is, of course, indus-try-specific. Although companies in all industries must take account of liquidity, some must focus more heavily on active liquidity management than others. This is true when the functions they perform and businesses they run are based on accepting and providing liquidity or transforming the maturity characteristics of a transaction. For instance, financial insti-tutions essentially act as liquidity conduits; they feature fluid and often unpredictable assets, liabilities, and contingencies that must be revalued every day. They also act as maturity transformers, synthetically convert-ing short-term assets and liabilities into longer-term ones, and vice-versa, for their own accounts and on behalf of their clients. This means that they must devote considerable effort to managing the internal liquidity process as precisely as possible. The collective balance sheet of the finan-cial sector – which includes banks, securities firms, broker/dealers, insur-ers, and asset management companies – is characterized by a high degree of liquid and transferable assets (and very little in the way of fixed assets), a large amount of short-term funding (which may be volatile), and sig-nificant off-balance sheet contingencies.


Industrial companies hold a much greater portion of their assets in inventory, property, plant, and equipment – the semi-fixed and fixed assets used to create computers, mobile phones, cars, jet engines, high definition TVs, steel bars, and other durable and non-durable goods. They allocate a smaller percentage of their balance sheets to short-term assets and short-term liabilities, and are far less active in off-balance sheet transactions than their financial counterparts. In addition, most follow accounting conventions that allow the bulk of their operations to be valued at the lower of cost or market value, meaning they may have no need to fund any losses or shortfalls that might arise through use of the mark-to-market accounting process. As a result, such companies tend to place somewhat less emphasis on the daily, active management of liquid-ity risk – though the financial crisis of 2007–2008 has caused many to revisit the issue.

Within the extremes of the financial and industrial sectors lies non-financial service companies, including those focused on transportation, retailing, hospitality, entertainment, beverages, foodstuffs, and so on. Their assets are not as liquid as those of financial institutions, but most carry a reasonably high proportion of inventories, receivables, payables, and short-term funding, and they may also be active in off-balance sheet transactions. They are more likely than industrial firms to employ an active approach to liquidity management.

Municipalities and sovereigns must also manage their liquidity care-fully, balancing inflows from taxes, bond issues, and grants with a variety of outflows, including those related to infrastructure, public safety, edu-cation, and transportation.

Since it is known that cross-industry differences exist, it is no surprise that each industry takes a different approach to the liquidity risk analysis and management process. While it is tempting to say that active liquid-ity risk management is most important for financial institutions – and in some respects it is, because financial institutions are liquidity providers to all other industries and are subject to greater systemic pressures – liquidity risk can prove devastating for firms from a range of non-financial indus-tries. It should not be considered to be of “secondary importance” in the management of corporate affairs. Indeed, some large non-financial corpo-rations have discovered just how critical is access to liquidity, as we shall discover later in the book. While we shall devote a portion of this book to considering liquidity risk for financial institutions, much of our discussion is equally appropriate and relevant for the corporate treasurers and CFOs running non-financial service and industrial companies, and for govern-ment officials managing sovereign/municipal cash flows. The need for an adequate supply of cash resources crosses industry boundaries.

12 Liquidity Risk

Allowing for the obvious differences that can arise as a result of indus-try or sector specialization, a company generally attempts to manage liquidity through its assets and liabilities, and by taking account of its off-balance sheet activities. Although we shall explore this topic in detail in subsequent chapters, we introduce several key thoughts at this point.

After taking account of net cash inflows from operations, funding liquidity is the traditional domain of liquidity risk management – it is con-sidered to be the “first line of defense” in meeting obligations. Effective funding liquidity management is based on determining how the firm’s primary funding sources – from the most committed, reliable, and stable, to the most volatile and unpredictable – can be used to meet demands. Indeed, funding remains the mainstay of many corporate liquidity risk management programs, particularly for firms operating outside of the financial sector. Assets, however, are an integral part of the liquidity risk process. Management of asset liquidity is based on understanding how assets can be used to supplement the cash position generated through core operations and funding. The process is based on analyzing the com-position of the primary asset accounts to determine how much cash value they might yield, and understanding the extent and value of any unen-cumbered assets that can be used as collateral in secured financing trans-actions that generate cash. Off-balance sheet activities have also received much greater attention in the liquidity process over the past decade. Off-balance sheet business can take many forms, including loan commit-ments, guarantees, contingencies, leases, and payments/receipts under derivative transactions. 2 Since these contracts may translate into real cash inflows and outflows, they must form part of any liquidity management program. Indeed, to be comprehensive and accurate, liquidity risk man-agement must be viewed across all three dimensions.

It is also important to note that at least two strategic considerations arise in any discussion of liquidity risk. First, companies typically operate on the basis of a defined business strategy, which dictates which business lines, markets, clients and/or products will be pursued. The development of a liquidity plan must follow from the definition of a business strategy, and not vice-versa. While the liquidity plan (such as one which defines liquidity risk tolerance, funding mix, asset composition, and so forth) will provide controls at the margin, it cannot be the driving force in defining the business of a company.

Second, companies must optimize their operations properly. If liquid-ity is so important, then an argument can be made to direct more assets into truly liquid instruments, and/or to arrange liabilities that are either very long-term in nature or absolutely committed. Each of these actions carries a cost – either a lower return on earning assets or a higher cost of


funding. For companies seeking to maximize enterprise value, such costs may be sub-optimal. For those seeking some form of ex-ante “liquidity insurance protection” the costs may be perfectly justifiable. Accordingly, weighing likely liquidity needs (and making some allowance for a stress scenario) against the resources that are actually needed to operate a busi-ness on value-maximizing principles is a vital part of corporate strategy.

Market Risk, Credit Risk, and Liquidity Risk

We have indicated above that the broad class of financial risks – market, credit, and liquidity risks – is often considered jointly. This is particularly true of market risk, which is sometimes said to include liquidity risk as a specific subset. 3 As we explore the theme of liquidity risk, it is important to consider how and why these risks are related, and how effective man-agement of one can affect the others.

Market risk, or the risk of loss due to adverse changes in the mar-ket prices/variables of a transaction or business, has a direct impact on a firm’s cash inflows and outflows. Market risk positions that produce realized or unrealized gains create cash, while those generating losses absorb cash and require funding. Furthermore, the actual amount of liquidity characterizing an asset, liability, or off-balance sheet contract has a direct bearing on its value. For instance, the more liquid an asset is (that is, the more readily saleable at its carrying value), the greater its worth (all other things equal), and the more rapidly it can be sold with-out affecting the bid–offer spread. Thus, an asset with a small amount of market risk will generate cash with greater ease than an asset with considerable market risk.

Credit risk is the risk of loss due to failure by a counterparty to perform on its contractual obligations. A safe credit risk is one that performs as expected and, where relevant, provides a firm with a planned cash flow; a poor credit risk is one that either delays or defaults on its obligations, cre-ating a cash flow disruption. Although virtually all firms are exposed to some amount of credit risk, financial institutions, which are in the busi-ness of extending credit risk through lending, bond underwriting, securi-ties trading, and securities warehousing, are particularly susceptible to problems – especially if they are not diligent in applying proper credit standards. Indeed, many global bank failures of the past few decades have been attributable to problems arising from the combined effects of credit risk and liquidity risk.

A firm that is highly exposed to market and/or credit risk is almost certainly exposed to a great deal of liquidity risk. The very value and performance of the market and credit risk positions will determine the

14 Liquidity Risk

firm’s own liquidity profile, and indicate whether it will have the liquid resources it expects (at the value it expects) or experience a shortfall and be forced to sustain a liquidity-induced loss. The firm that suffers a very large loss on its market risk portfolios may have to finance the resulting shortfall at a higher cost or through the disposal of assets on less favo-rable terms – crystallizing a loss. The firm that suffers an unexpected credit loss will have to cover the loss of anticipated cash inflows through similar means, again experiencing a shortfall. Given these relationships, the management of liquidity risk must be considered in the context of broader financial risks. A firm with significant market and credit risks cannot expect to have a small amount of liquidity risk, while a firm with negligible market and credit risks may indeed be exposed to a smaller amount of liquidity risk.

Liquidity risk and the financial crisis of 2007–2008

The role of liquidity in the crisis

With some preliminary facts on liquidity risk now in hand, it is helpful to tie directly into “real life” actual practice by taking a brief look at the finan-cial crisis of 2007–2008, along with some of the lessons learned. We will leverage on this discussion throughout the book, particularly in Part III.

The recent financial crisis, the latest in a long series of market dislo-cations, was certainly one of the costliest in terms of both direct and indirect losses (i.e., actual financial losses as well as broader economic contraction). A great deal has already been written on the causes of the crisis, from the original housing bubble built atop cheap credit and sub-prime mortgages, to lax regulation and credit rating agency work, to poor risk management at many global financial institutions: each element played a role in fomenting and transmitting the crisis. Accompanying this complex series of causes were two other notable characteristics: speed and breadth. Many institutions (and regulators) were caught off guard by the speed at which the problems swept through the financial sector and the global economy, and most were surprised by the actual breadth of the contagion. To be sure, the market environment prior to 2007 looked rea-sonably benign. Asset markets were liquid and well bid, corporate balance sheets were funded at low cost (particularly at the short-end) and corpo-rate earnings were generally robust. Little wonder, then, that so many institutions were caught by surprise when the global markets turned in early to mid-2007.

While the crisis featured significant problems with, and mishandling of, both credit and market risks, it also reflected a very poor under-standing of liquidity risks, how they behave and how they need to be


managed. Ex post analysis has revealed that liquidity pressures were – and are – intensified by global markets with rapidly shifting capital flows, a new catalog of sometimes complex financial instruments, and an operat-ing environment characterized by dynamic economic and financial con-ditions. The crisis also demonstrated that the maturity transformation business carried out by banks (and non-bank financial institutions) was pivotal to the liquidity problems that ultimately surfaced. Indeed, many institutions were funding their long-term mortgage loans, commercial loans and securities holdings with very cheap short-term funds, creating gaps that were susceptible to market dislocations. When refinancing was no longer possible (or possible only at a relatively high cost of funds), rapid deleveraging occurred, often involving long-term assets that were not as liquid as once believed; many banks and institutional investors held in their asset portfolios a great deal of structured credit and mort-gage investments that were difficult to value and, ultimately, difficult to sell – creating losses and more liquidity pressures. In addition, at least some banks were forced to bring back on to their balance sheet securi-tization conduits (some containing subprime mortgages) that could no longer access the commercial paper market; we consider this point below. Finally, not all institutions had contingency funding plans in place prior to the crisis, and not all of them enacted plans forcefully and rapidly when needed; this left them very vulnerable as funding sources started becoming scarce.

Most firms underestimated the scope and scale of the crisis because they had not stress-tested their portfolios sufficiently and linked the results into business and risk strategies or contingency funding plans. In fact, the standard operating procedure within the international banking community seems to have been one of “benign neglect”: most assumed that liquidity was, and would remain, cheap and plentiful, and few believed that a catastrophe was either imminent or would move so swiftly. The result, in some cases, was insufficient liquid resources to deal with an escalating crisis. Consider, as just one example, the case of US investment bank Bear Stearns: though its liquidity buffer in early 2008 was its largest ever, it proved completely insufficient when lenders and other creditors began pulling their credit lines – and as management failed to enact properly a crisis plan and dispel rumors of difficulties. The bank lost 80% of its buffer in just two days and was forced into an acquisition by JP Morgan.

Of course, it wasn’t just financial institutions that missed the looming crisis: financial regulators/supervisors were caught off guard as well. Most of them failed to spot the warning signs, and none had really thought to address the issue of liquidity risks in a formal fashion before the onset of

16 Liquidity Risk

the crisis. Consider that the Bank for International Settlements, as central bank of the central banks and the leading authority on global regulation, did not publish its first comprehensive paper on liquidity risk manage-ment challenges until the first quarter of 2007 (its previous paper on the topic was dated 2000) – the comments, which were concepts of potential best practices rather than formal regulations, came too late for financial institutions to consider.

A very notable feature of the crisis was the rapid “drying up” of the global commercial paper, repurchase agreement (repo) and short-term note markets, which created financial and corporate funding pressures; it became challenging, by early 2008, to arrange short-term financing on a stable, economic basis. Use of these key financing markets had grown steadily throughout the decade, and many financial and corporate insti-tutions had come to depend heavily on such short-term funds to support their balance sheets. The “shadow banking system,” including conduits, structured investment vehicles (SIVs), funds, and other special purpose entities, also financed themselves through short-term liabilities. Consider, for instance, that these entities accounted for $1.3 trillion of CP outstand-ings in 2003, and nearly $2.3 trillion just prior to the crisis; similarly, they had $1.3 trillion of repos in 2003 and $2.8 trillion four years later. It is not difficult to imagine what happens when portions of the CP and repo markets suddenly dry up: assets being supported by such funding must either be liquidated or pledged against other financings, either of which creates systemic instabilities (e.g., falling asset prices in “offered only” markets, rising funding costs, and so on). In effect, many of the liquidity provision, maturity transformation and arbitrage activities of banks and shadow banks were arranged during “calmer times” without the proper liquidity backstops.

Freezing up of the interbank market eventually followed, placing even greater strain on bank balance sheets. In fact, the interbank market, rep-resenting the borrowing and lending activities between banks, ceased to function properly during the crisis as banks began to lose trust in one another. The extent of unrealized losses on asset portfolios and the gen-eral opacity of bank balance sheets, the fragile state of funding markets and the uncertainty of risk portfolios meant banks had to be conservative in their extension of credit to others in the sector. Since most major inter-national banks rely quite heavily on such wholesale funding activities to conduct business and manage their liquidity profiles, the sudden loss of market access was troubling. Spreads in the interbank market moved from a normal +10 basis points (bps) to +50 bps during 2007 and +100 bps and more during the Lehman crisis in late 2008 (with the liquidity risk component comprising the bulk of that spread). 4 Global spreads did not


begin to recede until 2009 (but remained high in the Eurozone through 2010–2011 as the credit-driven Euro crisis continued to unfold).

With banks unable to borrow from their traditional sources, they were left with two solutions: constraining lending to companies and individu-als and deleveraging their balance sheets by selling assets – into an imbal-anced (e.g., offered only) and increasingly illiquid market, which caused downward price gaps and attendant losses. Pulling back on credit was a key element in the global recession that soon made its way through the world’s economies, while selling assets (particularly the above mentioned structured securities) into a thinly traded market created financial losses and added further to liquidity imbalances.

As indicated, securitization activities played a key role in escalating liquidity pressures. In normal times the process of originating loans, plac-ing them into a conduit, and then securitizing the conduit and selling the resulting securities to end investors has been an efficient risk transfer mechanism. In the years before the crisis, conduits (and associated struc-tured investment vehicles) containing long-term mortgage assets were typically financed with inexpensive short-term funds, creating a massive liquidity gap and significant vulnerabilities once the short-term market dried up. When this model broke down in mid-2007 (as investors became increasingly nervous about the underlying mortgage collateral), banks suffered heavily: many were forced to absorb unsold conduit assets back on to their balance sheets and fund them through any means possible, intensifying financing pressures. In addition, those which held unsold positions in past deals found themselves writing down the value of com-pletely illiquid assets of increasingly questionable value.

Another notable feature of this particular crisis was greater incidence of the so-called silent bank run. While the classic “bank run” – with queues of retail depositors lining outside of a troubled bank to withdraw money – can be disconcerting, an even more damaging phenomenon is the silent run. The silent run is pernicious because it happens away from the spotlight, generally over a short time frame. In the silent run, deposi-tors, primarily institutional/wholesale, do not withdraw their funds at a moment’s notice (as retail depositors might) but simply elect not to roll over their obligations when they come due: the bank suffering from lack of rollovers finds liquidity ebbing away in a very discreet, but very real, manner. Consider that during this crisis several large banks suffered heavily from such silent runs, including Washington Mutual, Wachovia and Dexia, among others. In all instances, the silent runs and resultant loss of liquidity led to last-minute acquisitions or bailouts.

With interbank lending grinding to a halt – and with eventual loss of additional funding through prime broker customer balances and

18 Liquidity Risk

tri-party repos – it is perhaps not surprising to note that the world’s central banks were finally forced to step in as major providers of liquid-ity, allowing significant repo transactions (with a very broad range of collateral), opening their discount window operations to a wide range of institutions, and arranging for special credit facilities to enhance market liquidity and reinforce capital levels (e.g., $900 billion term auction facility, $150 billion+ primary dealer credit facility, $700 bil-lion troubled asset relief program, $1 trillion term asset-backed loan facility, $1.6 trillion CP funding facility, £850 billion system liquidity, amongst many other schemes). In the aftermath of Lehman’s collapse, these efforts intensified further, with most central bank and national supervisory authorities electing to provide depositors with unlimited deposit guarantees (in order to make them comfortable keeping their funds with banks, thus avoiding massive, and potentially destructive, liquidity-induced bank runs) and, in the case of large “too big to fail” institutions, government-led equity recapitalizations (and in some cases outright nationalizations). Had they not acted to stem the growing loss of confidence in the global banking system, the results would have undoubtedly been catastrophic. The crisis had become so severe that liquidity and solvency problems had effectively merged. It is interesting to consider that in this crisis alone there were actual bank runs (e.g., deposit withdrawals), silent bank runs (e.g., non-renewal of maturity deposits) and “runs in the repo market” (e.g., non-renewal of repurchase agreements) at quite a number of large banking institutions around the world, including IndyMac, Northern Rock, Bradford and Bingley, Countrywide, Washington Mutual, Wachovia, Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, and Dexia, among others. The liquidity problems faced by these, and others, was all too real. Even macro struc-tures such as payment systems, clearinghouses, and settlement systems suffered problems, including volatility spikes, valuation challenges, vol-ume issues, and even customer defaults. In more than a few instances clearinghouses and other central counterparty functions had to scram-ble for their own liquidity to absorb temporary cash shortfalls coming from defaulting counterparties. Ultimately, refinancing capabilities from central banks proved an important mechanism in keeping these entities fully functional.

It is also worth mentioning that, although the crisis moved at times very quickly (in some cases claiming multiple institutions at about the same time, to wit September–October 2008), it was a protracted event with relative “peaks and valleys.” In fact, the financial sector went through 18 months of very critical events and, though some of the more vulner-able banks ostensibly had time to get their “houses in order” by raising


additional financing, sourcing extra capital and repoing whatever assets they could, not all of them did. Consider that the first critical liquidity-driven events appeared in August and September 2007 (e.g., Northern Rock, IKB), but it would be another 6 to 12 months before others suc-cumbed to the same liquidity pressures (e.g., Bear Stearns, Lehman, Dexia, AIG, Wachovia, Merrill Lynch, and so on). The issue we must consider is why, given that relatively lengthy span of time, did not more institutions enact their contingency funding plans to shore up liquidity and capital? We might point to mismanagement, lack of belief that “the worst would happen,” faith that some form of systemic bailout would be arranged, or perhaps some combination of the three.

The involvement of central banks in times of crisis is not, of course, unique. Some have played a key role in previous dislocations, attempting to restore confidence and stability through decisive actions. But their role in this crisis was very extensive and without precedent. Central banks certainly have a duty to provide liquidity to the marketplace in order to keep the financial system stable and healthy and to keep economies growing. The broader issue, and the one that became very obvious during the crisis, was whether central banks should provide liquidity support to individual troubled institutions in order to stave off a deeper prob-lem. Such support could be seen as going beyond the natural remit, and raises with it the perpetual “moral hazard” issue (i.e., encouraging bad behavior, such as excessive risk taking, knowing that there are no real consequences). In fact, any reasonable examination of the facts shows that central banks moved from the traditional role of liquidity suppliers to bailout architects – providing extra liquidity by accepting a wide range of collateral and maturities, but also providing capital-like bailout funds, including emergency loans, emergency capital, and so forth, ostensibly in an effort to prevent a deeper liquidity crisis. We may thus argue that the thin line between illiquidity and insolvency has to be considered in the context of the cost of moral hazard versus the cost of systemic disruption.

There were other liquidity-related features of this crisis, some of which reveal very clearly the nexus of credit, market and liquidity exposures. For instance, financial institutions (and others, including various classes of funds) held certain types of securities believed to be liquid – because they had always been liquid in the past. Many held AAA-rated structured credit and mortgage assets in their liquidity portfolios simply because they were AAA; AAA was synonymous with high quality, high quality was synonymous with liquidity – both of which proved false in the final analysis. 5 Financial institutions (and regulators) believed that the inter-bank market, the CP market, and the repo markets would work as they

20 Liquidity Risk

always had worked – meaning many were funded short. In fact, many banks ran large asset-liability gaps, with heavy short-term liabilities sup-porting long-term loans and securities. As we have already noted, many of the larger banks ran off-balance sheet conduits, SIVs, and SPEs – many of which had to be unwound or brought back on the balance sheet, absorb-ing additional funding. Many banks had risk management processes that were unable to properly deal with liquidity risks; which failed to provide the stress linkages between markets, assets, and liquidity levels, or to pro-vide a proper understanding of asset correlations; and which relied too heavily on inadequate models. Unfortunately, these problems were exac-erbated by weak technology and data, rendering the most basic under-standing of intraday cash and collateral positions virtually impossible. Of course, other external parties failed in a comprehensive understanding of liquidity risk and the potential dangers. Regulators and rating agencies, for instance, completely ignored and underestimated the importance of institutional or asset-specific liquidity and the speed at which both could disappear.

Lessons from the crisis

The post-mortems surrounding the financial crisis have dissected the problems and lessons learned in some detail, and most of the findings, with the benefit of hindsight, present no real surprises. Central to our theme is that liquidity is vital and mismanagement of liquidity can lead to financial distress, sometimes very quickly. Perhaps the only surprise is that the crisis didn’t happen sooner, and that it didn’t claim more insti-tutional victims. And perhaps the only thing we know for certain is that the financial system generally, and individual firms specifically, will face another financial crisis at some future time.

So, how to deal with this vital issue? We shall consider ideas and solu-tions in greater detail throughout the book, focusing on practical ideas. But, to begin introducing these lessons and solutions, let us here consider in summary form some of the working solutions put forth by regulators, credit rating agencies, sophisticated investors, bank directors and other stakeholders (with a reminder that we shall revisit them at greater length in subsequent chapters):

Making sure that governance structures work and that employees ●

throughout the firm have an appreciation of liquidity (and its poten-tial benefits and damage) Holding more capital in support of all risks generally ●

Creating a business strategy that properly and explicitly incorporates ●

liquidity risks


Developing a liquidity risk appetite (or tolerance) that is compatible ●

with the business strategy and available financial resources, and which is aligned with stakeholder expectations Increasing the liquidity buffer generally, increasing the high quality ●

component of the buffer specifically, and making greater use of collat-eral and pre-committed financing (i.e., the “insurance premium” cost of securing liquidity) Limiting the maturity transformation mechanism to levels that are ●

consistent with a stated liquidity risk appetite Ensuring that the most illiquid assets on the corporate balance sheet, as ●

well as the haircuts on liquid assets, are financed with stable funding Making sure stable funding sources are truly stable and that depend- ●

ency on volatile wholesale funding (regardless of market) is mini-mized Recognizing that market confidence is central to liquidity preservation ●

and taking all necessary steps to ensure that confidence exists Improving balance sheet transparency and expanding public disclo- ●

sure to instill confidence Analyzing cash inflows and outflows (current and future) on a regular ●

basis to be well aware of potential problems Implementing meaningful stress tests – including those that are par- ●

ticularly severe and which can reveal areas of vulnerability, however improbable they may appear. Improving the contingency planning process and the diversification ●

of funding; preparing for the downside means recognizing that liquid-ity providers are both credit and market sensitive, and likely to adjust behavior in the face of a dislocation Enacting the contingency plan quickly and forcefully when it is ●

needed

Regulatory supervisors also have additional responsibilities in this new world order. Specifically, they must be better prepared to monitor and take action with regard to deficient liquidity risk management practices at individual institutions, intervening before an idiosyncratic problem becomes a systemic problem. And they must be better able to cooperate across borders in order to halt liquidity-driven systemic crises before they spin out of control (as very nearly happened in September 2008).

Following the development of new rules and regulations, the creation of resolution/wind down authorities, the implementation of new govern-ance and risk processes, and the rollout of new reporting and monitor-ing across a range of risks – but especially liquidity risk – we must now consider whether the global financial system is safer. We might hope and

22 Liquidity Risk

suppose so, but in fact a “real life test” is the only way to verify potential efficacy. Thus, the strength of the solutions derived from lessons learned will only be known for certain after the next major dislocation.

It is equally important to note that new regulations and governance processes can help control liquidity (and other) risks, but not eliminate the downside. Central banks, which played such an important role in the last crisis, will have a role to play in the future as lenders of last resort – for the market in its entirety, but possibly still in support of individual institutions (as the “too big to fail” question has not yet been adequately resolved). A corollary is that the actual roles and authorities of individual central banks should be known in advance and should not be invented as events unfold. In addition, the precise terms on which they will par-ticipate in lending assistance should be made clear in advance of the next crisis.

Naturally, the points noted above relate specifically to financial institu-tions – they were at the center of the crisis, they made considerable mis-takes, and they need to take steps to avoid future problems. But many of the same lessons can be extended to corporate entities from other indus-tries. Some of these points are simple common sense and prudent risk management, regardless of industry or specialization. There are thus uni-versal lessons to take away from this rather wrenching experience.

Overview of the Book

As we embark on our analysis of liquidity risk, we shall consider the topic from a number of theoretical and practical perspectives.

● Part I: In the balance of Part I, we shall expand on aspects of corpo-rate liquidity, first by considering the nature of liquidity and financial operations in the modern corporation, and then by examining tradi-tional sources of asset, liability, and off-balance sheet liquidity. ● Part II: In Part II we analyze the nature of liquidity risks. In Chapter 4 we examine funding liquidity risk, in Chapter 5 we follow with asset liquidity risks, and in Chapter 6 we explore the combination of joint asset/funding liquidity risks and the theoretical nature of liquidity spi-rals, distress, bankruptcy, and contagion. We supplement these discus-sions with a number of “real life” case studies of liquidity crises in Chapter 7, including several that occurred during the financial crisis of 2007–2008. ● Part III: In Part III we shift from an examination of liquidity-induced problems to methods of management and control. In Chapter 8 we focus on practical mechanisms of measuring liquidity risk, in Chapter 9


we describe methods of managing and monitoring liquidity exposures, and in Chapter 10 we discuss the nature and benefits of liquidity-based crisis planning. Chapter 11 considers a range of new regulatory initia-tives that have been introduced in the aftermath of the financial crisis (with a specific focus on those affecting the banking and insurance sectors). We summarize our thoughts and provide some guidance on future challenges in Chapter 12.

24

2 Liquidity and Financial Operations

With some preliminary background on liquidity and its associated risks, we are now prepared to review the role of liquidity in financial opera-tions. By examining concepts related to the operating environment we come to understand the importance of liquidity from an internal and systemic perspective, which will be useful when we consider liquidi-ty-induced problems in Part II of the book. In this chapter we explore liquidity operating requirements, the liquidity risk/return trade-off, liquidity characteristics across industries, and endogenous versus exog-enous liquidity.

Liquidity Operating Requirements

During the 1950s and 1960s companies relied primarily on operations to generate the cash necessary to meet their short-term obligations and supplemented this with conventional bank funding arrangements. With the arrival of more significant volatility in the 1970s (fuelled by deregula-tion, floating interest/currency rates, inflation, and mobile capital) and the advent of new funding and asset management products/solutions in the 1980s and 1990s, firms started becoming more active and creative in their liquidity management practices. Such efforts have expanded further in the first two decades of the millennium as companies strive to maxi-mize enterprise value by utilizing their financial resources as efficiently as possible.

Ample liquidity is necessary in order for a company to meet its finan-cial imperatives and satisfy stakeholder expectations, regulatory rules, and credit rating agency requirements. Liquidity is not, of course, the only corporate or external imperative. Solvency, which we define as a suf-ficiency of capital resources, is just as critical to ongoing corporate opera-tions: absent sufficient capital, a firm becomes insolvent. Accordingly,


Liquidity and Financial Operations 25

individual firms and regulatory authorities devote considerable efforts to ensure capitalization levels are at all times adequate.

While liquidity and solvency are both essential to the corporate balance sheet, they are driven by different factors and are used to achieve differ-ent goals. Liquidity, as we know, relates to maintaining access to cash and equivalents to meet obligations as they come due. Solvency, in contrast, relates to preserving enough capital resources to fund a firm’s ongoing operations and absorb unexpected losses. Both are needed if a firm is to operate as a going concern, but they are still separate and unique: a firm that is technically solvent can fail from lack of liquidity, while a firm that is liquid may become technically insolvent. 1 The two concepts are drawn closer together when severe lack of liquidity, coupled with demands to meet large obligations, forces wholesale disposal of assets at prices that are well below carrying value; in extreme situations, such actions can lead to negative net worth (that is, technical insolvency). Generalizing, we might therefore say that liquidity is primarily concerned with managing short-and medium-term resources and obligations and is thus an essential tactical operating requirement; solvency is focused on the “going con-cern” paradigm over the long-term and is an essential strategic operating requirement.

Liquidity management is a dynamic process because the cash posi-tion of a firm changes, quite literally, every day. At any point in time a liquidity position that appears adequate can become inadequate, and vice versa – the passage of time, the movement of markets, the expected or unexpected inflow and outflow of cash, and the expansion or contraction of business activities ensure that this is the case. Dynamic liquidity man-agement, not surprisingly, is concentrated heavily in the short term, up to 30 or 60 days. While liquidity issues can also affect a medium- or long-term financial position, the degree of sensitivity is much smaller: actions taken today, which will only come to fruition in 6, 12, or 24 months, can often be reshaped during the intervening period – although they, too, will eventually impact the firm’s liquidity profile and requirements through the passage of time.

Since liquidity changes continuously, it is helpful to consider cycles of cash inflows, outflows, and requirements. Firms do not have the same demand for liquidity at all points in time – either seasonally or struc-turally – so a proper plan must be developed. Consider, for instance, Company A, which operates in a very predictable corporate environment, plans ahead for seasonal variations in cash flow, and keeps a liquidity buffer (i.e., a reserve of cash and liquid assets) to cope with unexpected payments; A’s demands for incremental liquidity under any scenario are likely to be negligible. Company B operates in a seasonal business with

26 Liquidity Risk

cash inflows and outflows occurring at regular intervals during the cycle. When B is in the “cash flow positive” portion of the cycle, it does not need extra liquidity and can accumulate a buffer for unexpected payments, or for the cash outflow part of the cycle. When B moves into the “cash flow negative” portion, it needs access to liquidity. If B has planned ahead, it might have accumulated enough of a buffer to meet requirements; oth-erwise, it will have to turn to alternative sources, intensifying liquidity pressures. Finally, we have Company C (operating in the same cycle), which is periodically impacted by unexpected payments (regardless of the phase of the cycle) and has not established a buffer to cover emer-gencies. C always requires access to external liquidity and thus suffers from more serious liquidity pressures. The primary point to emphasize is that companies, regardless of industry, face different liquidity profiles and needs over time, and must deal with a range of internal and external forces when creating a management process. Figure 2.1 illustrates this discussion.

Although dynamic management of liquidity is essential for virtually every organization with fluid operations, it may be of less concern for a very small subset of institutions we classify as “hold to maturity” firms. While this theory is applicable across industries, in practice it is associ-ated with certain investment management operations. The theory states that a firm that is properly match-funded (for instance, asset and liability durations (i.e., cash flow weighted maturities) are approximately equal) and is permitted to hold assets and liabilities until maturity faces no liquidity risk. This occurs because maturing assets provide the funds needed to repay liabilities as they come due. This business model is, however, part of an “ideal world” that is constructed atop several key assumptions:

The firm can hold all assets and liabilities until maturity. ●

Assets and liabilities are properly matched; liabilities, in particular, ●

cannot be presented for early repayment and assets cannot be called away. No unexpected payments arise (or those that arise can be met with an ●

extra buffer of liquidity). Accounts are not marked-to-market. ●

Assets are not subject to default and yield a defined value at maturity. ●

If these conditions exist, a firm arguably faces no liquidity risk. However, since very few organizations operate in this theoretical state, the prudent approach says that liquidity risk is an exposure that every firm must con-sider and manage.


General Approaches to Liquidity Management

Management of liquidity risk is a vital, sometimes complex, function – regardless of industry. In practice, the liquidity management process can be divided into three broad segments: daily management of cash flows, medium-term (6–24 months) management of business operations (includ-ing realignment of assets, liabilities, and off-balance sheet contingencies), and crisis management of stress/disaster events. In the large corporation, liquidity should be managed at both a business unit/legal entity/regional level and at a consolidated level. This is helpful and necessary if particu-lar units are subject to regulations or restrictions that influence access to cash resources. For instance, a subsidiary might be restricted from passing cash to a sister company or up to the parent, or it might have better access to competitive sources of local funding. Knowledge of such costs, benefits and barriers is integral to effective management. Ultimately, of course, consolidated management of liquidity is most critical because that reveals the total picture of a firm’s liquidity position.

In many organizations the task of managing liquidity has historically been the exclusive, or primary, responsibility of the corporate treasury function, with little (and sometimes no) participation by others. In recent years, however, it has become more common for other groups to be directly and indirectly involved in the process: financial control, risk management, operations/settlements, business units, and product development teams all have a stake in the process and are often actively

$ cashflows

Seasonal cashflow cycle

Company B:seasonal external

liquidity needs

Company C:constant external

liquidity needs

Company A:negligible external

liquidity needs

Time

Figure 2.1 Corporate liquidity needs

28 Liquidity Risk

involved. Their duties may also be overseen by executive management and/or board directors. Not surprisingly, the involvement of many differ-ent parties requires robust communication and coordination.

To avoid confusion and problems, many companies manage their liquidity on a formalized basis, through a structure that assigns specific responsibilities to different groups. Although we will consider detailed approaches to governance and liquidity management later in the book, we note at this juncture that a general liquidity plan might focus on the following steps:

Matching cash flows: offsetting cash inflows/outflows of assets and ●

liabilities as closely as possible across the maturity spectrum in order to keep the funding gap tight. Diversifying assets and liabilities: ensuring that portfolios of assets and ●

liabilities are diversified across maturities, markets, sectors, and pro-viders in order to reduce over-reliance on any single source. Creating a liquidity warehouse: developing a portfolio of high quality, ●

liquid securities that can easily be pledged as collateral or sold in order to raise new funds. Developing committed funding sources: obtaining bank facilities that ●

are truly committed, and that will not be withdrawn under any cir-cumstances. Purchasing liquidity options: using financial resources to acquire con- ●

tracts that will provide cash injections when needed.

By creating a plan based on such techniques a firm assumes greater con-trol of its liquidity profile and can actively manage the inflows and out-flows that drive daily operations.

Financial Imperatives

A firm faces certain financial imperatives when conducting business, including maximizing enterprise value and minimizing the possibility of financial distress. 2 From a liquidity perspective, a firm’s executives must be keenly aware of the cash position and be prepared to manage it under both normal market conditions and stress scenarios (where that stress event can last from days to months). Daily operations drive the majority of a firm’s liquidity requirements and are the foundation of any liquid-ity plan; expected cash inflows and outflows form the liquidity baseline, representing resources and obligations generated in the normal course of business. A firm with robust, positive operating cash flow, proper access to funding, and correctly structured asset, liability, and off-balance sheet


portfolios can manage its liquidity under normal market conditions with relative ease.

But financial imperatives related to liquidity must extend beyond the normal course of business. Some allowance must be made for the onset of unexpected obligations or payments – events that represent deviations from the baseline, when cash outflows are larger than expected. These can impact companies from any sector at virtually any time, so the pru-dent firm must prepare by arranging suitable ex ante resources and mar-ket access. For instance, a bank must be ready to respond to the cash pressures imposed by an unexpected wave of deposit withdrawals or the absence of buyers for particular assets that it needs to sell. A steel com-pany has to be ready to respond to emergency repairs to plant and equip-ment that are not suitably covered by insurance, or to a lack of investor interest in rollovers of its commercial paper. As noted, this means that a firm must understand in detail the nature of its cash inflows and out-flows; the structure of its assets, liabilities, and off-balance sheet con-tracts; and any potential surprises that might arise and consume cash resources. If it can do this accurately, then it is well positioned to man-age its liquidity in a prudent manner and meet its financial imperatives under all conditions.

External Requirements

Not all of a firm’s liquidity management process is driven by internal goals. Some portion may also be guided or required by regulatory authorities, who may want to see a robust control process in place. This is particularly true in the financial services sector, where regulatory frameworks (such as Basel II, Basel III, Solvency II, and so on) require a participating institution to adhere to defined liquidity monitoring and management practices. In addition, rating agencies (such as Standard and Poor’s, Moody’s Investor Services and Fitch) may require evidence of certain liquidity management controls in order to award higher credit ratings.

Regulators are interested in preserving systemic market stability and reinforcing investor and creditor confidence. By promoting minimum standards of liquidity (as well as capitalization, asset quality, and so forth) they can help achieve these goals. In the normal course of affairs regula-tors are thus concerned with:

maintaining systemic stability (particularly in industries that supply ●

liquidity to others, intermediate in the origination and allocation of capital funds, transform maturities of cash flows, or create liabilities that are due and payable to others);

30 Liquidity Risk

creating investor, depositor, and lender confidence (which can help ●

strengthen capital flows and participation in government securities markets, including benchmarks used to price other capital instruments and derivative contracts); ensuring conditions are conducive to monetary policy activities ●

(including open market operations, which rely heavily on active trad-ing in government securities and repurchase agreements).

In fact, regulatory involvement occurs on an ex ante and ex post basis. Ex ante , the regulator develops appropriate rules and regulations regarding maintenance of liquidity, and ex post it may provide a liquidity injection, restructuring, or rescue. Ex post involvement must necessarily be lim-ited to instances where systemic stability is truly at risk, such as we have seen during the financial crisis of 2007–2008. If it is applied too liberally, instances of moral hazard are almost certain to arise.

Regulators naturally focus considerable attention on financial institu-tions. In order for the system at large to remain stable, financial institutions must manage liquidity flows properly, providing borrowers, depositors, creditors, policyholders, and investors with funds when desired or con-tractually required. Regulators can ill afford liquidity-related problems in any portion of the financial sector, as dislocation can soon create systemic instabilities, which feed into other sectors of the macro-economy. For instance, problems in the banking sector can disrupt funding availability in the corporate sector, causing broader economic woes, including slow growth and higher unemployment; the crisis of 2007–2008 illustrated this point all too clearly. In order to help protect against systemic liquid-ity problems, regulators may attempt to directly or indirectly influence institutions by penalizing activities that are illiquid or create illiquid-ity. For instance, banks or insurance companies choosing to hold very illiquid securities may be required to allocate more capital in support of the positions or discount their value more heavily. Or financial holding companies that rely on other group companies or subsidiaries for liquid funds (for example through intracompany loans, or dividend upstream-ing) might be restricted in their ability to source such funds so that the broader group structure is not placed at risk. In fact, new regulations put in place starting in 2009 explicitly require banks and insurers to take defined and proactive steps in managing liquidity; we shall discuss this topic later in the book as it represents a fundamental, post-crisis change in the regulatory treatment of liquidity.

Rating agencies also factor into the process. The major credit rating agencies are responsible for assigning ratings to individual firms and sov-ereign entities. These debt ratings are, of course, a reflection of the ability of individual entities to repay their contractual obligations – the greater


the financial strength, the greater the likelihood of timely repayment, the higher the resulting credit rating. Although many factors are used in determining a rating (earnings, capital, asset quality, management, lever-age, competition, and so forth), liquidity counts as an essential ingredi-ent. All other factors equal, a firm that is illiquid will receive a lower rating than one that is liquid. Accordingly, firms must be cognizant of the perspective and requirements of rating agencies as related to finan-cial strength generally, and liquidity strength specifically. Expectations regarding minimum thresholds of acceptable liquidity must be incorpo-rated into overall management plans. Failure to take account of this exter-nal dimension can directly impact on the cost of a firm’s funding and its ability to access specific types of financing.

The consideration of liquidity can thus be seen as a combination of internal financial imperatives and external recommendations or require-ments. While best practices or minimum standards are a good starting point in creating a management framework, companies may find it help-ful to consider processes that go beyond such minimum standards, as we shall note in Part III.

The Liquidity Risk/Return Trade-Off

Let us now return to a point we introduced in Chapter 1. If ensuring an appropriate amount and type of liquidity in order to minimize, or elimi-nate, the prospect of financial distress is a key imperative, then it would seem logical for directors and executives to want to create a company that is as liquid as possible. At first glance it would appear beneficial for a firm to try to maximize the liquidity in its asset portfolio, arrange access to a suf-ficient amount of committed funding, and ensure ongoing ability to enter into contingent transactions that provide further financing options.

While these seem like sensible choices, we must recall that corpora-tions are risky entities, and suppliers of risk capital demand returns that are commensurate with the capital they allocate. Creating a truly liquid corporation comes at a price that detracts from returns: a sacrifice in yield on the asset side of the balance sheet, or a rise in all-in funding costs on the liability side or via off-balance sheet contingencies. For instance, in order to maintain a portfolio of liquid assets (such as short-term govern-ment securities or very high quality corporate or agency securities) that can be converted into cash quickly, with no discount to carrying value, a company must accept a lower yield. The return on liquid assets is lower because the liquidity premium commanded is small compared with assets that are less saleable. The creation of readily liquefiable assets therefore detracts from the company’s overall returns and translates into a lower return for risk capital investors.

32 Liquidity Risk

The same occurs with funding. For example, a company that wants to make certain it has undoubted access to financing will have to pay com-mitment and arrangement fees to its bank for backup revolving credit facilities – a cost of ensuring that liquidity is preserved, one that detracts from investor returns and decreases enterprise value.

The same applies to the banking institution. A bank relies heavily on short-term interbank and demand deposits to fund its loan business; while these may be cheap funding solutions, they are notoriously unstable, par-ticularly in difficult or competitive market scenarios. Lengthening liabil-ity maturities to match asset maturities and eliminate any gap seems like a reasonable solution. Once again, however, there is a price – this time in the form of an increased cost that must be paid for medium-term funding (in a normal positive yield curve environment). The cost compresses the bank’s net interest margin, reduces earnings, and leads to a lower earn-ings valuation. The marginal cost of ensuring liquidity must therefore factor into the corporate analysis. Again, it is relatively simple for a com-pany to remain completely liquid in order to meet any possible liquidity claims – but this will not maximize shareholder value. Naturally, this liquidity risk/return trade-off concept is consistent with other aspects of financial theory: firms and investors seeking greater returns must accept more risk – in this specific case, it is liquidity risk.

If the goal of directors and executives is to maximize enterprise value, the determination of optimal liquidity is complex: it is possible to create a perfectly liquid firm that will never suffer financial distress, but will gen-erate inadequate shareholder returns, or an illiquid firm that may indeed suffer from financial distress under certain scenarios, but will otherwise provide superior investment returns. In fact, the optimal answer is likely to lie between the two extremes: most firms balance the liquidity risk/return decision by attempting to create a liquidity risk profile that allows for pru-dent management of risk – particularly for extreme events that can create devastating losses – while still delivering adequate returns to investors.

The liquidity trade-off can be evaluated in a standard cost/benefit framework, just as a firm might weigh other financial and operating risks. The costs include lower yield on earning assets and/or payment of com-mitment fees to ensure the availability of standby facilities. The benefits include a smaller chance of having to arrange funding at a very high rate of interest or having to sell assets at a distressed level in order to cope with a liquidity crisis. When determining these costs and benefits, it is important for the firm to consider that holding liquid assets is equivalent to purchasing liquidity insurance; if a firm seeks such liquidity insurance from a third party, it will pay a cost in the form of a premium. Thus, to be accurate in the assessment of costs and benefits, it is unfair simply to view


the holding of liquid assets as a gross cost – an estimate of the implied benefit must be factored into the analysis.

Table 2.1 highlights the costs and benefits of a company with vary-ing degrees of liquidity, and Figure 2.2 summarizes the risk/return trade-offs facing firms that seek to eliminate all, a portion, or none, of their liquidity risk, and face no other financial or operating risks (for example the only source of potential risk is from a liquidity-induced loss). Excess returns are those above the risk-free rate.

Liquidity Profiles Across Industries

We have already mentioned that liquidity risk impacts individual indus-tries to varying degrees. In this section we consider some of the general characteristics of liquidity and liquidity risk across four general sectors: financial institutions, non-financial service industries, capital industries,

Table 2.1 Costs and benefits to a firm under various liquidity scenarios

Perfectly liquid firm

Partly liquid firm

Perfectly illiquid firm

Cost Lower investment returns

Possible financial distress

Likely financial distress

Benefit No financial distress Reasonable investment returns

Higher investment returns

Liquidity

Partly liquid firms

Perfecff tly liquid firms(maximum liquidity,

minimum excess returns)

Perfecff tly illiquid firms(minimum liquidity,

maximum excess returns)

Excess investmentreturns

Figure 2.2 Liquidity/return trade-off

34 Liquidity Risk

and municipal and sovereign entities. Given its importance in the pro-vision of liquidity (directly and through the maturity transformation process), we devote a considerable portion of this section to the financial sector.

Financial institutions

Financial institutions, which we define to include banks, securities firms, investment funds (that is, unleveraged mutual funds as well as lever-aged hedge funds), and insurance companies, are in business to supply investment, financial, and risk management services – which, depending on structure, can carry a degree of liquidity risk. Indeed, many finan-cial transactions arranged by, or flowing through, a financial institution carry some element of liquidity transfer. Through their intermediation duties, financial institutions match depositors with loan borrowers and investors with capital markets borrowers; in exchange for capital, they provide investment returns, and in exchange for ex ante premiums, they provide ex post loss financing.

Most financial institutions act as principals rather than agents, which has a direct impact on their own liquidity profiles. For instance, a bank accepts deposits, invests the funds in securities until needed, and makes loans to borrowers. If depositors want to withdraw money, the bank may be obliged to repay on short notice. Since it is unlikely that loans granted to borrowers will fall due at the same time (indeed they will not, as demand or short-sight deposits feature uncertain time horizons), the bank will have to repay depositors through alternative funds – mean-ing it must access other sources of liquidity. The same is true for capital markets dealing. Banks and securities firms regularly make markets in assets as principals, purchasing securities from clients in the secondary market, holding them for some time, and then reselling them to others. This business provides selling clients with liquidity and must be financed by accessing liquidity (for instance, pledging securities for cash in the repurchase agreement market).

A similar process exists in the insurance industry. An insurer might be required to pay expected or unexpected claims to policyholders, provid-ing them with post-loss liquidity, and can only do so by accessing its own internal and external sources of liquidity. In the investment fund industry, investors may redeem fund shares by providing notice, meaning the fund must be able to liquidate enough of the assets in the underlying portfolio to deliver capital back to investors – access to liquidity is essential. While it is true that some investment funds (e.g., hedge funds) require a longer notification period, allowing for more time in sourcing liquidity, many


others (e.g., mutual funds and the rapidly growing exchange traded fund market) are structured to provide either daily or instantaneous redemp-tion, meaning access to liquidity by the fund manager must be equally rapid.

Liquidity claims can also appear through off-balance sheet activities, including those generated by contingent liabilities, commitments, and derivative contracts; all represent important sources of business and risk for financial institutions. By warehousing risks, transforming maturities, and providing investment or risk-based cash flows, financial institutions are able to provide “liquidity insurance” to risk-averse depositors, bor-rowers, investors, and insureds; in order to be able to perform this func-tion properly, the typical financial balance sheet might feature more than 90 percent of assets in truly liquid form.

To decrease reliance on lower yielding stored liquidity, financial firms manage their liabilities closely. A bank’s liability position is generally built on short-term borrowing, such as deposits, interbank funds, and repur-chase agreements. Incremental asset growth is then managed through asset conversion and liability liquidity management. Under the asset con-version scheme, a bank issues additional savings and time deposits, floats bonds, or accesses non-deposit funding sources, and stores the proceeds in a liquidity warehouse until opportunities arise to lend at a higher rate. Through the liability liquidity management approach, a bank originates higher yielding loans, then attempts to fund the loans by actively raising new liability contracts. The asset conversion approach is more conserva-tive because a bank that cannot raise liabilities at a reasonable rate need not expand its balance sheet; a bank that has already granted a loan and cannot secure deposit funding will either have to secure more expensive funding from alternative sources or sell the loan to another bank. Either represents a cost. In practice, there is evidence to suggest that many banks follow the liability liquidity management strategy in order to reduce opportunity costs – but this generates additional liquidity pressures.

Financial institutions supplement their liability management with active asset management. For example, a bank might hold primary reserves (assets that are available immediately at no loss in carrying value but generate no earnings, such as cash, deposits at correspondent banks, and deposits at the central bank or monetary authority) and secondary reserves (short-term assets that are convertible quickly near carrying value and generate earnings, such as treasury bills and purchased inter-bank funds) in order to meet reserve requirements and fluctuations in the liability account. The core lending business and other investments – which generate much greater earnings but impose liquidity constraints – supplement these reserves.

36 Liquidity Risk

Financial institutions are also heavily focused on gap management, or management of the mismatch between assets and liabilities. In fact, man-aging the gap is a key mechanism for generating earnings, and a great deal of effort goes into understanding how portfolios can be optimized during particular interest rate cycles. In general, institutions operating in a positive yield curve environment where long-term rates are rising (or short-term rates are falling) want to widen the gap: this allows them to fund on a short-term basis and lend on a long-term basis, maximizing the spread between the two. Conversely, those operating in a positive yield curve environment where long-term rates are declining (or short-term rates are rising) want to narrow the gap in order to take advantage of (or protect against) the new interest rate environment. The reverse scenarios hold true for negative yield curve environments. (Appendix contains a primer on gap analysis for those interested in a more detailed discussion of this important concept).

More than any other economic sector, financial institutions must actively deal with the liquidity risk/return trade-off mentioned earlier. While many financial firms are aware of the need to maintain adequate access to cash or equivalents in order to respond to liquidity calls, they still strive to minimize liquid balances in order to maximize returns.

To consider the unique and critical role of financial institutions in the liquidity process, it is helpful to examine the liability claims of banks, securities firms, and insurance companies in terms of the amount and timing of cash flows – two dimensions that illustrate why liquidity man-agement can be complex. To begin, we note that the value and timing of a contract may be certain or uncertain. When certain, cash flows can be predicted with confidence and can easily be factored into the funding plan; as uncertainty is introduced, the degree of confidence declines, and accurate planning grows more difficult.

Consider, for example, a bank deposit, fixed with respect to maturity and rate. Both dimensions are certain, meaning there is no unpredictabil-ity regarding the magnitude or timing of cash outflow: the bank will repay the depositor a certain sum on a certain date. The same is true with an insurer writing a guaranteed investment contract (GIC): it will deliver to the GIC investor a specified amount of cash on a pre-determined date.

We now inject uncertainty into the timing dimension by considering an insurance company that has written a life insurance policy for a speci-fied amount (that is, a valued, rather than indemnity, contract). When the policyholder dies, the beneficiary makes a claim on the insurance com-pany: although the amount is fixed in advance, the timing is, of course, unknown. This extra dimension of uncertainty makes it more difficult for the insurer to plan for cash outflows (which can be estimated, though


never precisely, through actuarial processes). Insurers and reinsurers face similar time and quantity uncertainties in other aspects of their business, including policy surrenders, guarantee provisions, liquidity backstops, and so forth. Next we alter the process by fixing the timing but varying the amount: a bank accepting a floating rate deposit with a defined matu-rity date faces a known time horizon but is uncertain as to the amount it will be required to pay, as the obligation varies with movements in interest rates. This again injects some uncertainty into the bank’s cash flows. In the final stage we can vary timing and amount, introducing a maximum amount of uncertainty. For instance, an insurer may write an indemnity-based property and casualty contract with no policy cap and an expiry date extending many years into the future; it will thus be liable for paying out an unknown amount of money if a loss event strikes at some unknown time. Two dimensions of uncertainty combine to create a much more challenging liability management exercise. Table 2.2 high-lights these examples.

We can extend time and amount certainty/uncertainty to the assets and off-balance sheet contracts of financial institutions: the process is the same, meaning some contracts are well defined and highly predict-able, while others are not. Tables 2.3 and 2.4 provide further examples. The point of this discussion is to illustrate that liquidity providers, prima-rily those from the financial sector, face a considerable amount of uncer-tainty in attempting to manage the cash inflows and outflows of their businesses. If they fail to manage the process properly, they will damage their own operations and perhaps even impact their ability to offer non-financial firms the liquidity that they require.

Given these cash flow uncertainties, the balance sheet of a typical bank, fund, securities broker or insurer must necessarily be liquid – certainly when compared with that of an industrial company. Financial institutions keep a larger portion of their assets in the form of cash and marketable securities, and a much smaller portion in long-term illiquid investments

Table 2.2 Examples of liability amount and timing variations

Liability amount Liability timing Example

Certain Certain Fixed rate, fixed maturity deposit

Certain Uncertain Valued life insurance contract

Uncertain Certain Floating rate, fixed maturity deposit

Uncertain Uncertain Indemnity P&C insurance contract

38 Liquidity Risk

Table 2.4 Examples of off-balance sheet amount and timing variations

OBS amount OBS timing Example

Certain Certain Lease paymentCertain Uncertain Surety bond, financial

guaranteeUncertain Certain European exercise optionUncertain Uncertain Revolving credit facility

or fixed assets. Even banks with core long-term loan portfolios regularly attempt to reshape their commitments through syndications, loan par-ticipations, securitizations, credit derivative hedges, and other “liquefy-ing” techniques. Liabilities are generally short-term and often volatile. Although many financial institutions might prefer to concentrate them with a base of stable depositors/fund providers, the realities of modern finance are often quite different – particularly for those seeking to max-imize value in a positive yield curve environment. Financial liabilities can often be withdrawn, transferred, or presented for repayment on very short notice. Indeed, over the past few decades the funding of many insti-tutions has migrated from a stable base of retail and non-optionable lia-bilities to unpredictable and optionable wholesale funds. This has added greater cash flow uncertainty to financial institutions and exposed them to larger amounts of market and credit risk. Activity in off-balance sheet commitments – including derivative contracts, loan commitments, leases, letters of credit, and so forth – injects additional uncertainty.

These factors, taken together, require diligent management of the liquidity profile. Failure to do so can lead to an increase in financing costs, reduced financial flexibility, and even instances of financial dis-tress. Through differences in function, funding sources, leverage, asset composition, and regulatory schema, it is possible to create a spectrum of liquidity sensitivity within the financial sector. Securities firms, for

Table 2.3 Examples of asset amount and timing variations

Asset amount Asset timing Example

Certain Certain Fixed rate, fixed maturity loan

Certain Uncertain Fixed rate, callable bond (investment)

Uncertain Certain Floating rate, fixed maturity loan

Uncertain Uncertain Floating rate, callable bond (investment)


instance, are generally most susceptible to liquidity risks, primarily as a result of their high leverage and relatively unstable wholesale funding. Unlike banks and insurers, securities firms lack a base of core liabilities; their operations tend to be financed primarily through repurchase agree-ments and short-term notes. 3 In addition, they have historically lacked access to a central bank discount window or official lender of last resort (though the crisis of 2007–2008 partially altered this for some securities firms). Their reliance on unstable sources of funding, the fluid nature of their asset portfolios (including some 80 to 90 percent centered in short-term, liquid, or saleable/marketable assets), and the depth and breadth of their off-balance sheet activities (particularly derivative contracts) mean they have greater concentrations of market and credit risks than other financial institutions – which, as we have noted earlier, can magnify liquidity exposures. Hedge funds share similar characteristics: they lack stable funding, speculate on a highly leveraged basis, and encumber their balance sheets (that is, they pledge assets in support of greater leverage). These factors intensify liquidity exposure and often leave little margin for error.

Banks typically feature greater funding stability than securities firms and hedge funds, and generally enjoy access to central bank facilities and a lender of last resort. That said, some banks have excessive exposure to very short-term and/or volatile liabilities that can be withdrawn very rapidly. If they use short-term institutional deposits to finance medium and long-term loans, they increase curve/gap risk and are prone to greater losses. In addition, banks are extremely significant providers of off-bal-ance sheet facilities (such as revolving credits, guarantees and derivatives) and thus face a large amount of uncertain cash flows arising from con-tingent events.

Mutual funds, which are not generally permitted to directly lever-age their balance sheets, are exposed to liquidity risk primarily through redemptions. The fund management company must ensure that it has sufficient cash resources on hand to meet periodic redemptions, and enough liquid assets in the investment portfolio and contingent funding to meet more significant outflows. (Some funds are prohibited through their investment mandates from investing more than a certain amount of their portfolios in assets deemed to be illiquid; others, of course, face no such restrictions.)

Insurers are usually exposed to less liquidity uncertainty than banks or securities firms: most liability sources are quite long-term and stable, and assets tend to be conservatively managed. There are, however, instances where an insurer can face unexpected losses in its investment portfo-lio (through market or credit risks) or insurance operations (through

40 Liquidity Risk

extraordinary (or catastrophic) insurance claims, that is, those that are more severe, or occur more frequently, than actuarial expectations pre-dict). These events can create cash shortfalls and liquidity pressures. In addition, certain insurance liabilities contain features that allow inves-tors to demand return of their capital within relatively short time frames. Some GICs have clauses allowing investors to put the liabilities to the insurer in the event of a credit downgrade. Other funding arrangements have embedded short-term put options, and some feature cash build-up values that allow policyholders to borrow against them. (If such borrow-ing occurs en masse, an insurer may be faced with short-term borrowing needs of its own.) Like securities firms and banks, insurers also face con-tingent cash outflows through their participation in financial guarantees and liquidity backstops.

Non-financial service companies

Non-financial service companies can be exposed to a reasonably high degree of liquidity risk – less than most financial service firms, but often more than the average industrial company. Non-financial service com-panies, including those from retailing, foodstuffs, beverages, hospitality, computer services, consulting, pharmaceuticals, and so on, often derive a great deal of funding from short and medium-term note programs, trade payables, and revolving credit facilities. Some of these can prove volatile, particularly in times of general market stress or credit quality deterioration. Assets may also be heavily concentrated in the short- to medium-term – perhaps 60–70 percent of total balances – primarily through receivables and inventories (which, as we have noted, can be considered liquid, though certainly not as liquid as marketable securi-ties). Challenges can thus arise in matching the cash flows of assets and liabilities. Non-financial institutions tend to be less active in off-balance sheet activities than financial institutions: they are often only modest users of derivative contracts or providers of guarantees, and therefore need not be as concerned about cash inflows or outflows from such sources.

Asset trading companies are a unique “hybrid” within the sector – they are neither financial institutions nor capital-intensive companies, although they exhibit characteristics of both. For example, commodity and merchant energy trading firms have active short-term trading opera-tions, but often feature significant fixed plant and equipment associated with extraction, sourcing, refining, distribution, storage, and/or transpor-tation. The degree of liquidity they require, and their ongoing exposure to liquidity risk, depends ultimately on their business strategies and, by


extension, the resulting mix of revenues. For instance, an energy trading firm that derives 75 percent of its revenues and operating income from trading crude oil, natural gas, or electricity, relies very heavily on liquid-ity to conduct business: it will focus on maintaining a good credit rating, strong reputation, and robust access to cash to finance collateral calls and market-based profit and loss swings. An energy trading firm that obtains 25 percent of its revenues from trading and 75 percent from exploration, drilling, and refining still requires good access to liquidity, but its needs are unlikely to be as significant and its daily management of the process will be less intense.

Capital-intensive companies

Companies in capital-intensive industries use the majority of their resources to produce or refine resources, produce hard assets, or create durable goods. It is no surprise, therefore, that they invest primarily in property, plant, and equipment, including depreciable assets with lives of 5, 10, 30, or more years. Since these assets are long-term in nature, they are often funded with long-term capital; short-term liabilities are used primarily to balance short-term activities, such as receivables and inventories. The percentage of liquid assets found on the balance sheet of the typical capital-intensive company ranges from 5 to 20 percent (com-pared with 90 percent plus for an average securities firm and perhaps 60 percent for a retailer). Capital-intensive companies do not exhibit the same fluctuation in asset values as they mark the bulk of their assets to the lower of cost or historical value (rather than current market value); this obviates the need to fund shortfalls arising from assets with a more volatile value profile. (Capital assets are, of course, depreciated on steady basis through non-cash charges to the accumulated depreciation account.)

The corporate sector is generally not very active in off-balance sheet activities. Accordingly, contingent future cash flows, such as might arise from derivative contracts or cross-guarantees, are the exception rather than the norm, and tend not to form a significant part of corporate risk manage-ment activities. The need for intensive liquidity management in the average industrial company is thus lower than it is for firms in other sectors. That said, it is still very important for industrial firms to manage their liquid-ity closely; as we shall note later in the book, certain industrial firms have been at the centre of significant liquidity crises in recent years, suggesting that the spectre of liquidity-induced losses, or worse, is very real.

It is worth noting that a small number of global industrial companies have very significant financial operations that are involved in a wide

42 Liquidity Risk

range of financial transactions, including asset trading, leasing, deriva-tives dealing, group-wide funding, insurance, and factoring. The pres-ence of sufficient short-term liquidity and the commitment to active liquidity risk management is of paramount importance to such financial subsidiaries, meaning the comments we presented above for energy and commodity trading companies are applicable.

Municipalities and sovereigns

While most of our discussion is geared toward liquidity risk management in the corporate sector, we would be remiss in excluding some reference to municipalities and sovereigns, as such sectors must also balance their liquidity profiles. In the normal course of affairs, municipalities and sovereign nations with taxing power gather the bulk of their funding from corporate, personal, real estate, and consumption taxes, and the issuance of public or private debt securities. Against these inflows they face a series of outflows related to the provision of public goods and services, including education, health, transportation, welfare, medical care, retirement, infrastructure, law enforcement, fire safety and so on. In this sense they can be viewed as service providers, and they must therefore be attuned to the nature and timing of their cash inflows and outflows. Inability to match these properly can lead to the same liquid-ity-induced losses that impact firms in the corporate sector and may require the emergency issuance of debt or the liquidation of municipal or sovereign assets; it may also require selling or pledging portions of the investment portfolio. Indeed, some public sector entities have been at the centre of major liquidity crises in the past, as we shall discover later in the book. It is worth noting that sovereign nations that have the power of the printing press can always print more money as a way of overcoming a short-term liquidity crisis. That, however, is typically seen as an exceptional step as it devalues the local currency and creates inflation pressures.

Figure 2.3 depicts a stylized liquidity spectrum across a range of indus-tries – from those that face the smallest amount of liquidity exposure and cash flow uncertainty (and thus have the smallest need for intensive daily risk management) to those with the greatest amount of liquidity expo-sure and cash flow uncertainty (and, by extension, the most significant need to manage their liquidity profiles very dynamically). The figure is generalized: there are certainly instances when a non-financial service company or capital-intensive firm has greater liquidity risk exposure than a mutual fund or an insurance company. However, the general classifica-tion holds true for the majority of cases.


Endogenous Versus Exogenous Liquidity

In the last chapter we introduced the concepts of endogenous and exog-enous liquidity. These require further exploration, as they are central to the liquidity risk management topic. Indeed, it is important to consider which factors are under the direct or indirect control of a company, and which factors are driven solely or primarily by external forces. While either can lead to liquidity pressures, analyzing and managing each one is different. .

A company can control endogenous liquidity by understanding its liquid-ity profile and taking all necessary actions to ensure the profile is man-aged prudently. This means maintaining a realistic, generally conservative, approach to structuring the asset portfolio and securing liabilities – and can sometimes mean exchanging incremental return for the safety of a larger cash buffer or additional committed financing. It may mean sacrific-ing certain business opportunities (for instance, not accumulating a large market or credit risk position or expanding into a new area too rapidly) or refusing to take actions that might otherwise exacerbate risks (such as avoiding the rapid sale of an asset). The primary point is that a firm has a reasonable degree of control over these variables and can act as it sees fit; endogenous liquidity risks can thus be considered firm-specific.

Lowest liquidity risk,smallest cash flow uncertainty,yy

least active daily riskmanagement requirement

Highest liquidity risk,greatest cash flow uncertainty,

most active daily riskmanagement requirement

Municipalities,sovereigns

Capital-intensivecompanies

Non-financialservice companies



Lowest Highest

Commercial banksInsurance companies,mutual funds

Securities firms,hedge funds

Figure 2.3 Industry-based liquidity spectrum

44 Liquidity Risk

A single company generally lacks the ability to directly control liquid-ity risk created by systemic forces that are imposed by the marketplace, regulatory rules, activities of competing firms, and the state of micro and macro-economic and financial indicators. While a firm does not typi-cally drive exogenous forces, it must respond to them. (It is, however, worth noting that an extremely large firm with significant risks or an entire group of smaller institutions with similar risk positions and market expectations can influence or intensify such forces; the crisis of 2007–2008 demonstrated that quite clearly.)

Exogenous liquidity risk becomes particularly evident during times of stress, as market and regulatory actions introduce behaviors that exac-erbate price shocks and illiquidity. In more serious instances, external factors may induce widespread withdrawal of funding, forcing firms to sell assets at distressed prices in order to reinforce their cash positions. Certain stress events can lead to a flight-to-quality effect, which we define as the sale of risky assets and the purchase of those deemed to be “safe” (such as assets with low risk of default, low correlation with other risky assets, and/or lower price volatility than competing alternatives; government bonds of industrialized nations are a good example). They may also lead to a flight-to-liquidity, or the purchase of assets that are supported by two-way flows, even during times of extreme stress (which might be a subset of the flight-to-quality asset pool, such as benchmark, or on-the-run, government bonds of industrialized nations). These move-ments mean that assets deemed to be “less favorable” are liquidated, sometimes in large quantity, leading to sharp price declines, volatility spikes, and the onset of illiquid conditions.

Exogenous forces can quickly sweep through entire industries, markets, regions, or countries, impacting many firms – often without much dis-crimination. When lenders and investors refuse to differentiate among institutions, strong, intermediate, and weak credits within a particular sector may all suffer liquidity problems. (This happened with Asian banks and companies in the crises of 1997–1998, US energy firms in the millen-nium, and all manner of financial institutions in 2007–2008, for exam-ple.) In the face of such forces, it is easy to see how a single firm can lose control over its own exposures – and perhaps even its financial destiny.

Let us consider a simple example of a stress event that creates liquidity difficulties. In the early part of a speculative phase, economic growth leads to credit extension through the banking sector, inflating the prices of real and financial assets. When the peak of the cycle is reached, a tight-ening of interest rates leads to a “bursting” of the speculative asset bubble, the withdrawal of credit, and a drop in asset prices. The collapse may be fuelled, in part, by balance sheet deleveraging, including sales of assets


by companies eager to repay unsecured debt that cannot be rolled over and sales of collateral held by banks against credit extensions. The sale of illiquid assets, or assets sold into an increasingly illiquid market, magni-fies the downward price movements and generates even larger losses. In addition, financial institutions holding leveraged market risk positions may decide to liquidate; the idiosyncratic decision by each firm to sell or hedge such positions (or perhaps a requirement by regulators that they do so) may force other financial institutions to take similar actions, and individual actions exacerbate exogenous forces.

These events may be compounded by a pullback in funding by insti-tutional investors, who might grow nervous over the instability; finan-cial and non-financial institutions must then contend with lack of robust funding. Under this type of market dislocation scenario, exogenous forces dominate. While an individual institution may believe that its asset posi-tions and funding plans are prudent, external forces may prove other-wise. This is not, of course, a theoretical premise – it has occurred several times in recent years, for example the global stock market crash of 1987, the Japanese asset deflation and bad loan crisis of the 1980s and 1990s, the Nordic banking crisis of the early 1990s, the Mexican peso crisis of 1994, the Asian collapse of 1997, the Russian/hedge fund debacle of 1998, the Turkish and Argentine banking crises of 2000, the technology-media-telecom (TMT) asset burst of 2001, and the widespread financial crisis of 2007–2008. Awareness of the impact exogenous risks can have on indi-vidual corporate operations is therefore an important dimension of inter-nal risk management.

In some cases regulatory authorities attempt to manage, reduce, or pre-vent exogenous liquidity risk by creating safeguards and enhancing mar-ket structures to promote liquidity and stability; this is particularly true within the financial sector. Regulatory safeguards can take different forms, and we provide only a few examples that illustrate the point. For instance, in order to reinforce trading in government securities (which often serve as benchmarks for other corporate instruments), some systems adhere to the concept of primary dealerships, which give approved institutions the ability to bid on a primary basis for new government securities issues and deal actively in the secondary market with full quote transparency. Those granted primary dealer status are entitled to certain monopoly rents not available to other institutions; that rent can be regarded as de facto payment for the market-making and liquidity services they provide. As part of the process, governments regularly attempt to issue their own sovereign securities at various points on the yield curve in order to build a robust curve that can be used for corporate pricing and hedging, thus promoting more issuance and trading in the corporate sector.

46 Liquidity Risk

Some systems allow short selling, meaning that firms (and individuals) can borrow and then sell securities freely. A marketplace that allows short selling promotes more activity, as both sides can be reflected and deal-ing can occur under virtually any type of market scenario. The same is often true for “when issued” trading: if authorities permit dealers to trade newly announced, but not yet settled, securities in a grey market, they are permitting liquidity to build in advance of final settlement.

Regulators may aid in establishing and deepening associated markets such as listed futures and options and over-the-counter derivatives. Although there are instances when derivative instruments act as “competitors” or substitutes to underlying cash assets (and thus detract from asset liquidity), the two sectors often work in tandem, helping promote trading, hedging, and investing – and, by extension, market liquidity. Some systems allow the use of repurchase and reverse repurchase agreements so that institutions can manage their short-term funding and investment needs efficiently and securely. While many of these efforts work well in some countries during most market conditions, they are not always guaranteed to function as expected; this is particularly, though not exclusively, true in less mature markets that lack strong breadth and depth or regulatory experience. In fact, various emerging nations have been susceptible to fragile liquidity over the years, in part because of fail-ures or shortfalls within their macro regimes.

Unfortunately, there are times when regulatory rules and best prac-tice measures exacerbate liquidity problems. For example, the use of risk policies and limits, standardized models/pricing routines, and regulatory capital rules means that banks and securities firms often develop a “herd mentality” in their approach to risk management. During stressful times their actions might actually magnify problems. If all institutions have approximately similar positions and a consistent view and approach to the management of risks and the protection of liquidity, then simulta-neous response simply magnifies movements and dislocations. Two-way markets become one-way markets, historical asset correlations decouple, volatilities rise, and liquidity disappears. In the absence of “contrarian forces” that view such dislocations as a buying opportunity, the asset and funding markets can remain in a state of turmoil and liquidity can remain very fragile – or even non-existent. If contrarian forces actually exist, they are most likely to come from sectors that do not face the same set of regulations. (For instance, during such times insurance companies and hedge funds can provide some amount of stability as they are gov-erned by different regulations – if any at all.)

Endogenous and exogenous forces must be carefully considered in any analysis of liquidity risk. Later in the book we shall consider certain


market-related stress mechanisms that can be incorporated into the risk management process to reflect the effects of micro and macro forces on firm-specific liquidity. With these general thoughts in mind, we turn our attention in the next chapter to specific sources of liquidity a company can draw on in order to manage its risk profile.

48

3 Sources of Liquidity

As we consider liquidity risks and the challenges that can arise from both an asset and a funding perspective, it is helpful to begin by analyz-ing sources of liquidity that firms from a broad range of industries can access in support of their operations. This provides an understanding of how liquidity structure must be managed to ensure availability of cash resources when needed. In this chapter we review sources of liquidity found in the asset and liability accounts of the balance sheet, as well as those that exist off-balance sheet. We also discuss the amalgamated pic-ture of liquidity, in both theoretical and actual terms.

When analyzing liquidity sources, it is important to remember that this topic represents two sides of the same coin : institutions that have or require access to liquidity place demands on institutions that supply liquidity. Thus, while a company can use an unsecured bank loan as a source of liquidity, the bank granting that loan must be prepared to man-age its own liquidity by arranging access to funding mechanisms such as interbank or retail deposits. Interbank and retail depositors, in turn, must be prepared to supply such liquidity by arranging in advance their own access to cash. Similarly, a company selling assets to generate cash must find investors willing to buy those assets; they, in turn, will require their own sources of funding in order to purchase the assets. The same is true for other classes of assets, liabilities, and off-balance sheet contingencies. Suppliers and users of liquidity are therefore intimately linked, helping illustrate how endogenous and exogenous forces might interact to impact a firm’s operations.

As we analyze asset, liability, and off-balance sheet liquidity, it is worth re-emphasizing that the first source of operating cash comes from core business revenues; without a solid base of positive cash flow operations, access to other sources of liquidity can become uncertain or may prove inadequate. Our primary assumption is that a firm has one or more cash


Sources of Liquidity 49

flow-positive businesses that generate a base of internal financing; asset, funding, and off-balance liquidity serve to support and supplement that base of financing. Indeed, a firm that experiences continuous negative operating cash flow over successive quarters will eventually threaten its liquidity position and may ultimately encounter some type of financial distress.

Sources of Asset Liquidity

The balance sheet is a point-in-time snapshot reflecting the financial structure of a firm’s business. As noted in the last chapter, an industrial firm typically has a larger amount of fixed assets and a smaller amount of liquid assets than a financial or non-financial service firm. Although fixed assets are less liquid than short-term securities inventories, it does not mean that the industrial firm has a greater amount of liquidity risk; as we noted in the last chapter, the typical industrial company is likely to match its long-term fixed assets with long-term liabilities, and must therefore only balance short-term assets and liabilities (i.e., its working capital accounts) to ensure a proper liquidity position. Similarly, although a bank or service company might have a greater percentage of its assets in liquid form, it is likely to have a larger amount of short-term or uncertain liabilities and contingencies, and must therefore be even more acutely aware of its liquidity position. Indeed, comparing the amount of liquid versus fixed assets across industries tells us very little; comparisons must be made relative to liabilities and contingencies. Regardless of industry-specific characteristics, however, firms considered to be of good to aver-age credit quality maintain a certain amount of liquid assets that can be used to meet obligations; they are also likely to preserve a reasonable percentage of unencumbered fixed assets that can be pledged to secure cash. We consider each of these in turn.

Liquid assets

Cash and marketable securities

Cash and near-cash instruments are the most liquid assets in the corpo-rate portfolio. Cash is held to meet expected and unexpected payments; no conversion is required, so payments can simply be made from the cash account. However, since cash is a non-earning asset, companies that are sensitive to the liquidity risk/return trade-off we mentioned in the last chapter try to minimize their pure cash holdings, preferring to keep some amount of assets in the “near cash” category – very liquid, earn-ing instruments that can be sold immediately at the carrying price. This

50 Liquidity Risk

class of investments generally includes instruments with negligible credit and market risks, such as government treasury bills and money market instruments issued by very highly rated companies and financial insti-tutions (such as A-1/P-1-rated industrial commercial paper, prime grade bank certificates of deposit, and bankers’ acceptances). Note that while such securities are readily saleable under normal market conditions, they do not always result in an immediate infusion of cash; trading settlement conventions in many markets call for exchange of cash and securities over two, three, or five business days. Firms, such as financial institu-tions, whose operations depend heavily on the acceptance and provision of liquidity and the transformation of maturities, carry a great deal of their assets in the form of marketable securities; we shall revisit this in greater detail in our discussion of “high quality liquid assets” (HQLAs) later in the book, which has been formalized as part of the new regula-tory framework.

While the instruments noted above can form the core of a “near cash” store of value, a word of caution is necessary: the financial crisis of 2007–2008 demonstrated how some marketable securities that might be clas-sified as “low risk” during normal market conditions can become rather risky during a market dislocation; that is, they are correlated with securi-ties that have a riskier profile. For instance, industrial and financial com-mercial paper and other bank securities became riskier than their credit ratings would imply during the depths of the crisis, trading at a several point discount to face value as a result of credit risk concerns. Some of these instruments became partly or totally illiquid as a result, causing a drop in value. It is thus critical to remember that at least some assets in the liquidity buffer are likely to be very sensitive to market and credit risks, which can ultimately affect their liquidity profile.

Next we find investments that carry higher yields but may not be as easy to sell on short-notice at the recorded carrying value; indeed, it is difficult to know ex-ante which investments will be more or less market-able in advance of a liquidity event, and it is also probably true that mar-ketability will change through any given economic cycle. Although such investments lack the same degree of marketability (owing to greater credit and/or market risks), they are still an important source of liquidity. The prudent firm must therefore account for the relatively lower saleability by applying a “haircut” – or discount – when computing the value that might be obtained in a disposal scenario. If $100 million market value of short-term treasury bills will yield $100 million of cash, other securi-ties – including medium- and long-term corporate bonds, government bonds, and agency securities – might under normal market conditions yield $90 million or $95 million.


Lesser quality securities, such as emerging market bonds, high-yield bonds, or preferred stock, will tend to yield even less under the “rapid disposal” scenario because the instruments carry greater market and credit risks and the population of buyers is much smaller (suggesting less liquidity). This again re-emphasizes our previous point: the riskier the investment and the more urgent the need to generate cash, the greater the discount. A seller that can liquidate an emerging market bond portfolio in a leisurely fashion in normal market conditions over several weeks or months will tend to exit at a price that approximates the carrying value; an urgent or distressed seller will not.

Of course, not all investment portfolios stand ready to be sold; in many cases they are used instead as collateral for loans, which fulfils the desired liquidity function without requiring that the firm sell assets it may wish to retain. But there are several costs associated with this scenario. The first is the size of the haircut the lending firm will require for provid-ing a collateralized loan, the second is the interest charge applied to the borrowing, and the third is the reduced financial flexibility that comes from encumbering the balance sheet. For instance, a bank may be willing to lend $98 million on an overnight basis for $100 million of treasury notes (that is, a 2 percent haircut) as it will have no concerns about price deterioration in the treasury securities or the ability of the company to repay the loan over the next 24 hours. If the term is for one week, without any ability for the bank to ask for additional collateral, the haircut might be 5 percent. If the term is 24 hours but the securities being posted are long-term corporate bonds, the haircut might be 5 percent or 7 percent; if the term is one week, it might be 10 percent. Thus, determination of the liquid worth of a securities portfolio that can be used as collateral is based on the haircut level imposed by the bank, which is, itself, a function of the quality and price volatility of the asset, the saleability of the asset, the tenor of the loan, and the ability to request additional collateral (should that prove necessary).

It is worth noting that financial institutions actively use reverse repur-chase agreements, or collateralized loans to third parties, to place their excess cash. These contracts rank below marketable securities in terms of liquidity, although they can sometimes be sold on a secondary basis if needed – we therefore include them in this sub-section. It is common for banks and securities firms to grant reverse repo financing to customers, often on an overnight or very short-term basis. If an institution extend-ing reverse repos needs to recover its cash, it simply ceases to roll over its overnight reverses and suspends renewal of short-term reverses as they come due; this gives the firm extra cash resources that it can apply to its own obligations. Longer term reverses, extending out several weeks

52 Liquidity Risk

or months, can be sold in a secondary market (as long as the underlying collateral is high-quality and fungible, such as high quality government securities). Thus, the reverse repurchase book must be viewed as a good source of asset liquidity. 1

Receivables

Receivables, which represent credit extended by a company to its cus-tomers, rank below cash and marketable securities in terms of liquid-ity. Receivables arise when a firm providing customers with goods and services permits them to pay at some future date (such as 7, 30, 60, or 90+ days from the date goods or services are delivered). The delayed payments generate implicit interest earnings for the firm, meaning that receivables are simply short-term, generally unsecured, loans to custom-ers. Since receivables represent future cash inflows to the firm, they are valuable assets that can be liquefied at an appropriate discount. Thus, a firm in need of cash can sell a portfolio of receivables to a third party directly (through a process known as factoring) or use the portfolio as collateral against a loan (through a practice known as accounts receiv-able financing).

There are subtle differences between the two. First, factoring represents a direct inflow of cash achieved through sale, while receivables financing represents an indirect inflow through the draw-down of credit. Second, factoring is typically arranged on a non-recourse basis: that is, if the com-pany sells the receivables to a factor, any customer defaults become the responsibility of the factor, not the originating firm. Receivables financ-ing, in contrast, is typically arranged on a recourse basis: if defaults occur and insufficient cash exists to repay the loan, the bank can turn to the borrowing firm for restitution. In addition to factoring or collateralized lending, receivables can also be liquefied through the securitization proc-ess, which we discuss later in the chapter.

Inventories

The general category of physical inventory ranks below receivables in order of liquidity and potential for conversion into cash (we exclude inventories of financial instruments from this classification, under the assumption that they form part of the portfolios of marketable invest-ments mentioned above). Inventory may be classified by its stage of pro-duction, such as raw materials, work in progress, or finished goods, each with its own value and value-added elements. The type of inventory kept on hand to satisfy customer demand depends on the nature of a company’s business. In some cases inventory is perishable and must be consumed rapidly (e.g., food, certain pharmaceuticals), while in other


cases it is durable and designed to be consumed over a period of weeks, months, or years (e.g., textiles, computers, automobiles, and steel bars). Durable inventory, in particular, can often serve as a source of liquid-ity; this is particularly true for inventory that is in strong demand and is relatively generic and fungible. Selling inventory rapidly to gener-ate cash means, of course, that some discount to carrying value will be taken. But if cash proceeds are required, the sale of inventory is a viable solution.

It is important to consider how inventories are financed. If they are funded from general corporate debt sources (such as commercial paper, term loans, or revolvers) they are almost certainly unencumbered – meaning that they can be pledged instead of sold, should that prove an advisable course of action. The pledge may take the form of a specific lien on particular inventory, or a floating lien applicable generally to cur-rent and future inventories. Inventories of raw materials or finished goods that have been conveyed to bonded storage or warehouse facilities can be secured and documented via warehouse receipts, meaning that only the bearer of the receipt is entitled to withdraw the goods; once the warehouse receipt has been issued, it can be transferred to a third-party creditor as a form of collateral. In other instances inventories are financed through self-liquidating loans, where inventory sales in the normal course of busi-ness generate the proceeds used to repay the bank for the initial funding. Self-liquidating loans may include a claim over the inventory by the lend-ing bank. In these cases a firm has no ability to use the inventory as a cash-generating asset, as the assets secure a previous cash inflow provided by the lending bank.

The liquid assets we have described above comprise (in whole or part) what is often termed a liquidity warehouse: a segregated portion of the asset accounts that can be sold or pledged to supplement the funding program to meet unexpected payments. The liquidity warehouse is likely to be based on securities that are available for sale (which are marked-to-market and unrestricted), rather than those that are being held to matu-rity (which are likely to be marked at historical value and whose sale may be restricted). It may also include receivables that can be factored or financed quickly and, in some instances, generic inventories (although these are likely to comprise only a small percentage of the available ware-house). We shall revisit the liquidity warehouse concept at various points throughout the text, as it is an important element of prudent liquidity risk management. Indeed, within the banking industry financial regula-tors believe creation and preservation of a liquidity warehouse is so vital that they have mandated its use; we shall discuss this framework, embed-ded in Basel III, later in the book. 2

54 Liquidity Risk

Fixed assets and intangibles

While the main focus of asset liquidity is rightly on the liquid portion of the asset accounts, a firm might also have access to fixed assets that can be used to generate cash. These, not surprisingly, are of secondary importance as they generally cannot be used to meet emergency cash obligations; obtaining liquidity from fixed assets can be a time-consum-ing affair, certainly when compared with disposal or pledging solutions in the liquid asset accounts.

Fixed assets

Fixed assets comprise the primary means of production for companies in the industrial sector. As we have noted, they are as important to rev-enue generation as financial assets are to banks and securities firms. Hard assets, including plant and equipment used to transform raw materials into finished goods, must therefore be treated with care; pledging or sell-ing such assets can reduce flexibility and impact a firm’s ability to man-age its daily business affairs, generate cash flow, and maximize enterprise value.

In practice, long-term fixed assets are most often financed with long-term capital, including equity and long-term debt. The debt supporting plant and equipment might or might not be secured, depending on the credit strength of the company and the nature and life of the asset. The strongest credits may not have to pledge fixed assets in support of bor-rowings, while those of medium and low quality typically must. Assets securing debt obviously cannot be sold or pledged to others, meaning a firm can only generate cash through its lien-free fixed assets. That said, negotiating a financing facility supported by a pledge of fixed assets can take time and may not be suitable for emergency payments. Since the mechanics involved in arranging a credit facility that involves a valuation of fixed assets can take several weeks or months to conclude, unencum-bered fixed assets can only serve as a source of liquidity when there is enough time available to perform necessary due diligence work.

Selling fixed assets to generate cash is not usually considered a via-ble, or advisable, action (although the sale and leaseback transaction, described below, and the sale of non-core assets, serve as exceptions). 3 Since fixed assets are central to revenue generation and the creation of enterprise value, outright sale leads to a decline in revenues and operating cash flows, and erosion in enterprise value. In addition, the disposal of fixed assets must be considered to be a medium-term transaction, espe-cially for assets that are unique and lack a ready market of buyers. Selling heavy machinery, a microchip factory, or an auto plant, for instance, is a bespoke transaction that is likely to attract the interest of a very limited


number of buyers and take many months to agree and finalize; unless a firm is willing to take a substantial discount to carrying value, fixed assets cannot typically be sold quickly.

Intangibles

Intangibles, which can be defined as assets that generate value but have no physical or tangible qualities, cannot really be regarded as a potential source of liquidity. The primary intangible of the corporate world is good-will – the reputation, branding, and intellectual property of a firm, or in an acquisition scenario the differential between the acquisition value and book value of the company or asset acquired. In either event, goodwill is a non-cash depreciable asset that has value to a company and market-place – but not necessarily a value that can be immediately converted into cash. There are, of course, situations when a firm sells one of its brand products or services to a third party; the assets associated with the sale, including the transfer of goodwill, are exchanged for cash. However, such sales are relatively unusual and designed for strategic reasons rather than as a liquidity management mechanism (for instance, exiting a market for a particular strategic or competitive motive).

Figure 3.1 depicts sources of asset liquidity for a standard corporation.

Sources of Funding Liquidity

After taking account of operating cash flows, funding is the first line of defence in raising cash to meet payments; only when funding has been exhausted or proves too expensive is a company likely to pledge or sell assets in order to supplement the cash position. In practice companies use various types of liabilities (depending on industry), including short-term financing facilities (such as commercial paper and Euro commercial paper, short-term bank facilities, payables, interbank/retail deposits, repurchase agreements, and putable funding arrangements) and medium/long-term facilities (such as medium-term notes and Euronote facilities, non-putable funding arrangements, long-term bonds, and loans). Some firms, particu-larly those that are part of broader conglomerates, may also have access to intracompany cash; presuming other group members have excess liquid-ity, and assuming no meaningful regulatory and legal restrictions exist regarding intracompany flow of funds, this can be considered an addi-tional source of financing.

Consistent with our comments above, the relative mix of short versus medium/long-term debt does not, by itself, indicate a firm’s relative level of liquidity. While a firm that has most of its funding obliga-tions coming due in three or five years might have fewer immediate

56 Liquidity Risk

funding pressures (that is, no need for constant rollovers and no risk that short-term funds will be withdrawn rapidly), it might still be sub-ject to liquidity risk if it lacks immediate access to cash to meet emer-gency payments. A firm that has a great deal of short-term liabilities might appear to have greater liquidity risk, but if these contracts are well matched by short-term assets the liquidity position might be per-fectly manageable and not much riskier than one with longer maturi-ties. Of course, if those short-term liabilities are funding long-term, illiquid assets, a company is far more vulnerable to a liquidity prob-lem; indeed, an excessive amount of short-term liabilities supporting a balance sheet with a fairly significant amount of long-term assets is a warning signal that liquidity problems may arise. Gauging a firm’s overall liquidity position therefore involves a joint evaluation of assets, liabilities, and off-balance sheet activities.

Assets Liabilities

Equity

Liquid assets

Cash and marketable securitieskkA ready source of liquidity, either

through outright sale or pledge ofunencumbered securities for cashff

ReceivablesA ready source of liquidity, eitheryy

through outright sale (factoring) orpledge of unencumbered receivables

for cashff

InventoriesAn acceptable source of liquidity, either

through outright sale or pledge of unencumbered inventories; most effecffff tive

for standard, durable inff ventories

Fixed assetsA possible source of liquidity, primarily

through pledge of unencumberedplant and equipment for cashff

IntangiblesNot a source of liquidity


Figure 3.1 Common sources of asset liquidity


In practice firms from different industries appear to favor different types of funding liquidity. As noted, financial institutions often obtain a great deal of their financing from the short-term markets in order to balance the very liquid nature of their assets, contingencies, and off-bal-ance sheet obligations, and to attempt to maximize earnings in a positive yield curve environment. Capital-intensive institutions derive the bulk of their funding from medium- and long-term sources in order to match the financing requirements of long-term plant and equipment. (Of course, they still need to preserve access to the short-term markets in order to meet obligations coming due.)

Short-term funding markets

Commercial paper, Euro commercial paper

The commercial paper (CP) and Euro commercial paper (ECP) markets are a popular source of short-term unsecured funding for creditworthy companies in virtually all major industry classes. 4 The obligations issued by companies under CP programs (arranged and agented by investment and commercial banks) range from 1 to 270 days in the US market, and 1 to 360 days in the Euromarket. In practice only prime credits (those rated A-1+/P-1, A-1/P-1 and, periodically, A-2/P-2 5 ) can access the CP/ECP market; non-prime companies are effectively barred access by interme-diaries and investors. Conventional CP facilities are unsecured, 6 but in the US market they are generally backed by bank lines (swing lines) that can be drawn down if rollovers of existing paper prove difficult (such as during a market dislocation). Rating agencies generally expect such bank lines to be committed and large enough to cover at least half of an issuer’s program (and sometimes as much as 100 percent). Though popular, it is important to stress that the CP and ECP markets are credit and market sensitive, and extremely unstable during times of market stress; they can-not be considered a reliable source of funding under all conditions, even for good credits.

Short-term bank facilities

Corporations regularly use short-term credit facilities supplied by banks to cover seasonal or emergency needs. Such facilities, available as revolvers or fixed-term loans, have maturities ranging from 6 to 24 months and can be viewed as a relatively stable source of funding during the period in which they remain in effect. As with other short-term funding, however, they must be managed closely as the maturity date approaches – the possibil-ity of “non-renewal” exists, particularly if a borrowing company’s credit standing has deteriorated or the financial system has become strained.

58 Liquidity Risk

Payables

Accounts payable are another important form of short-term funding, particularly for non-financial service and industrial companies. Just as a company grants credit to its clients by allowing delayed payment on invoices, it accepts credit from suppliers by utilizing delayed payment terms. In fact, companies often seek to extend their payables to the last possible moment in order to enjoy funding access. There is, of course, a price for the credit that a firm absorbs: payables, like receivables, carry an implicit interest rate – in this case a cost, rather than a return, to the firm.

Like other short-term facilities, payables can be a volatile source of funds: while they may be stable when a firm’s creditworthiness is steady and general market conditions are tranquil, they can disappear very quickly. Thus, if providers of trade credit are no longer comfortable with a company’s financial situation or are coping with broader systemic dis-locations, they may tighten the terms of payment for future transactions (for instance, payment within 7 days rather than 30 or 60 days) or simply refuse to renew payable credit terms at all (that is, move strictly to a cash on delivery basis).

Deposits and repurchase agreements

Deposits and repurchase agreements form the two primary sources of short-term funding for most financial institutions; these liabilities tend to be very short-term in tenor, with maturities ranging from overnight to several weeks. Interbank deposits are onshore or offshore institu-tional funds accepted by banks from other banks; most mature in 1 to 30 days and may be denominated in any one of several reserve curren-cies. Interbank deposits are part of what is termed “hot money,” or credit and interest rate-sensitive funds that can be withdrawn and reallocated at very short notice. 7 Consequently, deposit takers must be prepared to fill the void should funds disappear or the offer price become too large.

The same instability does not necessarily exist with retail deposits, which have longer behavioral, if not always contractual, maturities. Banks with a broad base of core retail deposits enjoy a greater level of funding stabil-ity, as individual depositors are generally unwilling to shift their funds in search of a few basis points of extra yield. Retail deposits, in the form of checking and savings accounts, money market accounts, and certificates of deposit, are said to be “sticky”: in an era of electronic banking, where the potential for funds movement has increased dramatically, some lia-bilities continue to remain quite stable. Note that in most national bank-ing systems depositors of all types are protected through some form of government backed deposit insurance scheme, up to defined amounts per


account. This adds a degree of comfort and is a factor in the willingness of depositors to leave their funds in situ , even during market turmoil.

Another major source of funding for financial institutions comes from the repurchase agreement (repo) market – the opposite side of the reverse repo market mentioned earlier. Just as a financial institution extends credit by entering into reverse repos, it accepts credit by arranging repos, with terms ranging from overnight out to several weeks (term transac-tions to several months are also possible, though rather less common). Unlike interbank deposits, CP, and other financial institution funding mechanisms, repos are secured transactions. This means they are only available as a funding option if an institution has access to unencum-bered securities that can be pledged as collateral per standard haircut requirements demanded by the marketplace. Haircuts can range from 10 to 50 basis points on high-quality government securities (for instance, $100 million of US Treasuries creates a $99.75 million loan when the hair-cut is 25 basis points) to 50 percent on emerging market and high-yield bonds (for instance, $100 million of bonds generates a $50 million loan). It is common market practice for the collateral to be revalued every day, and for collateral calls to be made if certain minimum maintenance levels are breached.

It is worth noting that in some systems banks have access to other short-term sources of funding. For instance, in the US markets author-ized banks can take advances (loans) at the Federal Reserve discount win-dow, and can sell Federal Funds to other banks in the system; they may also borrow via the Federal Home Loan Bank system and accept brokered deposits. Similar facilities are available in various other national systems. Such mechanisms are important in equalizing surplus/deficit balances, but they are not necessarily available to all banks at all times and may thus be a questionable source of liquidity.

It comes as no surprise that the short-term funding markets, while an extremely important source of corporate financing, and less costly than medium-term funds in a normal positive yield curve environment, are susceptible to a considerable amount of instability and require close mon-itoring. The short-term nature of the obligations means that companies have to actively manage the repayment/redemption process, making sure sufficient alternative sources of funding are available in the event renewal is not possible or proves too expensive. A large company is likely to have to deal with millions, and even hundreds of millions, of maturing liabili-ties on a daily or weekly basis, and must therefore be prepared to take action in the event of disruption. In practice, short-term funding facilities are often the initial target of firm-specific or systemic financing prob-lems. If any instance of disruption is not managed forcefully, problems

60 Liquidity Risk

can soon multiply. Lack of confidence by lenders/investors in the short-term markets soon makes its way to other forms of funding, and can lead to cancellation or withdrawal of other facilities. 8

Medium/ long-term funding markets

Medium-term notes and Euronote facilities

Companies regularly access funding via medium-term notes (MTNs), Euro MTNs and Euronotes (that is, note issuance facilities (NIFs), revolv-ing underwriting facilities (RUFs), and related structures 9 ) in order to lengthen liability maturities to the two to ten year sector. Notes can be issued in fixed or floating rate form, and in a variety of currencies and markets. Funding of this type has proven very popular over the past few decades, as it can be accessed via “shelf” programs, with draw-down arranged quickly in order to take advantage of favorable financing opportunities or to meet sudden obligations. The shelf registration proc-ess means that the program only needs to be established and registered with regulators once every few years; multiple draw-downs can then occur when needed, with only a modest amount of new disclosure for each incremental tranche issued. Notes are often floated on an unse-cured basis; only weaker credits are required to post security in support of their issuance.

Lengthening maturities can help companies ease some of the active liquidity management demands imposed by the short-term funding markets. In addition, the public medium-term markets tend to be less credit-sensitive than the short-term markets (apart from notes issued by sub-investment-grade credits). Once notes have been issued they remain outstanding until maturity (unless the issuing company breaches terms of the indenture or securities are putable by investors, in which case the put date must be used as the appropriate reference when determining the liquidity profile). This means that a multi-year obligation provides required funding and makes no demands on cash flow, apart from inter-est servicing (and possibly principal amortization via a sinking fund), for the period in question. The trade-off in the common positive yield curve environment is cost: medium-term funding is more expensive than short-term funding, and this must be considered in the cost/benefit anal-ysis framework.

Funding agreements and GICs

Insurance companies rely heavily on funding agreements and GICs to finance portions of their insurance and investment management activi-ties. Such agreements generally have maturities extending from one to


ten-plus years, and are typically issued and placed with institutional investors on a fixed rate basis. Funding agreements and GICs that have stated maturity dates and no put options or surrender provisions can be considered as medium- to long-term financing. However, some contracts permit surrender at will or are putable by investors with relatively short notice; if such features exist, the funding must again be considered short-term. For instance, some funding agreements contain 7, 30, or 90 day put periods; although investors may hold the agreements for many years, they retain the right to put the contracts back with as little as one week’s notice, and these must therefore be considered short-term funding. GICs and other contractual liabilities that allow surrender on short notice must be viewed in a similar manner. In practice insurers attempt to limit puta-ble and surrenderable features in their funding agreements in order to create true medium-term financing.

Long-term bonds

Long-term bond issues extend the funding yield curve even further, pro-viding corporate financing in the 10 to 30+ year sector. Unsecured bonds add an extra dimension of funding flexibility and stability for the rea-sons mentioned immediately above, and can often be used to match the time horizon of long-term capital investments (such as those that cer-tain industrial companies are required to make). Long-term bonds can be issued in the US and Euro markets, as well as the domestic markets of other advanced national systems. Bonds may be fixed or floating rate, single or multiple tranche, and registered or bearer; they may be floated as public or private placement securities in any one of several currencies. Bonds may also be structured as senior or subordinated securities; those that are deeply subordinated can be viewed as a form of quasi-equity, particularly when they are issued on a perpetual basis. Convertible bonds are a form of hybrid bond financing (although mandatory convertible bonds are more accurately classified as equity). Secured bonds, supported through specific or general liens on an issuer’s assets, are an important source of funding for some firms. Although the encumbrance prohibits the issuer from freely disposing of the underlying asset, the secured bond remains common in certain industrial sectors as a form of “semi-perma-nent” capital financing.

It is important to note that bonds might not always provide the timely liquidity injection that a firm requires. The process involved in issuing a bond can be lengthy as extensive due diligence, rating agency work and disclosure are typically necessary. Although the shelf registration approach to bond issuance accelerates the flotation process, issuers that lack such programs must float securities on an ad hoc basis, which requires

62 Liquidity Risk

a minimum of several weeks to prepare and launch. In some cases bonds can take several months to bring to market, particularly for issuing com-panies that are not readily recognized in the marketplace. A firm seeking a quick cash infusion to bridge a cash shortfall might thus find bonds ill-suited for the task.

Loans

Medium- and long-term loans are another popular form of financing for a broad range of companies and are, in fact, the single most stable form of debt capital. Even when the public debt securities markets are in turmoil and the ability to issue is limited, companies are generally able to access the bank loan markets (unless, of course, the banking system itself is in crisis and lenders are pulling back on their lending activities, as was evi-dent during the financial crisis of 2007–2008). This relates, of course, to documented credit facilities for which a borrower pays commitment and borrowing fees – those that are merely advised or undocumented cannot be regarded as robust.

Banks routinely lend funds to companies on an unsecured or secured basis for periods ranging from 2 to 20+ years. Loans may be fixed or floating rate, and structured with amortizing, balloon, or bullet prin-cipal repayments; they may be drawn onshore or offshore, in one of many currencies. Secured loans with a charge over fixed assets are quite common, although the same lack of flexibility mentioned above exists. Evergreen facilities, which are “dateless” facilities that remain in exist-ence until the lending bank provides notice of conversion into a term loan with a defined final maturity, can be viewed as a form of medium-term lending (until the notice of maturity date has been established, which generally provides for a minimum repayment term of at least one year).

As we have noted, the medium and long-term funding markets can provide companies with greater certainty than the short-term markets, as cash flows are extended over a longer horizon and the need to con-stantly refund, rollover, or otherwise refinance liabilities coming due is eliminated. While regular payments of interest and principal amortiza-tion represent cash outflows, these are quite small in relation to principal repayments due several years in the future. Naturally, to be considered true medium- or long-term funds, note, bond, and loan facilities cannot be putable, cancellable, or callable at the option of the lender or investor; the contractual and behavioral maturity of the liabilities must therefore be identical (or very nearly so). A 10-year straight bond without puta-ble features or triggering covenants in the indenture is equivalent to 10-year money in the context of liability management. A 10-year bond


that is putable by investors at 30 days’ notice is 30-day money and must be viewed as part of the short-term program; failure to do so misstates funding gaps and understates liquidity risk. We again re-emphasize the point that while funding may become more stable as it is termed out, it need not necessarily close or eliminate asset/liability gaps or mismatches, meaning liquidity risk issues might still exist.

Figure 3.2 highlights common sources of funding liquidity.

Equity capital

In considering the corporate balance sheet in a dual-entry accounting system, we know that equity capital exists to support the assets and lia-bilities of the firm. Equity capital – retained earnings, paid-in capital, and capital surplus, along with certain classes of preferred securities – while absolutely critical to the solvency of the company and protection against

Assets Liabilities

CP, Euro CPPPshort-term bank facilities

payablesdeposits, repurchase agreements

putable funding agreementsReady sources of liquidity, but ones thatyy

are more complex to manage and can be withdrawn or cancelled very rapidly

Medium-term notes/Euronotesnon-putable funding agreements

bondsloans

Ready sources of liquidity that provide a greater degree of funding stability;

secured facilities remove somebalance sheet flexibility

Equity

Short-term funding

Medium-/long-term funding

Figure 3.2 Common sources of funding liquidity

64 Liquidity Risk

unexpected losses, is not typically viewed as a short-term source of liquid-ity. From a practical perspective, a firm in need of short-term cash to meet a payment coming due in one week or one month is unlikely to issue a new tranche of common or preferred stock; the process is time-consuming (a matter of several months in most cases) and not synchro-nized with the short-term time frame that is required when dealing with liquidity issues. A firm with a treasury stock contra account has some ability to resell shares repurchased at an earlier time, but this would be an unusual transaction, and not one normally associated with liquidity management.

Of course, equity capital serves as a very important source of stable, long-term funding for the balance sheet, and in that sense it is enormously useful in guarding against liquidity problems. For instance, illiquid assets can (and should) be funded with long-term financing such as long-term debt and equity (sometimes referred to as cash capital) 10 – this helps elim-inate liquidity uncertainties that might otherwise affect the balance sheet through, for instance, the withdrawal of short-term funding. .

Sources of Off-Balance Sheet Liquidity

Off-balance sheet transactions have grown rapidly in scope, depth, and breadth over the past four decades and are now an elemental part of financial and corporate risk management. As the name implies, off-balance sheet transactions reside off the corporate balance sheet rather than in the “visible” asset or liability accounts, and may be characterized by uncertain value. They might exist as contingencies that have not yet resulted in the direct creation of credit or market risk exposure, and they might feature economic worth that fluctuates with changing market con-ditions. Although portions of the exposure generated by these contracts can appear through the balance sheet and/or income statement as value is “crystallized” (for example derivative receivables/ payables, based on mark-to-market valuations, appear on the balance sheet, and draw-downs on revolving credit facilities appear as assets for the lenders and liabilities for the borrowers), the remainder of the future/contingent exposure is generally referenced in the footnotes to a company’s statutory financial statements.

Nevertheless, such instruments represent important sources of liquidity for those who can use them to gain access to cash or assets. Perhaps more importantly, they represent potential liabilities of liquidity providers who might be required to fund in the event of exercise, sale or draw-down. Not surprisingly, since the financial crisis of 2007–2008 companies across many industries have placed much greater emphasis on gaining a bet-ter understanding of their off-balance sheet activities and how they can


affect, and be used to manage, the corporate liquidity profile. In this sec-tion we consider several broad classes of instruments that can serve as sources of liquidity: securitizations, derivatives, contingent financings, and leases.

Securitization

Securitization is a common technique of financial engineering that can be used to transfer risk and generate liquidity. Although credit/market risk transfer is generally the main motivation for engaging in securitiza-tion, we shall focus strictly on the liquidity features of the process.

In a standard securitization, a firm sells a portfolio of assets into a con-duit (generally a trust or special purpose entity (SPE)), generating a cash inflow. The conduit then issues tranches of notes to investors, with each tranche representing a different claim/priority/maturity that gives inves-tors the option of purchasing the investment profile they prefer. Flows from the underlying assets are used to pay periodic interest payments to investors according to the sequence and schedule established through the tranching mechanism. At maturity, the underlying assets are used to repay the principal, and once complete, the securitization transaction terminates. In some instances specific tranches are insured by outside support providers, such as insurance companies or financial guarantee companies (effectively monoline insurers), in order to create securities with very strong credit ratings.

With this basic description, it is possible to see how securitization can liquefy the sponsoring institution’s balance sheet: the sale of assets, such as mortgages, mortgage-backed securities, loans, corporate bonds, auto or credit card receivables, or inventories, converts a portfolio of assets into cash. 11 The process, however, takes time to arrange. Establishing a trust or SPE to purchase the assets, creating and then “seasoning” portfolios that generate the proper profile to meet investor requirements, and identify-ing investors interested in buying specific tranches can take months to structure, negotiate, and conclude. Even subsequent securitizations can take several weeks of work. Securitization must therefore be viewed as a medium-term solution to generating cash.

It is also worth noting that not all securitizations free a sponsoring institution from liquidity risk. For instance, when a bank is involved in selling assets to the SPE, it often provides a contingent liquidity facility that helps support timely payment of principal and interest on the notes; although the liquidity risk becomes contingent rather than first-order, it still exists and must be properly recognized as an exposure. (Corporate securitizations do not carry the same risks for the sponsors, as companies contract with banks to provide appropriate backstops.)

66 Liquidity Risk

Not surprisingly, the market for securitizations depends on the state of financial markets generally, and investor appetite for struc-tured transactions specifically, and is not available at all times. For instance, the financial crisis of 2007–2008, which was created in part by ill-advised and often unsuccessful attempts to securitize subprime (e.g., high risk) mortgages, called into question the entire securitiza-tion “originate and distribute” model. Losses sustained by both spon-sors and investors meant that the broad market for securitizations was effectively shut down for several years. Resumption of “vanilla” securi-tizations commenced in 2010–2011 (under new regulations and qual-ity standards).

Figure 3.3 illustrates the generic flows of a securitization involving mortgages; as noted, we might just as easily substitute receivables or other assets.

Contingent financings

Contingent financings are an extremely popular form of liquidity for institutions, permitting the ex-ante establishment of funding that might not be needed until some future time. For instance, rather than taking out a $100 million loan to fund a future event that might not occur, a firm can simply contract to take out an option to draw-down $100 million when, and if, needed. (Once drawn, the liability becomes

Company

SPE trust

Insurer

Super AAAtranche

AAAtranche

BBBtranche

BBtranche

Residual

Capitalmarketsinvestors

Premium

Creditwrap

P&I

P&I

P&I

P&I

P&I

Securitizationproceeds

Cash inflow

Sale of mortgages withprincipal and interest

(P&I)

Mortgageportfolioff

Figure 3.3 Generic securitization


a funded loan, as described above.) Under most circumstances the firm will pay a fee for the facility (that is, a commitment fee, which essen-tially serves as a liquidity option premium), but need not inflate its balance sheet or pay a full funding cost for a facility that might never be required.

Contingent financings are available in a number of forms, including revolving lines of credit (known also as a line of credit, revolver, or loan commitment), direct pay letters of credit, backstops, backup lines, and swing lines. Access to funds may be direct, as in a draw-down of a credit line, or indirect, as in a disbursement of funds by a bank/tender panel in the event existing liabilities cannot be rolled over or an issue of notes is not absorbed by investors (for instance, a swing line supporting a CP program, or a tender panel facility supporting a RUF or NIF). If draw-down actually occurs, the borrower generates cash for its operations and creates a liability that becomes due and payable over a period ranging from several weeks to several years. In most cases borrowings are senior, unsecured obligations, although security may be demanded (particularly if the credit quality of the borrower has deteriorated between the time of contract and draw-down). The nature of the commitment varies, from absolute to advised. If only advised, a company that believes it has access to a source of funds must exercise due care, as the “commitment” may be withdrawn by the financial institution. In most instances a firm can strengthen the degree of commitment by executing a formal revolving credit agreement with defined terms and obligations and paying a com-mitment fee.

Banks and insurers also provide contingent funding to third-party ben-eficiaries designated by client firms. This provides the third party with a source of liquidity should the contracting firm fail to perform as expected on a commercial or financial transaction. Surety bonds, financial guar-antees, and standby letters of credit are all examples of such third-party contingencies. If the drawing firm fails to make good on its obligations to the beneficiary, the beneficiary is left without a vital source of cash inflow. To compensate, it turns to the bank or insurer and obtains the expected cash flow.

Leases

Lease contracts are another source of off-balance sheet liquidity for com-panies that prefer to lease, rather than purchase, certain types of assets. Operating leases, for instance, act as de facto borrowing arrangements, permitting the lessee to use an asset without having to fund the principal element of the acquisition cost. Although lease payments can be likened

68 Liquidity Risk

to standard interest payments on a bond or loan, there is no principal exchange involved in the standard lease. The fact that the lessee does not own or fund the underlying asset creates a cash flow that can be used for other purposes, including the establishment of a liquidity buffer or the payment of obligations.

In one popular lease transaction, the sale and leaseback, a firm sells an asset to the lessor and then enters into a lease agreement that allows it to continue using the asset. The process liquefies the firm’s balance sheet via the infusion of cash from the sale. Standard leasing arrangements covering various types of fixed assets are also common. Although they do not result in a direct inflow of cash as in the sale and leaseback, the effect is nearly the same: cash earmarked for asset acquisition can be reallocated to meet other obligations. Note that in certain accounting regimes various classes of leases appear on, rather than off, the balance sheet; when this occurs, the lease is simply classified as another form of long-term debt.

Derivatives

Listed and over-the-counter (OTC) derivatives – financial contracts that derive their value from an asset or market reference – have become a pop-ular means of hedging, speculating, and arbitraging since their popu-larization in the 1980s and 1990s. While derivatives are used primarily to manage aspects of corporate investment and risk, they can impact liquidity by supplying or absorbing periodic cash flows. For instance, a firm can enter into a zero coupon swap where it receives regular quarterly payments for a period of years but makes no payments of its own until maturity of the transaction; until the final maturity it enjoys regular cash inflows without facing any outflows. (The bank on the other side of the transaction faces the opposite scenario, of course.)

A total return swap, which is a contract that synthetically replicates the cash flows of an underlying asset on an unfunded basis, provides the pur-chaser with regular cash inflows without requiring it to fund the underly-ing asset (cash that would normally be used to buy the asset can be used to meet other obligations). Under a more speculative approach, a firm can generate extra cash inflows by selling options (derivative contracts that convey the right to buy (call option) or sell (put option) an asset at a par-ticular price and time); the premium it receives represents a cash inflow on trade date, with no resulting liability until some future time, if ever. While this is a high-risk transaction, particularly if the underlying assets are not held on the balance sheet or insufficient cash exists to meet any exercise (this is known as “naked” option writing), a firm can actually generate cash.


Figure 3.4 summarizes common sources of off-balance sheet liquidity. Other sources of on- and off-balance sheet funding exist, but most are

variations on the structures we have mentioned above, such as related-party transactions, where a company borrows from a subsidiary, affiliate, or joint venture, SPEs established to raise funds and channel them to par-ticular parts of a corporate operation, and so forth. Regardless of the spe-cific mechanism, it is important to re-emphasize that sources of liquidity are just one side of the equation. For every source that a company uses there must be a party to supply the liquidity – a purchaser of receivables, a lender against an investment portfolio or fixed assets, a provider of a swing line or term loan, an investor in CP or MTNs, a lessor of equipment, a writer of a zero coupon swap, and so forth. Liquidity suppliers must therefore manage their own positions very closely; failure to do so means

Off-balance sheet

Securitization

An acceptable source of liquidity,primarily through transfer of securitiesffor receivables to a conduit in exchange

for cashff

Contingent financing

A good source of liquidity, to be yydrawn down as needed

Leases

A good source of liquidity, releasingyycash to be used to meet other obligations

Derivatives

A limited source of liquidity,primarily through off-market, synthetic, or leveraged structures that provide upfront

cash or relieve funding requirements

Figure 3.4 Common sources of off-balance sheet liquidity

70 Liquidity Risk

Assets Liabilities

Liquid assets

Cash and marketable securitieskkA ready source of liquidity, either

through outright sale or pledge of unencumbered securities for cashff

ReceivablesA ready source of liquidity, eitheryy

through outright sale (factoring) or pledge of unencumbered receivables

for cashff

InventoriesAn acceptable source of liquidity, either

through outright sale or pledge of unencumbered inventories; most effecffff tive

for standard, durable inff ventories


Fixed assetsA possible source of liquidity, primarily

through pledge of unencumbered plant and equipment for cash

IntangiblesNot a source of liquidity

Off-balance sheetffff

Securitization

An acceptable source of liquidity,primarily through transfer of securitiesffor receivables to a conduit in exchange

for casff h

Contingent financing

A good source of liquidity, to beyydrawn down as needed

Leases

A good source of liquidity, releasing cash to be used to meet other obligations

Derivatives

A limited source of liquidity,yyprimarily through off-market, synthetic, orleveraged structures that provide upfront

cash or relieve funding requirements

Short-term funding

CP, Euro CPPPshort-term bank facilities

payablesdeposits, repurchase agreements

Ready sources of liquidity, but ones thatyyare more complex to manage and can be

withdrawn or cancelled very rapidly

Medium-/long-term funding

Medium-term notes/Euronotesbondsloans

Ready sources of liquidity that providea greater degree of funding stability;

secured facilities removesome flexibility

Equity

Equity capital

N/A

Figure 3.5 Key sources of on- and off-balance sheet liquidity


that they may be unable to provide the cash that other firms are counting on, creating a “ripple effect” that can lead to broader disruptions. As we have noted, this might happen during periods of financial stress, when those accustomed to providing large amounts of liquidity to the corpo-rate system pull back, curtail their investments or loans, or commence flight-to-quality by redirecting capital.

Figure 3.5 summarizes key sources of on and off-balance sheet liquidity.

Amalgamating Liquidity Sources

Companies often develop plans on how to access their amalgamated sources of liquidity in order to minimize costs and avoid any possibility of disruption. Such a plan might be especially relevant when a firm is in strong financial condition and in full control of its cash inflows and out-flows, and the market environment is benign. It might, however, be less applicable when internal difficulties arise or external forces create market disruptions; adjustments might be needed in such cases, as we shall note later in the book. Assuming normal market conditions, however, a firm is likely to use most, or all, of the liquidity mechanisms that it can access in a timely, and economically rational, manner. A typical “rank ordering” might therefore be as follows:

Rollover of existing facilities. ●

Draw-down of bank lines or contingent funding sources. ●

Pledge of unencumbered assets for loans. ●

Sale of liquid assets from the liquidity warehouse, in order of market- ●

ability. Securitization of assets. ●

Sale of additional illiquid assets, including fixed assets and entire busi- ●

ness units.

In general, sales of long-term, illiquid assets that form part of a company’s core business are reserved for the latter stages of any liquidity manage-ment program, for at least two reasons. First, since they are not readily marketable – certainly not in the sense of cash, securities, receivables, or certain inventories – they are likely to be sold at greater discounts, mean-ing more significant loss of value. And, second, since such assets form an essential component of business-generating activities, they can lead to a permanent reduction in enterprise value. Core long-term asset sales are often regarded as a last measure, taken to reinforce a damaged liquidity position.

72 Liquidity Risk

Leaving aside these illiquid fixed assets, a company can create a list of liquidity sources that it can tap as needed. Obviously, no company can access every source of liquidity: some are industry-specific, others are credit rating sensitive, still others are restricted by regulatory actions or market practice. The liquidity “palette” for each company is thus a unique combination of the options we have discussed in this chapter. Furthermore, a distinction must be drawn between theoretical liquid-ity sources – accessible during normal market conditions – and actual liquidity sources – accessible during times of market stress. The two are often different. Consider, for example, the theoretical and actual sources a securities firm can access, as shown in Figure 3.6.

The actual source portion reflects the securities firm’s true ability to gen-erate cash or obtain cash from its amalgamated sources during all market conditions, and may be considered a more accurate representation of cash power. During times of market stress, when the call for liquidity is particu-larly significant, some of the theoretical sources, such as CP, MTNs, paya-bles, or uncommitted facilities, might disappear, creating a shortfall when compared with the theoretical source baseline. Knowledge of theoretical versus actual sources of amalgamated liquidity can be used when creating a liquidity risk management plan, as we shall note in Part III.

Theoretical sources:Net cash from operations +Cash on hand +Borrowing value or liquidation value of unencumbered assets (post haircut) +Commercial paper +Broker call loans +Medium term notes +Unsecured portion of undrawn, uncommitted bank facility +Unsecured portion of undrawn, committed bank facility +Certain and contracted cash inflows

Actual sources:Net cash from operations +Cash on hand +Borrowing value or liquidation value of unencumbered assets (post haircut) +Commercial paper +Broker call loans kk +Medium term notes +Unsecured portion of undrawn, uncommitted bank facility +Unsecured portion of undrawn, committed bank facility +Certain and contracted cash inflows

Disappear

Figure 3.6 Theoretical and actual liquidity sources for a securities firm


Financial and non-financial institutions have access to a number of liquidity sources. While not all types of asset, funding, and off-balance sheet liquidity are accessible to all companies at all times, many of them are. Companies seeking to manage their liquidity profiles are thus wise to arrange ex-ante access to as many as possible. Although this implies a cost, it can help minimize the likelihood of liquidity-induced losses, particularly those that might appear during difficult market conditions. However, the process is not always simple; in the next part of the book we shall consider difficulties that can arise when funding, asset, and joint liquidity risk problems appear.

Part II

Liquidity Problems

77

4 Funding Liquidity Risk

We begin our discussion of theoretical and practical liquidity risk prob-lems with an analysis of funding liquidity risk, which we have previously defined as the risk of loss stemming from an inability to obtain unse-cured funding at economically reasonable levels when needed. If short- and long-term debt facilities and off-balance sheet contingencies cannot be accessed as required, a firm might experience funding losses; when coupled with the asset liquidity risk problems discussed in the next chap-ter, more serious instances of financial distress can develop.

Funding access might be influenced by endogenous or exogenous fac-tors. For instance, from an endogenous perspective a firm might not be able to obtain necessary unsecured financing if its overall financial per-formance has deteriorated sharply and rapidly or if its credit rating is too weak. From an exogenous perspective, a severe disruption in overall mar-ket conditions as a result of systemic instabilities might jeopardize appro-priate access for many (all) firms.

Let us consider the notion of liquid and illiquid markets for funding. A liquid market allows participants to meet requirements when needed through rollovers of existing financing arrangements, or draw-downs of new or pre-arranged facilities. A liquid market will absorb a firm’s funding requirement at, or very near, the firm’s expected cost of funds, with no change in terms (i.e., no change in maturities, no inclusion of restrictive covenants or collateralization). An illiquid market – one that lacks depth or is unstable – prohibits large financing needs from being met without a significant rise in costs, change in structure, and/or time delay; if lenders or investors are unwilling to supply funds at a company’s expected cost levels on relatively short notice, losses may result. There are, of course, instances when a firm can fund a large position in an otherwise illiquid financing market by dividing its obligations into many small cash flows or utilizing multiple products, sources, or conduits; the market in total


78 Liquidity Risk

might be able to absorb the requirement, so funding levels might not rise appreciably. However, funding liquidity management is often based on speed of execution. Immediate access to cash is generally important, so the time dimension can become as vital as the cost dimension, and the funding premium demanded for immediacy can lead to losses.

Sources of Funding Liquidity Risk

Unexpected demand for cash is at the heart of funding liquidity risk. Anticipated obligations can typically be accommodated without dif-ficulty since they fall within the scope of known corporate plans and forecasts. Unanticipated obligations are difficult to incorporate in a risk management plan, although some amount of contingent funding can be established to manage “surprises” (within the confines of a rational liquidity risk/return trade-off, as mentioned in Chapter 2). Whether this amount will ultimately be sufficient cannot be precisely determined on an ex ante basis, though running a series of plausible scenario analyses may provide appropriate guidance. Unexpected demand for liquidity can come from various sources. We consider several of the most significant in this section, including:

unpredictable cash flows ●

unfavorable legal or regulatory judgments ●

mismanagement ●

negative perceptions/market actions. ●

Naturally, each one of these factors can extend into asset liquidity risk. Unexpected demand for liquidity that exceeds the capacity of an unse-cured funding program (and any ex ante contingent buffer) to cover obli-gations requires action on the asset side of the balance sheet, which reverts to the point we made immediately above: if a firm must post assets as col-lateral at unreasonably large discounts, or can only sell its asset portfolio at distressed prices in order to supplement the cash position, then the very sources that impact funding risk will feed directly into asset liquid-ity problems.

Unpredictable cash flows

Unpredictable cash flows are at the centre of liquidity risks. The realities of the 21st century corporate environment mean that virtually every firm faces a certain amount of cash flow unpredictability; the greater the level of unpredictability, the greater the spectre of funding liquidity risk (and

Funding Liquidity Risk 79

possibly asset liquidity risk). While some element of uncertainty can be managed through buffers, reserves, or extra sources of contingent financ-ing, even the savviest companies cannot predict with precision whether such measures will ultimately be sufficient.

Since the largest global corporate and financial firms are complex entities, cash flow surprises can come from many sources. A review of a typical cash flow statement based on Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) reveals areas where such uncertainties might appear, including revenues, costs of goods sold, receivables, payables, disposals, acquisitions, financ-ings, and investments. We consider corporations and financial institu-tions separately.

Corporations

Figure 4.1 illustrates a generic non-financial corporate cash flow state-ment prepared under US GAAP, with a highlight of potential sources of cash flow unpredictability, including those where a company may have considerable, little, or no control over value received or paid. As the figure demonstrates, cash flow uncertainties can impact various parts of tactical and strategic operations. Tactically, a company might misjudge the size, timing, and nature of its daily business requirements or might be pre-sented with unexpected payment demands from suppliers. Strategically, it might miscalculate the nature of market expansion, acquisitions, prod-uct development, or competition. Either situation can cause the firm to underestimate its commitments and/or funding requirements.

Consider, for instance, a gain/loss on the sale of an investment. If a company estimates that it will realize $100 million from the sale of a factory and uses that figure in its forward cash flow forecasts and budg-eting but only receives $75 million, it experiences an unexpected cash flow shortfall of $25 million. Or, if the firm anticipates earning $1 billion of operating revenue but is forced to make extra supplier payments of $100 million (reflected in its cost of goods sold account), it again experi-ences an unplanned cash flow shortfall.

We can also consider situations where the purchase price of a strate-gic acquisition is greater than originally budgeted, the non-discretionary capital expenditures of a hard asset build-out exceed targets, a cata-strophic event damages a facility that is underinsured, and so forth. Each and every one of these events can create unexpected demand for cash, increasing funding risk pressures.

Cash flow unpredictability can also arise from off-balance sheet con-tracts with uncertain value and timing. Let us first take the case of a company that has sold a $250 million American exercise call option on

80 Liquidity Risk

an asset and has left the position unhedged. Assuming the transaction is not reversed at some future date, one of two scenarios will appear at any date prior to expiry. First, the option will move in-the-money, leading the buyer to exercise; this will compel the company to pay $250 million to buy the asset from the option buyer, and will require $250 million of financing. If the sole source of the $250 million is via sale of the asset, the company must then hope that the price when it liquidates is high enough to yield at least $250 million. Supposing the price yields less than $250 million, if the firm has other sources of funding, it will then have to tap those to meet the cash call.

Cash flows from operating activitiesNet earningsAdjustments

Depreciation and amortizationGain/loss on sale of investmentsGain/loss on unconsolidated affiliatesGain/loss on minority interestsIncrease/decrease in deferred income taxesChanges in:

Accounts receivableInventoriesOther current assetsAccounts payableAccrued expensesForeign currency translation

Net cash flow from operating activities

Cash flows from investing activitiesAdditions to plant, property, and equipmentInvestment in minority partnershipsProceeds from sale of investmentsPurchase of investmentsAcquisitions, excluding cash acquiredOther investmentsNet cash flow from investing activities

Cash flows from financing activitiesIncrease/decrease in accounts/notes payableIncrease/decrease in accounts/notes receivableProceeds from issuance of long-term borrowingsRepayment of long-term borrowingsTreasury stock purchasesCommon shares issuedDividends paidNet cash flow from financing activities

Net change in cash flows

Potential sources ofoperating cash flow

uncertainty

Potential sources ofinvesting cash flow

uncertainty

Potential sources offinancing cash flow

uncertainty

Figure 4.1 Generic statement of cash flows and possible sources of cash flow uncertainty


Alternatively, the option might remain out-of-the-money, meaning the company is under no obligation to raise $250 million. Again, the main point to emphasize is that a simple option transaction creates a contingent cash flow that is uncertain with regard to amount and timing. Non-financial corpora-tions may have hundreds (and even thousands) of such derivatives (financial corporations typically have tens, if not hundreds, of thousands), suggesting considerable complexity in distilling future cash flows. It is not difficult to see through these simple examples how estimating cash flows with a reasonable degree of precision can be challenging; the process can never be completely precise, meaning uncertain cash flows are a reality for all companies.


Similar cash flow unpredictability exists with financial institutions. Although the nature of operating, financing, and investing cash flows is slightly different, the same challenge applies: predicting future cash flows with a reasonable degree of precision is a tricky task. For instance, a bank granting a backstop or revolving credit line is providing a commit-ment to fund in the future, at the borrower’s option; the amount and tim-ing of draw-down are unknown at the time the contract is created. Such contingencies are extremely popular with companies, as they constitute a form of liquidity insurance that allows funds to be drawn only when needed. (They are also attractive to lenders as they allow fees to be earned even when no credit has been drawn down.) But they are fraught with uncertainty from a cash flow perspective because they can be accessed at any time and in any amount up to the maximum size of the facility. The same is true for standby letters of credit, which require a bank to fund in favor of a beneficiary if the original drawing party ceases to make pay-ments; non-performance is, of course, an unpredictable event.

While various techniques can be applied to estimate the likelihood that these types of contingent outflows will arise (for example past experience, probabilities based on interest rate or default forecasts over particular time horizons, and simulations under different scenarios), the results can never be totally precise – meaning that an accurate estimate is virtually impossible. The bank must then multiply this uncertainty by (tens of) thousands of customers that have been granted similar facilities and add in the effects of other uncertain cash flows from optionable derivative contracts, demand or call liabilities that can be withdrawn almost instan-taneously, and so forth.

Let us also explore the example of a bank that funds itself with a large percentage of demand (or sight) deposits, which can be immedi-ately presented for redemption by depositors. The cash flow horizon of such deposits is uncertain; under most situations the deposits are likely to remain outstanding without change (e.g., a core amount of the

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deposit base is said to be “sticky”). However, if the bank becomes the subject of negative press or market rumors, more attractive alternatives present themselves in the financial markets, or the financial system in general enters a period of instability, depositors might withdraw their funds. The bank must then immediately repay the demand deposits – failure to do so will lead to a loss of confidence and a potential run on the bank. The cash flow behavior of the demand deposits is therefore uncertain.

As part of this process a bank must distinguish between the contrac-tual and behavioral maturity of liabilities – this helps illustrate why esti-mating liability cash flows can be complicated. Contractual maturity is the actual maturity of a liability, or the earliest (and sometimes final) time at which the obligation can be presented for repayment or redemp-tion; its time horizon is explicit and definite. Behavioral maturity is the practical maturity of a liability, or the “realistic” time at which the obligation will be presented for repayment; its time horizon is unknown and will depend on various internal and external factors. In fact, there is evidence to suggest that behavioral maturity is a more accurate rep-resentation of liability horizons. For instance, retail or institutional depositors holding demand obligations can technically present them for redemption at any time; the contractual maturity suggests they should be viewed as overnight funding. In practice, however, depositors generally roll them over continuously, with no intention of redeeming them unless there is a disruption or more favorable investment oppor-tunity. The behavioral maturity thus suggests the liabilities may be very long-dated, complicating the estimate of future cash flows and funding requirements.

The same often occurs in the CP market, where investors in 7-, 14-, or 30-day paper constantly renew their investments; the contractual and behavioral time horizons are thus quite different. The reverse can occur in the mortgage market, where an original contractual mortgage loan maturity of 10, 20, or 30 years might give way to a behavioral maturity of 3 or 5 years as a result of property sales or refinancings.

An insurance company might also have to deal with multiple sources of cash flow uncertainty. In the first instance the insurer must attempt to estimate claims payments it will have to make over a given time horizon. The nature, magnitude, and timing of these payments are, by definition, uncertain. The insurer has some idea of potential cash outflows through the use of actuarial techniques and the development of expected loss dis-tributions based on the law of large numbers, but an element of uncer-tainty remains. If an unexpected event occurs, claims might be much larger than the expected loss computation would suggest – leading to ex


post cash deficits. Putable funding arrangements, which permit holders of certain liabilities to put them to the insurer at very short notice, can add to cash flow uncertainties; while the insurer might budget a certain amount of redemptions, it can never be entirely sure that it will not be faced with a simultaneous exodus of funding.

It is worth noting that some contingent and actual cash flows are uncertain but contain “delay” features or mechanisms that allow a firm to stagger any ensuing funding requirement. For instance, an insur-ance company that has sold an investor a GIC that can be presented for redemption at any time with a 30-day delay faces an uncertain cash flow (that is, uncertainty over when (or if) the investor will present the GIC for redemption) – but an uncertain cash flow with a timing “cushion” that provides a window during which the insurer can attempt to arrange additional funding as needed.

Again, it is not difficult to see how unexpected cash flows can filter through the entire financial sector. A financial institution will naturally be reluctant to be excessively conservative and assume worst-case cash flow scenarios (such as instant withdrawal of all demand liabilities or complete funding of all contingencies) as this will result in a very inef-ficient use of resources. Equally, it will be hesitant to be overly aggres-sive by assuming best-case scenarios (such as no liability withdrawal and no funding of contingencies) as such an approach could leave it with a potentially large cash shortfall if the contingent events actually occur. Some practical estimates, however imperfect, will always be required, a point we consider later in the book.

Unfavorable legal or regulatory actions

There are instances when a firm might be called on to make unan-ticipated payments to customers or other stakeholders that have been financially harmed or misused. For instance, a court might find a com-pany liable for product defects, environmental damage, neglect, fraud, or breach of fiduciary duties. These actions can lead to what might be sizeable financial judgments in favor of the plaintiff(s). If this occurs, the firm must draw on sources of liquidity to make good any payments due. While it is unlikely that unfavorable legal judgments will be a “sur-prise” – the company will, after all, have spent many months, or even years, preparing for the possibility of a negative legal outcome (perhaps establishing adequate legal reserves in the process) – the magnitude of the payment might indeed be a surprise. It is possible, for instance, for a court to award punitive damages that are multiples of any amount origi-nally sought by plaintiffs; these can put immediate funding pressures

84 Liquidity Risk

on the company, and although the right of appeal often exists, out-comes can remain uncertain and partial payments might still have to be made.

Short of pure legal action, a firm might be forced by regulatory authorities to unexpectedly recall a product, contain or clean up environ-mental damage, or otherwise “cease and desist” from some type of harm-ful activity. These are extraordinary events that might involve immediate payments, restitution, and/or closure costs, and which may temporarily or permanently disrupt operating activities and associated cash flows; both have the potential of pressuring funding.

As noted, there are instances when a company prepares for legal or reg-ulatory eventualities by funding contingent legal reserves 1 or establishing certain types of insurance coverage. These comprise a general class of pre-loss financing, providing cash inflows in the event they are needed. However, not all companies engage in this anticipatory activity, and those that do might still be faced with shortfalls – meaning the potential for cash deficits remains.

Mismanagement

A firm that fails to properly manage its financial affairs as a result of inexperience, incompetence, or negligence might ultimately experience liquidity problems. Diligent discharge of financial responsibilities is a key function of executives operating under the direction and oversight of board directors; failure to perform this function adequately can lead to errors, bad decisions, or behavior that can jeopardize the cash position and create liquidity pressures.

Financial management is a complicated discipline that is characterized by a certain amount of unpredictability; dynamic corporate opera-tions, volatile markets, risk, and human behavior combine to create this unpredictability. That said, disciplined management can lead to prudent handling of assets and liabilities, while lax management can do precisely the opposite. If a company’s executives accidentally or deliberately fail to adequately consider the liquidity process or do not create a proper control environment to deal with liquidity risks, they may expose the company to an undue amount of cash flow unpredict-ability and pressure. 2

Negative perceptions/market actions

Reputation in the marketplace – among investors, creditors, regulators, and rating agencies – is of paramount importance to all firms, espe-cially financial and non-financial service companies that rely heavily on


relationships, goodwill, and intellectual property to generate revenues. Defending reputation is an important executive management function: success leads to stakeholder confidence and, when coupled with solid business results, can translate into a higher stock price, improved credit rating, and lower cost of capital. The reverse is also true. Any doubt regarding the reputation of a company can prove costly – not only in terms of lost business opportunities, but in actual instances of increased funding pressure, higher funding costs, and, in the extreme, financial distress. 3

If a company is impacted by negative perceptions, its business might begin to suffer. Once a problem has begun, the specific reasons for the negative view may be less important than the uncertainty that is introduced into corporate operations and cash flows. Negative perception that leads to particular market actions by external stakeholders – such as withdrawal of capital or cancellation of financing – can thus be viewed as a direct source of funding liability risk; while causes may be endogenous, response is exogenous.

When depositors, creditors, lenders, or suppliers are no longer com-fortable with aspects of a firm, its business, management, or strategy, they become nervous and pull back on the supply of capital, demand a greater premium for any capital they are still willing to supply, or rene-gotiate terms that place additional financial strain on corporate cash flows. Any one of these can lead to unanticipated demands for fund-ing. For instance, it is not unusual for a company with a bank credit facility to feature covenants or downgrade clauses requiring repayment of funds if a credit rating is downgraded or the stock price falls below some predefined level. If negative perceptions in the marketplace are enough to cause either event, a company might then be obligated to repay a portion of its facility: it will have an immediate, and unex-pected, demand for funding. News of the downgrade and partial pay-down might exacerbate negative perceptions, driving the stock price down further, leading to the cancellation of more facilities, generating additional credit downgrades, and so on, in a continuing downward spiral.

Exogenous Considerations

Not all funding difficulties are endogenous. There are instances when a firm might not be facing any significant degree of unpredictability in its cash flows, or be the subject of legal actions, or be impacted by misman-agement or negative market perceptions, but still find that it is affected by funding liquidity risks and associated problems. Forces at work in the

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macro-operating environment might leave a firm (or an entire sector or industry) without access to the funding it requires.

Macro-economic or sector difficulties, particularly among suppliers of liquidity, can be a catalyst. For instance, if the banking system at large has suffered large losses in its credit risk activities, it may reduce its credit extensions to mid-grade companies or require that they collateralize their borrowings; such actions are likely to increase the cost of funding for all borrowers in the category, even though their creditworthiness might remain unchanged; for some companies the reduced credit or the col-lateralization requirements could create liquidity strains. Or, if banks have concerns about a particular sector (believing, perhaps, that too much credit has been extended over a relatively short period), they may begin reducing or cancelling facilities across the board; each individual company in that sector, regardless of credit strength, will feel the impact of the funding withdrawal. Similarly, if institutional investors in CP or MTNs discover opportunities to invest in other assets that provide a more attractive risk/return proposition, they may reallocate capital en masse , leaving companies that rely on such rollover facilities without a steady supply of financing.

It is worth noting that some institutions actually gain funding liquid-ity during periods of market stress. When a financial system is in the midst of panic selling and a general flight-to-quality, there is evidence to suggest that the largest banks in the system actually gain retail and institutional deposits from parties that wish to place funds in “safe haven” instruments. This does not mean that all banks are recipients of the flight-to-quality largesse, but the leading banks – those that might be regarded as “too big to fail” within the local financial system – might indeed receive excess inflows (indeed, this was partially borne out dur-ing the last financial crisis). During market crises these banks might not even have to persuade depositors to increase their deposit flows; it may happen quite naturally. This has the interesting effect of allowing banks to increase their holdings of other investments (perhaps liquid investments, although there might be little need to do so if their own funding liquidity position is being revitalized by the flight-to-quality effect) and extend additional credits on a selective basis. Indeed, certain empirical research 4 has suggested that, as long as the demand for liquid-ity from depositors and borrowers is not highly correlated, banks may be willing to provide higher-rated corporate borrowers with additional backup lines of credit during times of market stress, at competitive all-in funding rates. The point to emphasize is that exogenous dislocations do not always damage the financing access of all institutions. That said, the conservative approach suggests that any beneficial effects accruing


to a select group of institutions be ignored when considering stress scenarios.

The Nature of Funding Problems

When liquidity difficulties increase for one of the reasons cited above, a firm turns to its funding program in order to address the problem. In the normal course of affairs, and assuming the firm’s financing program is both comprehensive and stable, obligations can be met without difficulty. Access to incremental or rollover liquidity is gained through one or more of the liability sources referenced in the last chapter, necessary payments are made, and the firm continues to operate as it normally would. There are, however, instances when the funding program does not function as it should. This exposes the firm to risk of loss – directly, by forcing it to pay an increased cost of funds to secure alternate funds, or indirectly, by forcing it to sell or encumber assets (a topic we consider in the next chap-ter). Although there are various reasons why access to funding might be temporarily or permanently affected, we consider some of the most com-mon in this section, including:

rollover problems ●

lack of market access ●

commitment withdrawal ●

excessive concentrations. ●

While each one of these difficulties is generally endogenous, problems can be compounded by the presence of exogenous forces.

Rollover problems

Difficulties rolling over, or renewing, credit can be an early sign of fund-ing liquidity pressure. When credit providers – whether they are inves-tors in a company’s short-term securities, lenders providing evergreen revolvers, or suppliers providing trade credit through payables – are unwilling to roll over or extend a firm’s maturing liabilities as they come due, or are only willing to do so at sharply higher costs, a firm begins to encounter true funding problems. In fact, these can be very difficult to manage as negative news travels quickly and rollovers must be dealt with promptly.

Problems are generally attributable to actual or perceived problems with the company. If creditors believe that the firm’s creditworthiness has become impaired, they will be reluctant to renew their funding

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obligations without extracting a higher premium or demanding security in the form of asset collateral. In more serious situations they may be unwilling to provide capital regardless of premium or collateral. Banks responsible for arranging short-term backup financing might be morally or contractually required to replace maturing liabilities through backup lines or swing lines. This can be a complicated situation, as other credi-tors in the marketplace might view a company that is forced to draw on bank facilities as a substitute in a negative light. If perceptions are not aggressively managed at this early stage, broader loss of confidence might follow.

While most rollover problems tend to be company-specific, and therefore a direct reflection of the solvency and liquidity risk of a par-ticular firm, they can also be influenced by external forces, includ-ing those that create negative market conditions for all companies in a country, ratings category, or industry sector. As noted above, while a firm’s credit quality might not have deteriorated, it might still have trouble with rollovers if the market is in a state of turmoil. A financial crisis that causes flight-to-quality can lead to substantial withdrawal of capital from the short-term corporate funding markets. Alternatively, if investors are drawn to other investment alternatives that provide a higher return on invested capital, companies seeking to roll over their funding might have to do so at higher yields – even if credit quality is stable.

Lack of market access

Another common funding problem relates to lack of market access – simply an inability to utilize a particular financing market at a particular point in time. We have described the broad array of debt-related instru-ments that are available to companies of varying characteristics and credit qualities. While not all sources of financing are available to all companies at all times, well-managed firms strive to arrange and use the largest number of funding conduits. For instance, a company may estab-lish a shelf registration program so that it can issue bonds on relatively short notice, arrange for a committed bank facility to be drawn down seasonally (or as needed in a crisis), and create a CP program (backed by bank swing lines) to tap into short-term funds and roll them over when needed. However, not all companies have the ability to access all markets of their choice – either initially or on an ongoing basis – and this can constrain corporate operations.

Let us first consider initial funding access. The global debt marketplace allows access based on the characteristics of each individual firm. In


general, larger companies have better access opportunities than smaller ones, public companies better access than private ones, and creditworthy companies better access than less creditworthy ones. As noted in Chapter 3, the CP/ECP and short-term unsecured debt markets are gen-erally reserved for the largest and strongest public companies, meaning that smaller, lower rated, or private companies are barred from access. The same is often true in the unsecured loan market: despite earning lower returns, banks often favor lending to companies with solid credit ratings, meaning weak firms may be prevented from tapping another important source of funds (unless they are willing and able to post collateral as secu-rity, an act that reduces financial flexibility).

Private firms, though potentially very creditworthy, may be unwilling to provide the marketplace with proper financial disclosure and might thus be prevented from gaining financing on favorable terms. Small firms, even if they are excellent credits, are often considered unacceptable candidates for unsecured financing by virtue of their scale. Even good companies that are reluctant to agree to specific bank loan covenants might be unable to arrange proper access.

We must also consider funding access over time, which can deteriorate if a company’s fortunes begin to weaken: avenues of funding generally shut down when the market is concerned about future ability to perform. Firms enjoying access to the money, capital, or loan markets might find some sources are cut off, while others become too expensive as credit quality deteriorates. Not surprisingly, decreased flexibility in accessing different markets, instruments, and lenders can lead to, or compound, funding liquidity risks, particularly when the market at large becomes aware of difficulties – a point we consider in the next section.

Commitment withdrawal

It is no surprise that the withdrawal of funds by suppliers of capital leads directly to funding liquidity risk problems. If a firm has not previously experienced withdrawals, it might simply be forced to bear increased costs as it arranges more expensive alternatives. If it has already been weakened by other facility withdrawals, additional cancellations can lead to more damaging problems, including instances of financial dis-tress. Funding withdrawal can result from breach of covenants, triggers, or conditions precedent, and cause the supplier of funds to terminate a commitment (or refuse to renew the commitment when it comes due, which is akin to the rollover problem mentioned above). It may also arise from a perceived deterioration in credit quality: if lenders or investors are concerned about a firm’s ability to remain current on its

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obligations – for reasons that include, but may not be limited to, those we have already indicated – they may simply withdraw commitments as they fall due.

For example, if a company is able to borrow through an unsecured revolving credit facility only by maintaining minimum net worth, maximum leverage, and minimum credit ratings, a breach of any one of these might lead the arranging bank to cancel the facility and perhaps demand repayment of any funds already drawn down. As the company attempts to secure new sources of funding to replace what has been lost, it might encounter difficulties with other capital providers – news of a cancelled facility can travel quickly. This can set off an entire chain of negative events, as we shall note later. The same might occur with other types of financing facilities. For instance, an investment bank may refuse to act as dealer or placement agent on a company’s MTN program if it is concerned about the company’s viability. While the program may not be technically cancelled, the effective result is the same: the bank charged with arranging funds simply refuses to par-ticipate in the intermediation or agenting process, meaning a source of financing is lost.

Excessive concentrations

Any of the funding problems we have cited above can be exacerbated by the existence of product, market, or lender funding concentrations. A firm that is overly reliant on a single product, marketplace, or lender/inves-tor magnifies its funding liquidity risk because closure of, or withdrawal by, the concentrated source leaves a firm without access to a significant means of financing. Great effort might be required to replace what has been lost. For instance, a firm that derives 50 percent of its funding from CP, or the offshore term loan market, or a single bank, might be unable to replace, at a reasonable cost and within a short time frame, the necessary financing should that 50 percent disappear. Whether the loss occurs for endogenous or exogenous reasons is less relevant than the fact that the funds are no longer available.

In some cases concentrations can arise through changes in historical relationships or correlations. Although a firm might believe it has diver-sified its funding program by spreading its requirement across markets, products, and institutions, a change in systemic factors in the market environment can lead to a change in correlations: products, markets, and lenders might all be affected by the same negative news and react in the same fashion, creating concentrations for the borrowing firm. Excessive concentration is not a theoretical concept, but a real problem that


periodically impacts firms, particularly during times of widespread mar-ket stress; we shall consider in subsequent chapters the financial damage that can be wrought by concentrated funding.

The Effects of Funding Liquidity Risk

The effects of funding liquidity risk are generally felt most acutely by financial firms operating in the “high liquidity risk” portion of the spec-trum we introduced in Chapter 2. This is especially true for securities firms and other highly leveraged financial institutions that lack a core base of depositors and are reliant primarily on the wholesale market for funds. The effects of exposure might be compounded by the speed of news/price diffusion and institutional reaction; while a financial firm might appear to have sufficient liquidity based on normal market condi-tions, that liquidity could evaporate almost instantly.

To summarize aspects of our discussion in this chapter, we consider that in the normal course of business a company will be able to meet its expected and unexpected obligations without difficulty. There are, however, instances when funding uncertainties can arise. These might be due to unexpected cash flows emanating from balance sheet or off-balance sheet activities, a credit downgrade, some unfavorable legal action, general financial mismanagement, or negative perceptions circulating in the marketplace. Any one of these can lead to funding pressures.

The intensity of the funding pressure will depend largely on how the company reacts to the difficulties, and how external parties perceive the problem. Under the most benign scenario the firm can cope adequately by drawing on alternative sources of funds, redirecting activities, tem-porarily reducing its own commitments or expansion, and convincing the marketplace that problems are manageable. Under a more serious scenario the firm might succumb to deeper funding pressures, experi-encing rollover problems and partial or total loss of market or product access. When this occurs the firm suffers the economic effect of fund-ing liquidity risk. At a minimum this involves sourcing new funds at a higher cost, generating a loss. In more serious situations it might lead to a greater economic price: forcing a pledge or outright sale of assets in order to generate funds. In the most extreme cases funding liquidity risk problems, coupled with the burden of asset liquidity risk difficulties, can give rise to the liquidity spirals and financial distress scenarios we consider in Chapter 6.

Figure 4.2 summarizes aspects of our discussion in this chapter.

92 Liquidity Risk

Exogenousforces

Economic loss Lack of financialflexibility

Rolloverproblems

Lack of marketaccess

Commitmentwithdrawal

Excessiveconcentrations

Funding liquidity risk problems

Financial distress

Unpredictablecash flows

Unfavorablelegal/regulatory

judgmentsMismanagement

Negative perceptions/

market action

Sources of funding liquidity risk

Figure 4.2 Funding liquidity risks

93

5 Asset Liquidity Risk

As we continue with our discussion of the theoretical and practical nature of liquidity risk problems, we turn our attention to asset liquidity risk, which we have defined as the risk of loss arising from an inability to con-vert assets into cash at carrying value when needed. Asset liquidity risk is sometimes known as market liquidity risk, since the process relates to the market price that is assigned to, and can be obtained by, a portfolio of assets. In fact, the market value of an asset has two primary sources of risk: the uncertainty of asset returns (that is, pure market risk) and the uncertainty of liquidity (that is, pure liquidity risk); the two at any time may be strongly correlated.

Since a firm must periodically liquidate assets or pledge them as col-lateral to obtain financing, asset prices surface as a central element of asset liquidity risk management. Naturally, a firm with robust operating cash flows and adequate funding sources, which can hold all of its assets until maturity, faces no asset liquidity risk. Risk is injected when oper-ating cash flows are inadequate or mismatched; funding sources prove insufficient, unpredictable, or too expensive; and asset prices and holding periods become uncertain. Since these dimensions represent the realities of the corporate world, it is reasonable to assume that asset liquidity risk impacts the majority of firms, albeit to varying degrees.

To cover unexpected payments or obligations, a firm must preserve some amount of truly liquid assets on its balance sheet. For most firms operating under most market scenarios, assets are a “backstop,” or safety measure, in managing cash flows. As noted in the last chapter, unse-cured funding arrangements form the first line of defence after operating cash flows; this is true because selling or encumbering productive assets reduces financial flexibility and detracts from a firm’s ability to generate future operating income.


94 Liquidity Risk

While borrowing decreases a firm’s net income by increasing interest expense, the sale of assets, particularly those that are non-marketable or are critical to a firm’s existence, can damage enterprise value. If assets must be sold at a reasonably large discount as a result of illiquidity, and the operating cash flows they once produced are sacrificed, enterprise value can become permanently impaired. This is an especially critical issue for non-financial institutions because it may not be easy to replace unique and productive assets at a reasonable cost. The same is true with asset pledges: though using assets to secure loans is not as drastic as an outright asset sale, the action reduces a firm’s financial flexibility. Thus, the sale or pledge of productive assets must be viewed as a safety net, used only if operating cash flows are inadequate and unsecured funding strategies prove too expensive or are otherwise unavailable. This does not suggest that firms cannot and should not use assets as a liquidity risk management tool, but simply that they may only choose to do so if other alternatives are too expensive or cannot be accessed.

Knowing this, it comes as no surprise to note that diligent manage-ment of assets is extremely important. Unfortunately, a firm might be susceptible to a number of potential problems, including lack of asset marketability, lack of unencumbered assets, excessive concentrations, asset misvaluation, and inappropriate collateralization. We shall consider each point below.

Before doing so, let us first discuss liquid and illiquid markets for assets, with a general focus on financial assets. A liquid market for assets allows participants to execute large sales or pledge transactions as needed, with-out impacting prices. A liquid market features no meaningful difference between realizable and carrying value, which reduces (or even eliminates) the prospects of an unexpected cash shortfall through sale or pledging. An illiquid market for assets is one where large transactions cannot be executed without a significant price impact or time delay. As noted in the last chapter, cost and time are key factors in the management of liquidity. There are cases when a firm can liquidate a large position in an otherwise illiquid market by atomizing the transaction into a series of smaller ones that can be absorbed by the market without materially impacting price levels. But, as with funding liquidity management, asset liquidity must often be managed with a degree of speed, which can be challenging dur-ing times of market stress. Immediate access to cash is generally an over-arching goal, so the time dimension becomes as important as the cost dimension; the price discount that must be absorbed for immediacy can create a loss. Indeed, there is considerable evidence that this happens in the financial markets (during the Long Term Capital Management/Russia cri-sis of 1998 and the financial crisis of 2007–2008 to cite two examples). The

Asset Liquidity Risk 95

concept is sometimes expressed in terms of “slippage,” where large asset purchases are filled at increasing offer prices, while large asset sales are filled at decreasing bid prices. We consider this in greater detail below.

Product fungibility, or the ability to substitute one asset with another, is a determining factor in an asset’s liquidity. An asset with substitutes offers alternatives that can induce greater activity but can also fractionalize pools of liquidity. 1 Market structure, or the way in which market activity is conducted, is another influential factor. In a quote-driven dealer mar-ket, dealers give prices to brokers/traders who can then buy or sell; in an order-driven auction market, orders are grouped in the books of principals or agents, and are then matched according to certain rules. There is evi-dence to suggest that quote-driven markets offer more immediate execu-tion, and thus generate necessary liquidity under certain scenarios, while order-driven markets offer more efficient price discovery and transparency and are thus better able to provide liquidity under alternate scenarios. 2

Supporting structure and regulations may also influence market liquidity. Asset markets that permit, or provide for, short selling, repurchase agree-ments/collateralized lending, interdealer broking, listed/OTC derivative contracts, onshore/offshore dealing, and standardized settlement terms can help create two-way interest and trading volume – and, thus, market liquidity. Although the volatility associated with supporting structures might increase, the benefits obtained from tighter pricing and larger deal-ing size might outweigh such “costs.” Heterogeneity in both the dealer and customer base can help reinforce different views and create more robust two-way markets and an expansion of volume and dealing activity.

Asset liquidity is also impacted by transaction costs (that is, the higher the costs, the lower the level of activity, and vice versa) and information availability (the greater the depth of information on statistics, volatility, earnings, the more inclined participants are to make buy/sell decisions, and vice versa). When transparency declines, only informed partici-pants are willing to increase their participation; when transparency increases, liquidity can accumulate as previously uninformed investors start participating. Market liquidity is also shaped by the behavior and views of participants. These can include preferred time horizons, levels of risk aversion, reactions to market information, and future expectations regarding micro- and macro-economic variables. For example, those with strong short-term views are more apt to participate, increasing market activity, and those lacking a strong view may exit or remain sidelined. Those that are risk-averse may be less inclined to join, decreasing activity, while those that are risk-seeking may be eager to join. Expectations are self-fulfilling: when dealers or customers view a market as being liquid they are more inclined to join, helping boost liquidity. The reverse is also

96 Liquidity Risk

true. Knowledge of market flows can also affect liquidity: the mere threat of large asset disposals by one or more institutions can freeze activity and cause a sharp drop in asset prices. This “overhang” phenomenon was in evidence throughout the financial crisis of 2007–2008, when continuous deleveraging by major financial institutions, particularly in structured credit assets, created “offered only” conditions and a complete lack of liquidity. All of these factors can influence asset market liquidity, which is particularly critical for financial assets that a firm might hold in its liquidity warehouse. To be sure, a distinction must be drawn between “normal” market conditions and “stressed” market conditions. Whilst the ability to sell assets may be possible in normal markets under the condi-tions and constrains noted above, they may be severely curtailed – or disappear entirely – in a stressed market environment.

Sources of Asset Liquidity Risk

The specific sources of risk we have considered in the last chapter can easily be extended to create or intensify asset liquidity risks. Unexpected demand for cash is at the heart of asset liquidity risk, but becomes a more prominent concern once unsecured funding alternatives have been exhausted. Again, obligations that are anticipated can generally be accom-modated within the scope of a firm’s standard funding plan. But if sudden demand for cash – caused by the unpredictable cash flows, unfavorable legal, regulatory, or management actions, or negative market perceptions we referenced in the last chapter – cannot be met by a firm’s normal and contingency financing plans, then asset liquidity risk assumes a larger role in the financial risk process. Endogenous factors that consume avail-able funding thus fuel asset pressures.

Exogenous Considerations

Reverting to our discussion on exogenous factors, a firm can manage its asset liquidity in a prudent manner, but still encounter problems related to external effects and actions. This is most often expressed in terms of marketability, concentration, and misvaluation. For instance, a firm might believe that its portfolios of receivables or emerging market bonds are marketable, but stress within the economic or financial system might cause demand for such assets to disappear. If this occurs, what might have rightly been considered a marketable asset is now partly or wholly unmar-ketable. This tends to happen primarily with instruments that lack the flight-to-quality characteristics of industrialized government bonds and the highest rated corporate obligations. While high-quality assets rarely


become unmarketable (perhaps only for very short periods of time dur-ing extreme market dislocations, as in 2007–2008), the same is not true for other classes of assets. The temporary or permanent disappearance of asset market markers directly affects marketability. An asset that might have traded at a small discount to carrying value in most market circum-stances may now only be sold at a deep discount, dramatically reducing the amount of cash that can be realized.

The effects of asset concentration can also intensify in the face of an external dislocation. A firm might not believe that it has a concentrated position if its holding is equal to one day’s turnover, but if systemic char-acteristics change, causing liquidity to decrease to the point where the position constitutes 20 days’ turnover, the firm is left with a concentrated position – it will take 20 days, rather than one day, to realize cash, mean-ing a greater price discount when trying to sell or pledge the position.

If market dislocations cause a change in volatility or correlation, then assets – particularly those that are complex or model-driven – can become misvalued, sometimes by considerable amounts. These systemic effects can feed through to the collateral taken by institutions to secure their credit extensions to others; this is especially true in the case of correlated credit exposures. Although a firm might consciously take collateral with value that is uncorrelated with the general performance of its counterparties based on historical correlations, relationships might change and cause the value of the collateral to deteriorate precisely as counterparties weaken. These effects illustrate again the joint nature of credit, market, and liquid-ity risks; stress events tend to reveal the true degree of interrelationship.

Liquidity misvaluations might also be influenced, or compounded, by the existence of an imbalance – a temporary event that suspends tradi-tional supply and demand equilibrium in the marketplace at large. In a liquid market, “negative feedback” traders act as buyers when asset prices fall and thus dominate activity; this tends to dampen market price fluc-tuations and ensures liquidity does not completely disappear during mar-ket shocks. When “positive feedback” traders are in control, the situation changes: they sell as prices fall, meaning the market becomes increasingly one-way, and liquidity erodes. The degree of positive feedback influenc-ing a market is based on several factors, including stop loss rules (selling when certain levels are hit on the downside), leverage (selling assets to repay borrowings), arbitrage limitations (being unable to replicate nega-tive feedback arbitrage trades that might help stabilize the market) and dynamic hedging (creating feedback loops by selling puts and shorting the underlying).

Stable market liquidity requires that investors not sell assets simultane-ously, but rational behavior suggests that selling should be done before

98 Liquidity Risk

disequilibrium sets in; no one, after all, wants to be the last one “head-ing for the exit.” In response to instances of significant one-way selling, market makers might simply refuse to quote, creating a liquidity imbal-ance (though market makers may have an obligation to quote two-way markets, in practice they tend to walk away when the market is in severe turmoil or distress). Liquidity holes, a specific imbalance that can be dif-ficult to gauge, can arise from information asymmetries, where market makers possess or lack information that causes them to bid or offer more or less aggressively than might be expected. If a liquidity hole arises, trad-ing may be suspended temporarily, meaning that a large seller might hit a bid that is well below its carrying value (or even expected value).

In certain instances stop loss orders or limit orders can influence price and volume patterns and create slippage, imbalances, and liquidity holes. This is especially true if there is a “bunching” of orders around a particu-lar trigger price; once the trigger is hit and dealers attempt to fill orders, price patterns might deviate rapidly and sharply from what might other-wise be expected. (For instance, during the 1998 Russia/hedge fund crisis, dealers with US$/yen carry trades saw the dollar fall from ¥131 to ¥112 and then close at ¥119 in just two days, through short covering of yen positions. Much of this occurred when firms with leveraged carry trades hit similar stop loss and barrier prices that forced automatic liquidation of long dollars.) Liquidity traps can also appear: one-way markets may temporarily show signs of two-way business, luring others into the mar-ketplace and creating the illusion of strong liquidity. Once in, however, dealers might see liquidity erode and the market return to its normal one-way state; exiting from the trap might prove extremely costly.

The Nature of Asset Problems

In the event a firm cannot reasonably and economically access enough unsecured funds to meet obligations, it must rely on its asset portfolio to make up for the shortfall. As outlined in our previous discussion, the focus turns to:

pledging unencumbered assets to secure loans ●

selling liquid assets from the liquidity warehouse, typically in order of ●

marketability securitizing assets ●

selling additional illiquid assets, including fixed assets and business ●

units.

In many cases these solutions can be implemented successfully; although they might lead to some loss of flexibility and economic value, the


chances of a firm encountering severe financial distress remain small. In other instances more significant problems arise, creating stress. This can occur when pledging requirements are so large that they severely restrict financial flexibility, assets can only be sold at a deep discount into highly illiquid markets, or securitization proves too time-consuming to provide a viable cash solution.

In this section we consider the nature of five common asset problems, including:

lack of asset marketability ●

lack of unencumbered assets ●

excessive concentrations ●

misvalued assets ●

insufficient collateralization. ●

These internal factors might be intensified by the external factors cited above. Since many of the asset-related solutions to cope with unexpected obligations form the second line of defence after unsecured funding alter-natives have been exhausted, institutions must manage the process force-fully. Failure to do so might ultimately lead to the joint asset/liability complications we consider in the next chapter.

Lack of asset marketability

Lack of asset marketability is a core issue in asset liquidity risk. A firm that holds assets that cannot be readily transferred, at or near carrying value, injects structural illiquidity into its operations and might suffer consid-erable losses if it needs to dispose of assets rapidly. Financial contracts that are transferable might still not be readily marketable. This generally applies to assets that are complex, customized, or risky (for instance, a collateralized debt obligation residual, an emerging market bond, or some other structured note valued by a model), or that take too much time, effort, and/or legal negotiation to transfer. Such instruments have a lim-ited base of buyers and, by extension, limited marketability.

The relative lack of marketability can be discerned by the liquidity pre-mium investors demand for holding an asset: the less liquid the asset, the greater the premium. (For instance, during the Russia/hedge fund crisis of 1998, the liquidity differential between on and off-the-run assets with the same duration and credit risk was as large as 35 basis points (bps); dur-ing the financial crisis of 2007–2008, the difference between AAA gov-ernment bonds and AAA corporate bonds was as wide as several hundred bps). 3 Financial contracts that are created to be non-transferable and non-saleable prior to maturity (such as a non-qualifying private placement)

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must be considered completely unmarketable and illiquid. Physical assets such as property, plant, and equipment might have a degree of saleability but obviously cannot be considered readily marketable. Selling a tract of unused land, an office building, or a semiconductor factory might take months, if not years, to negotiate and conclude.

Any firm that possesses an excessive amount of such assets cannot sell what it owns, and is thus constrained in its ability to generate a reason-able amount of cash in a short time frame. In some cases this shortcom-ing can be offset or mitigated by pledging otherwise illiquid assets for additional borrowings, but success depends on two factors: the assets are not already encumbered (for example, the factory might already be secured by a claim held by the bank that provided the original construc-tion funding); and the loan-to-value discount is not so large that it yields insufficient proceeds (for instance, a bank might only lend $50 million against a $100 million asset, rather than the $90 million the firm thought it could obtain). Any balance sheet that is burdened by a large amount of unmarketable assets runs a high degree of asset liquidity risk – a problem that becomes very evident in the event of forced pledging or disposals.

It is important to note that asset marketability is a dynamic characteris-tic that can change over time. In some instances assets might be market-able but then suffer from a problem that renders them less marketable or completely unmarketable. A period of “unmarketability” might last for weeks, months, or even years; in more extreme cases saleability can dis-appear permanently. The reasons are typically event-specific, but might commence with an accumulation of speculative positions by institutional investors and financial intermediaries. A reversal in economic strength, or the establishment of regulations or trading curbs, can alter market dynamics and create investor and intermediary losses. These losses can lead to a wholesale revaluation of assets, generating further write-downs and gradual or rapid exit. Subsequent activity may not reappear for a con-siderable period of time. Consider, for instance, that high-yield bonds were quite marketable during the mid- to late-1980s when issuer demand for capital was high and investor demand for above-market yields was strong. The collapse of Drexel Burnham Lambert in 1990, negative con-notations associated with high-yield bonds and hostile takeovers, and a significant US recession and period of credit defaults rendered high-yield bonds virtually unmarketable. Investors needing to sell or pledge their holdings suffered significant price discounts as liquidity evaporated. Not until economic growth restarted in 1993 did the saleability of high-yield bonds recover. They remained actively traded until the credit crisis and recession of 2001, at which time marketability subsided, only to return with economic recovery and corporate growth in 2003. The financial


crisis of 2007–2008 also provides ample evidence of this effect: prior to the crisis, short-term obligations and medium-term bonds of banks and bank holding companies enjoyed good liquidity and relatively tight credit spreads to their relevant government benchmarks. During and after the crisis liquidity all but disappeared as investors lost faith in, and appetite for, any such obligations – even those with the highest credit ratings and/or implicit or explicit government backing. Liquidity slowly began return-ing for the best of these bank issuers in 2010 and 2011 – meaning that the market for bank liabilities was effectively illiquid for three to five years.

In some instances marketability never returns in a meaningful way, as in the instance of perpetual floating rate notes (FRNs) issued by banks in the mid-1980s. Although the instruments were quite liquid for several years, a change in the market environment in late 1986 caused certain investors to withdraw. Concerns over regulatory treatment of perpetuals in bank capital computations and rumors related to the exit of various market makers created considerable investor nervousness. Buying ceased, prices fell, dealers and investors abandoned the market, and liquidity vanished: the asset marketability that once existed never returned. Similar lack of marketability has occurred in other areas, such as European currency unit (ECU) bonds, Swedish CP, unrated US CP, and certain types of collateral-ized mortgage obligations and synthetic collateralized debt obligations.

Lack of unencumbered assets

We already know that a firm may choose to borrow against its assets instead of selling them. By retaining ownership of productive assets and granting creditor liens against them, the firm preserves its ability to gen-erate revenues and build enterprise value. For instance, an auto manufac-turer might pledge its assembly line as collateral against a loan rather than sell it to a third party. Although it temporarily loses control (though not ownership 4 ) of the assembly line and thus constrains its financial flex-ibility, it still benefits from the productive qualities of the infrastructure and retains an ability to generate direct revenues. When the company reverts to a normal state of liquidity, it repays the loan and regains posses-sion of its plant. The same is true of a bank holding a portfolio of invest-ment securities; the bank can sell them in the marketplace to generate the cash it needs, but may prefer to pledge the investments to another bank through the repurchase agreement market. When its liquidity returns to a desired level, it simply unwinds the repo.

These concepts are important when considering another potential asset liquidity problem: lack of unencumbered assets. A firm that has pledged the majority or totality of its assets to creditors decreases its ability to

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manage liquidity-related problems: not only does it reduce its financial flexibility by limiting borrowing capacity, it effectively loses control over its balance sheet. It cannot dispose of any of its assets, as the right to do so belongs to the creditors holding liens. A firm in such a state is fully leveraged and presents a considerable credit risk. The need to make any additional unexpected payments and the slightest difficulty in obtaining funding from conventional sources leave it with little room to maneu-ver – meaning the likelihood of financial distress increases considerably.


Significant asset liquidity risk problems can arise from concentrations. We can define a concentration as a position in an asset that is large relative to the daily turnover activity in the marketplace, or one that is large relative to a firm’s own financial position. The degree of concentration depends on the specific asset, market, and turnover (as well as supporting activi-ties in the off-balance sheet markets). For instance, a 10 percent share of a $10 million asset that trades an average of $100,000 per day might be con-sidered excessively concentrated, while a 10 percent share of a $5 billion asset that trades $350 million per day in physical form and $150 million in derivative form might not be. A $1 billion position in a US Treasury issue might not be concentrated, while a $100 million position in a BB-rated junk bond might well be. There is thus no set rule on what constitutes a concentrated position, although a reasonable “rule of thumb” suggests that a position that comprises more than a few days of average trading volume under normal market conditions might be considered excessive. In addi-tion, to be truly concentrated the position must be significant enough in the scope of a company’s operations to create a meaningful financial loss. When a firm holds a concentration, it might not be able to easily sell at the carrying value in order to generate cash. Indeed, it will likely sustain some loss, the magnitude of which will depend on the absolute size of the posi-tion relative to market depth and the speed at which disposal must occur.

While a concentrated position can be carried at the mid-market price and might thus appear to be fairly priced, it is important to remember that bids, offers, and the resulting mid-markets are generally only relevant for trans-actions of limited size, not those that are excessively large. Market quotes are a reflection of average trading size, which varies by market; rarely are quotes intended to apply to large volume blocks. Accordingly, a firm must be aware of the carrying value on the position by relating the actual size to market prices and market depth. Failure to do so might result in an over-statement of value, crystallizing a loss when forced disposal is required.

For instance, assume an asset is trading steadily with a 5-point bid–offer spread when a firm with a large holding decides to liquidate. If the size


of the position being sold is within the quoted depth, the market impact cost will be the mid-market of 2.5 points (half of the bid–offer spread). However, if the size of the position is greater than the quoted depth, the market impact cost will be far greater as the bid–offer widens, suggesting a misvaluation and ensuing loss. Rather than filling the order at mid-market, the firm might only be able to realize a weak bid, meaning a loss versus carrying value. As noted earlier, this effect is sometimes referred to as slippage – the variation between the average execution price and the ex-ante mid-market price. Figure 5.1 highlights the slippage problem for a concentrated position of size X.

Misvalued assets

Asset liquidity problems sometimes have their genesis in misvaluation. This is true whether a firm follows a mark-to-market convention or an accounting policy of the lower of cost or market. If assets are misvalued, realizable prices from pledging or disposal might fall short of expecta-tions, leading to a gap between anticipated and actual cash inflows. For example, if a firm believes that its investment portfolio is worth $1 billion and is counting on that estimated value to generate $800 million of new

Price

Dealeroffer

Dealer bid

Concentratedposition

Actual sale priceExpected sale priceat mid-market

Figure 5.1 Sale price of concentrated position

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financing through collateralized borrowing, it will experience liquidity pressures if it discovers the investments are only worth $900 million. It might now only be able to borrow $700 million, $100 million less than anticipated, as a result of valuation errors.

Asset misvaluation can occur for a number of reasons, including exces-sive size, complex structure, or errors in modelling or haircut assump-tions – or, from an exogenous perspective, the liquidity imbalances referenced earlier in the chapter. We have briefly mentioned the first problem above. A firm holding a concentrated position that it values at an expected mid-market disposal price (or a borrowing price of mid-market less some discount) will have insufficient asset coverage when it learns that the large position size requires disposal (or pledging) at a weak bid price. Again, the concentrated position might be large in absolute terms, or it might be large relative to trading volume – the effects are likely to be similar. In fact, while firms often mark their assets to mid-market, they should actually be marking at the bid, as only the first seller gets the mid-price: all others lose by paying the liquidity premium.

If an asset (or entire portfolio) is overly complex, it might be challeng-ing to obtain a reasonable estimate. While a conservative firm might apply a significant discount to the value it believes it can obtain, a less conservative firm might not – and will, again, encounter a surprise when it attempts to liquefy the asset.

An asset might be difficult to value if it is based on dynamic parameters that fluctuate with market conditions or assumptions that are subjective (for which no external reference exists). For instance, the prices of certain mortgage-backed securities, particularly those with esoteric dimensions, require assumptions about future interest rates and prepayment behavior. If the assumptions are wrong, the assets will be incorrectly valued, perhaps by a significant amount. The same is true with certain OTC derivatives. While vanilla derivatives can be quite simple to value (and benefit from robust benchmarks arising from strong two-way trading flows), exotic options and swaps are complicated and challenging to price – meaning the same pitfalls can surface. If a firm holding exotic assets makes assump-tions regarding the mathematical behavior of the asset that prove flawed, it will not achieve the value it expects. This has become more apparent in recent years, especially when market dislocations cause traditional sta-tistical relationships to decouple. Historical correlations and volatilities underpinning a book of complex assets produce particular values, and any disruption as a result of stress or flight-to-quality can alter relationships and resulting values. Alternatively, if a firm experiences operational/pro-gramming errors in its valuation routines, an entire book of model-driven assets might be misvalued. The same pricing and error issues can apply to structured credit products, such as collateralized debt obligations and


other synthetic/structured instruments. Many of these instruments rely on complex modelling of correlations and joint probabilities of default, which creates at least some level of valuation uncertainty.

Assets might also be mispriced through the application of incorrect haircut assumptions. The prudent firm seeking to convert a particular asset into cash generally applies a haircut to the valuation in order to compensate for uncertainties related to actual disposal price or collateral-ized borrowing levels; the larger, more complex, volatile, or illiquid the asset, the greater the haircut and the lower the resulting cash value. If a firm has made an error in establishing haircut levels, it will suffer a shortfall when trying to obtain the cash it requires. Thus, if a particular asset is valued at $100 million and is haircut by 10 percent instead of the 30 percent the market demands, the firm suffers a $20 million shortfall in its realizable cash and will have to seek other solutions.

Insufficient collateralization

Collateral taken to secure transactions can also be impacted by asset liquidity problems. This is primarily relevant for institutions that are in the business of providing credit on the basis of security. Secured credit transactions are generally extended to counterparties that have some degree of financial weakness; this means that the probability of having to rely on an alternative source of repayment, such as collateral, is much greater than in a non-collateralized situation. If a lender has not prop-erly defined the type and level of collateral it requires – it takes collateral that cannot be readily sold at the carrying value less haircut – it might sustain an asset-related liquidity loss if two events occur. First, the under-lying borrower defaults on the extension of credit, forcing the lender to dispose of the collateral to effect repayment; and second, the sale of the collateral yields insufficient proceeds to cover the original amount of the loan. Although the joint probability of both events occurring is typically quite small (for example, if there is a 10 percent likelihood of each occurring there is only a 1 percent likelihood of both occurring), it can happen. During the crises of 1997 and 1998, for instance, certain borrowers and counterparties in Korea, Thailand, Indonesia, and Russia defaulted, and the collateral held by lenders proved in some cases to be insufficient to protect against losses as it was being liquidated in a weak market. The same occurred during the Enron bankruptcy in 2001 and the Lehman Brothers bankruptcy in 2008: collateralized lenders to Enron and Lehman realized, in at least some instances, that they lacked suffi-cient collateral to cover the credit extended to the defaulting parties.

Two different pressures impact the asset value of collateral: the general state of economic affairs and sales pressure from wholesale disposal of

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collateral by banks. If a shock hits the financial system and conditions become particularly fragile, borrowers relinquish (or banks seize) collateral because they can no longer perform on their obligations. Banks then dis-pose of the security, perhaps simultaneously, to cover the credits they have previously extended. If the sale occurs synchronously with other liquida-tions, is too large for the market to absorb, too complex to value with accu-racy, or based on extremely illiquid assets such as real property, plant and equipment, or structured financial instruments, banks might find them-selves with insufficient funds to redeem the credits they have extended. The shortfall places them in a disadvantageous position. The downward cycle of collateral valuation and margin calls can be self-fulfilling. Once the price of the asset collateral drops below a variation margin threshold and generates a margin call, one of two options exists: the borrower can fund the margin call through its own external sources, thus preserving the financed position, or it can refuse to fund and force the lender to dispose of the asset to cover the call. The liquidation of a position, particularly in a thin market, can cause price declines large enough to trigger a new set of margin calls. Failure to meet the new calls results in additional liquidation, further declines in the asset price, and so forth, in a repeated cycle. The greater the degree of leverage in the system, the more damaging the liqui-dation process. We note examples of this effect in Chapter 7.

The Effects of Asset Liquidity Risk

To summarize our discussion of asset liquidity risk, we consider that in the normal course of business a company will be able to meet its expected and unexpected obligations without difficulty. If it cannot, it turns first to its unsecured funding program, gaining resources through the acquisi-tion of liabilities. However, in instances where unexpected cash flows are so significant that they overwhelm the firm’s ability to meet the excess with unsecured funding (or when such funding becomes prohibitively expensive), asset liquidity pressures move to the forefront. The intensity of these pressures will depend largely on the company’s actions and the presence of external forces.

Under the most favorable scenario the firm can cope adequately with the pressure by borrowing against unencumbered assets or disposing of the most liquid instruments in its warehouse. If it has been prudent in gauging the value of the assets in relation to their marketability (that is, its haircuts are correct), it will have little difficulty securing the resources it requires. Under a more serious scenario the firm might be susceptible to greater problems, particularly if it has not been conservative enough in its management of the asset portfolio or is subject to greater exogenous


forces. Problems can centre on lack of marketable or unencumbered assets; excessive concentrations that cannot be liquidated at, or near, carrying value; misvaluation; or insufficient collateralization to cover exposures due. At a minimum, these can lead to a financial loss through liquidation at a larger than expected discount or pledging at a larger than normal haircut. If this occurs in tandem with maximized leverage from accessing all available sources of funding and permanent asset sales (which subtract from enterprise value), the firm reduces its financial flexibility and enters a more critical phase of joint asset/funding liquidity risk, which we con-sider in the next chapter.

Figure 5.2 summarizes aspects of our discussion above.

Exogenousforces

Economic loss Lack of financialflexibility

Financial distress

Unpredictablecash flows

Unfavorablelegal/regulatory

judgmentsMismanagement

Negative perceptions/

market action

Sources of asset liquidity risk

Asset liquidity risk problems

Lack of assetmarketability

Lack of unencumbered

assets


Misvaluedassets

Insufficientcollateral

Figure 5.2 Asset liquidity risks

108

6 Liquidity Spirals and Financial Distress

We have examined the difficulties that can arise with asset and funding risks, and we extend the theme in this chapter by analyzing instances of financial distress that can arise from joint asset/funding liquidity problems. We know from previous chapters that difficulties in raising funding or selling/pledging assets can produce losses. While such losses can be serious, widespread financial damage can generally be contained. However, in some cases asset and funding difficulties combine to create a much more dire scenario. Specifically, when asset and funding liquid-ity risks join together, a liquidity spiral – or a cycle where attempts to secure additional liquidity come at an increasing cost and a decreasing level of financial flexibility – can develop. Once a liquidity spiral has commenced, each new attempt to source cash becomes more critical, dif-ficult, and costly. A company caught in a spiral must deal forcefully with the crisis or risk sliding into financial distress and possible insolvency – sometimes very rapidly.

In this chapter we consider the specifics of joint asset/funding prob-lems, the liquidity spiral, and the onset of financial distress. We shall relate this conceptual discussion to the realities of the corporate world when we introduce a number of actual case studies in Chapter 7.

Joint Asset and Funding Risks

In Chapter 1 we defined joint asset/funding risk as the risk of loss arising when funding cannot be accessed and assets cannot be converted into cash at a reasonable cost and within a necessary time frame. In fact, this perspective is perhaps closest to the practical experience of stress liquidity management, as liquidity issues tend to impact both dimensions of the corporate operation simultaneously when micro and macro difficulties are present.


Liquidity Spirals and Financial Distress 109

Problems

Joint asset and funding problems, which can appear in different forms, impact firms in unique ways. The scenarios we consider in this section are by no means exhaustive, but are representative of our main point: namely, that the onset of a funding liquidity problem can lead to actions within the asset portfolio that can actually create more constraints, dif-ficulties, and losses. To illustrate how joint problems can prove damaging, let us trace the potential actions of a hypothetical company migrating through various phases of funding and asset liquidity pressures.

Assume that a company attempts to source new funding in order to meet its normal, planned obligations along with $100 million of pre-viously unexpected payments (coming, perhaps, from a negative legal judgment or a product recall). News of the large payment causes concern among existing debt holders, leading to a moderate widening of credit spreads. The company is able to rollover existing liabilities in the CP mar-ket at higher spreads to cover its normal obligations, but cannot obtain enough new unsecured funding at a sufficiently reasonable cost to cover the unexpected payment. Although the company still has some undrawn bank lines in place, it prefers to preserve them for a serious emergency. Accordingly, it decides to pledge assets in order to raise cash to meet the $100 million payment.

If the company’s unencumbered assets are liquid and generic (for instance, AAA-rated government securities), it can borrow sums that are very near the carrying value. Thus, a $100 million portfolio of US Treasury bonds might yield a $98 million loan when pledged. However, if its assets are more unique or esoteric, the discount will be much larger – larger, perhaps, than the firm was expecting. For instance, $100 million of work-in-progress inventory might yield $75 million of cash, and fac-tory equipment only $60 million.

If the company lacks enough liquid assets to raise $100 million, it will have to put up a greater amount of collateral to secure the required sums, further encumbering its balance sheet. Importantly, any pledging of assets to secure additional funds (done, of course, in compliance with existing negative pledge agreements) reduces financial flexibility and sends a negative signal to credit rating agencies, investors, and bank lend-ers. In fact, creditors may become nervous and charge more for any future credit extensions and/or rollovers. In this particular case the company may pledge a combination of securities, receivables, and inventories with a total carrying value of $120 million to generate $100 million of cash.

As a result of the asset pledges and the resulting increase in leverage needed to meet the unexpected payment, credit rating agencies lower the company’s rating one notch, to the lowest investment grade category of

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BBB-/Baa3. On hearing the news, CP investors grow concerned and refuse to roll over their capital when notes come due over ensuing weeks; paya-bles terms compress dramatically as well, declining from 30 days to 7 days. The company now needs $80 million to meet the next round of normal operating requirements but lacks CP funding and is forced to draw-down on the unused “emergency” bank lines. The draw-down again sends a negative signal to the marketplace. Indeed, when a company draws on a facility that is typically reserved for true emergencies rather than regular working capital, it is invariably sending a message to lenders and inves-tors. Other unsecured lenders who have provided advised, but not com-mitted, facilities, move to cancel credit to the firm; in addition, suppliers change payables to a “cash on delivery” basis.

Needing access to additional funds to meet a third round of normal pay-ments that can no longer be covered by CP or newly revoked uncommit-ted facilities, and possessing no further unused bank lines, the company is again forced to turn to its assets to generate cash. It can pledge remain-ing unencumbered inventories and securities carried at a combined value of $100 million for cash proceeds of $70 million, or it can sell them out-right for $80 million. Increasingly desperate for the additional funds, the company becomes an outright seller of assets, sustaining a loss from sales at distressed prices. News of the asset sales filters into the marketplace, causing further concerns among stakeholders.

The credit rating agencies downgrade the company to sub-investment grade as a result of the firm’s growing illiquidity, lack of financial flex-ibility (from draw-downs, cancelled bank lines, and lack of CP rollovers), and liquidity-induced losses (from outright asset sales at increasingly dis-tressed prices and higher funding costs on outstanding facilities). The downgrade to sub-investment grade breaches covenants in the drawn bank lines. Certain lenders demand immediate repayment of their funds, though they know that such actions may force the company into greater financial distress. In order to repay the bank lines and secure enough cash for survival, the company and its investment bankers arrange for the issuance of a high-yield bond at a very high cost; proceeds are used to meet obligations and give the company time to restructure its asset and liability portfolios and negotiate new facilities with its bankers. It is not hard to imagine continued deterioration if high-yield bond investors can-not be found and the company does not manage its operations forcefully following the bond issuance.

The point of this simple example is to demonstrate that the conflu-ence of funding and asset liquidity problems can create significant direct economic losses (higher funding costs, loss on sale of assets at prices below carrying value) and indirect losses (lack of investor confidence,


diminished financial flexibility, deteriorating credit rating, and breach of covenants).

The classic “run on the bank” scenario is another good example of joint asset and funding problems that can lead, in theory and practice, to liquidity spirals and instances of financial distress. Although a bank run can occur for various reasons 1 (perhaps for example rumors circulate about a bank’s growing bad loan portfolio, regulators discover significant problems in its operations, the bank is believed to have been the victim of a very large internal fraud, or is liable under legal judgments), the first vis-ible sign of difficulties might appear when short-term interbank deposits increase sharply in cost and/or are withdrawn by various banking com-petitors. This might be followed by retail deposit withdrawals, forcing the bank to tap alternate sources of funding (such as term funds), for which it will be required to pay higher rates, sustaining losses. The bank may simultaneously pledge or liquidate financial assets from its liquidity ware-house in order to boost its cash position. The sale or pledge of assets, par-ticularly those that are less liquid (such as high-yield bonds and loans), might be done at larger than expected discounts, leaving the bank with a shortfall and a loss. A credit downgrade might follow. Negative news on the asset difficulties, encumbrances, and downgrade might accelerate the spiral, leading to further deposit withdrawals, more asset sales and pledges, higher funding costs, greater lack of flexibility, additional down-grades, contractions in the credit business (which can impact funds avail-ability for other borrowers), growing loss of confidence, further deposit withdrawals, and so on, in a continuous downward spiral. Unless the cycle is halted, the bank may be forced to seek funding from regulatory sources, an act which is almost certain to destroy any remaining confi-dence in the institution.

Problems are not always confined to individual firms – joint asset and funding risks can also appear at a macro level. Although each firm might be impacted by the events and suffer losses, the total effect is much more damaging as it can involve dozens of institutions from related or unre-lated industries. For example, individual firms with lack of funding access can become sellers of assets in an attempt to generate cash; distressed sales lead to further shortfalls and more selling in a ripple effect that engulfs other firms with similar funding needs. Each new wave of sales into a thin market leads to further price markdowns, more funding withdrawal and flight-to-quality, and so forth, until dozens, and perhaps hundreds, of institutions are damaged by the effects. In fact, this is precisely what occurred during the financial crisis of 2007–2008, where the systemic interrelationships between companies, industries and even countries became painfully clear.

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Causes

Joint asset and funding problems can arise as a result of endogenous fac-tors, including one or more of those we have mentioned in the last two chapters: unpredictable cash flows, unfavorable legal or regulatory judg-ments, mismanagement, and/or negative market perceptions/actions. Any one of these can trigger the chain of events described above. A poorly planned or executed contingency funding program can exacerbate diffi-culties. If executives do not have the proper tools to control problems as they grow larger, events might ultimately overtake the company.

Exogenous forces can also play a part. Reverting to our point in Chapter 3 regarding theoretical and actual access to amalgamated liquidity, it is clear that during dislocations normal channels of capital-raising and asset sales/pledging are disrupted, meaning standard operating procedures based on theoretical access might not solve the problems. Under stress scenarios, assets might not be worth the amount suggested by carrying value; this is especially true for assets that are complex or non-standard. Equally, liabilities might not always behave as anticipated; contractual and behavioral maturities might diverge; and sources of funding might be withdrawn, recalled, or cancelled.

It is precisely during times of market stress that certain firms demand liquidity and those that supply it might not be able, or willing, to do so. For instance, if a major financial dislocation occurs, investors in the CP or ECP markets may be reluctant to fund corporate balance sheets, preferring the relative safety of highly rated government securities. The short-term corporate funding markets shut down as the flight-to-quality process begins. In an effort to remain liquid, companies may start tap-ping other facilities. While the capital markets might emerge as another funding alternative, in practice they might close down when there is evi-dence of significant systemic uncertainty – meaning firms place greater reliance on bank lines. If credit facilities are truly committed, banks will have no choice but to fund, regardless of the general credit environment. 2 But if the facilities are only advised, banks may cancel them, placing com-panies in more dire financial straits, forcing them ultimately to pay more for their funding access.

Banks that choose to finance corporate clients in this stressful environ-ment must arrange for their own liquidity; if depositors are nervous and have joined investors in the flight-to-quality movement, they may not be willing to grant deposits at reasonable rates, forcing banks to fund their operations at a higher cost, dispose of assets at a loss to carrying value (i.e., a de-facto deleveraging exercise), or pledge assets on unfavorable terms. 3 Systemic pressures can thus flow throughout the system, creating losses for institutions from various sectors.


The diffusion of illiquid conditions through a system – from related mar-kets to seemingly unrelated markets – has been the focus of empirical work over the past few years. Although the reasons for contagion have yet to be fully understood, some studies point to the damaging effects of concen-trated and leveraged positions in risky sectors, and the ensuing flight-to-quality that occurs as institutions seek relatively risk-free and liquid havens for their cash. Riskier markets grow increasingly susceptible to illiquidity, and quoting becomes offered-only. The ability for firms to dispose of risky assets declines markedly – liquidation horizons lengthen, volatility rises, and discounts deepen. Investors holding short-term, unsecured funding instru-ments may be unwilling to continue doing so, leading to further strains in funding. Until the systemic dislocation is halted and calm returns to the market, companies and banks are faced with declining asset values and rising funding costs. Exogenous factors can easily compound institution-specific problems. This is, of course, precisely what happened in mid- to late-1998, and in a much more obvious fashion between 2007 and 2009.

The Liquidity Spiral

Joint asset/funding problems might be contained when the crisis is in its earliest stages and management deals aggressively with mounting prob-lems. However, in some cases the situation can be difficult to contain and might move out of control; indeed, the liquidity spiral can be quick and devastating, and in the most serious cases can culminate in insolvency. (We will note in the next chapter an example of a liquidity spiral and bankruptcy that commenced and finished in only ten days.)

Problems

There is no definitive sequence of events that leads a firm from joint asset/funding problems into a more serious liquidity spiral; each instance is institution and market-specific. Similarly, there is no set time frame during which problems can intensify: a spiral might appear and termi-nate in a matter of days, or it might take several weeks. It is unlikely, however, to last much longer than that, as a firm caught in a spiral uti-lizes all available resources and mechanisms until the point of recovery, intervention, or collapse.

Building on examples from earlier in the chapter, we can trace a gen-eral sequence of events leading to a liquidity spiral. A company is pre-sented with an unexpected payment or obligation, and lack of sufficient funds requires a draw-down from backup sources; the remaining shortfall requires funding via asset encumbrances. Credit rating agencies, investors,

114 Liquidity Risk

and lenders become aware of the draw-down and pledging, and grow con-cerned; the company’s cost of funds on rollovers rises, and some investors withdraw their capital. The loss of funding sources (such as rollovers) to meet standard operating payments leads to further encumbrances and asset sales; credit rating agencies downgrade the company’s rating as a result of the decreased flexibility and growing funding pressures. More investors withdraw funds on news of the downgrade; some banks raise their effective interest charges sharply, while others demand repayment or cancel their facilities. 4

The loss of additional funding leads to further encumbrances and the start of more active asset sales. The company becomes a distressed price taker, suggesting growing loss of control over its own financial position. As this pressure builds, rating agencies again downgrade the firm on heightened concerns about growing liquidity problems and decreased financial flexibility. The downgrade pierces the critical investment grade floor, triggering covenants that require the company to post collateral on existing credit facilities. This action reduces flexibility even further and leads to wholesale withdrawal of funds by remaining investors. Banks with material adverse change clauses or financial test ratios that have been breached cancel their undrawn credit facilities, cutting off another source of financing.

The company and its investment bankers consider floating a high-yield bond to raise desperately needed cash, but investors shun the proposal as they are unwilling to supply funds at any risk premium. Confidence of investors, creditors, and rating agencies deteriorates rapidly; the firm’s stock price plunges on rumors of impending bankruptcy, and manage-ment utilizes the last of its assets to generate cash. However, the “last-ditch” actions come too late: loss of market confidence is total, and the company is forced into a position of financial distress. It must arrange for a rapid sale to a third party or file a bankruptcy petition in the courts.

Curiously, in some cases regulatory pressures may heighten or accel-erate aspects of the liquidity spiral. Consider, for instance, that banks subject to regulatory review in some national systems are prohibited from accessing certain types of funding as their financial condition deterio-rates – precisely when an injection would prove most helpful. Historically, in the US system, banks with weak capital levels (created, perhaps, by excessive credit or market risk losses) have not been able to tap the bro-kered deposit market and have been constrained in their ability to use the Federal Reserve discount window (though some temporary changes were permitted in 2008). Lack of access to such funds can cause other deposi-tors to withdraw their capital, leading to more losses through higher cost of funding from alternate sources. Such actions create more difficulties, further restrictions, and an acceleration of the spiral.


Figure 6.1 illustrates a generic sequence of events in the liquidity spiral.

The liquidity spiral can be expanded to the systemic level by applying the same sequence of events to dozens of institutions. This can result in a particularly severe crisis, leading ultimately to the financial impairment or insolvency of a large number of firms. When financial institutions are at risk, regulatory intervention may be required in order to prevent con-tagion. Indeed, some regulators may choose to suspend financial require-ments or measures – such as solvency ratios or resiliency tests – during times of system-wide crisis in order not to perpetuate or accelerate behav-iors that might actually fuel further market instability. In other cases they may be forced to sponsor or orchestrate rescue packages. Though such systemic liquidity spiral events are quite rare, they do occur (i.e., they did so in the UK banking systems in 1974, Sweden in 1991, Southeast Asia in 1997, Russia/hedge funds in 1998 and various national financial systems in 2007–2008).

Causes

Liquidity spirals do not occur in every instance of joint asset/fund-ing problems – additional forces must generally be present to create a

Unexpectedpayment

Funding shortfall

Asset pledging/sales

Reduced flexibility, losses

Stakeholder nervousness,downgrades

Lack ofrollovers, funds

withdrawal

Financialdistress

Spiral: nth iteration

Spiral: 2nd iteration

Spiral: 1st iteration

Figure 6.1 The liquidity spiral

116 Liquidity Risk

deterioration that leads to a spiral. While the initial reasons for liquidity problems might be entirely endogenous (mismanagement of a liquidity facility, unexpected cash flow surprises, and so on), the accelerating spiral might be a mix of exogenous and endogenous factors, based on both loss of stakeholder confidence and management inability to respond to the crisis. Loss of confidence can appear in investors or depositors (who may be unwilling to hold or renew liabilities), bankers (who may be reluctant to provide additional funding), and rating agencies (who may question or doubt a firm’s ability to repay obligations as they come due).

The actual reasons for the loss of confidence may be irrelevant once a crisis is underway. Indeed, lack of confidence need not always be grounded in fact – rumor can be enough to trigger a damaging chain of events. The critical point is that once confidence is lost it can feed on itself; since news travels fast in this connected age, it is rarely long before other stake-holders become aware of the concerns of other parties, and take defensive actions in order to protect capital or reputation. The banker that has lost confidence will refuse to lend any more funds; investors holding bonds or CP will sell or refuse to rollover; rating agencies, aware of the exodus of funding, may downgrade the firm. These actions lead to further loss of funding, asset disposals, and encumbrances, perpetuating the spiral.

If management does not act forcefully to stop the outflows and halt the spiral, events can continue until they reach their final conclusion – financial distress, which we discuss below. The role and actions of certain stakeholders, and management’s response, are thus critical in determin-ing whether a joint problem is resolved or accelerates. We consider the specific roles of debt investors/banks, rating agencies, and company management.

Debt investors and banks

Debt investors, including those holding short-term debt obligations of a company (as well as medium/long-term bonds coming due in the current period), often hold the fate of a company in their hands. Their willingness or reluctance to continue supplying a troubled firm with funds is central in determining whether a spiral will accelerate or slow. If debt investors are concerned about the financial status and outlook of the firm, but not to the point where they believe a default is imminent, they may continue to supply capital through rollovers, extensions, or new money. (Recall our example from the beginning of the chapter, where the hypothetical company was able to place a high-yield bond because investors agreed to continue providing capital.) Although they will surely demand a higher risk premium because the company has become a poorer credit, funding remains intact. As long as management can convince debt investors that


sufficient cash will be available to pay interest and principal and meet other obligations, the firm gains time to strengthen its overall financial status.

However, if investors grow wary, they may be unwilling to continue their rollovers. If they truly believe default is inevitable, they will seek to recover whatever capital they can while the firm remains solvent. If man-agement is unable to convince investors to remain committed, redemp-tions/cessation of rollovers will occur, and the firm will be forced to take additional measures, such as borrowing on a secured basis (assuming that is an option). Debt investors, in declaring their unwillingness to roll over funds, thus have a direct hand in deciding the firm’s fate. The actions they take might actually induce an acceleration of the spiral that leads ultimately to default.

A similar process is true, to a lesser extent, for investors holding medium- and long-term debt. Although they cannot refuse to roll over their paper, as maturities are not current, they can sell the liabilities in the marketplace at what might be considered distressed prices. The sale of a firm’s debt at a deep discount will convey a negative signal to others in the marketplace, leading again to an acceleration of the spiral.

Banks play an equally important role. As the primary suppliers of secured or unsecured funds to a company, they have a significant say in whether or not a troubled firm will be able to exit a spiral. If banks believe that the company can be salvaged through the injection of additional short- or medium-term loans (on either a secured or unsecured basis), they provide the marketplace with a vote of confidence and can often reverse a deteriorating situation. Debt investors and rating agencies are likely to view such actions positively, and the company may once again buy additional time to strengthen its position. If, however, banks become convinced through their discussions with management and/or the due diligence process that any further supply of credit is unwise (i.e., it repre-sents “throwing good money after bad”), they will almost certainly have sealed the firm’s fate. Banks that refuse to provide further cash injections, even on a secured basis, indicate to the marketplace that the company is not worthy of additional credit – meaning the firm will be forced to take drastic action (such as distressed asset sales, or sale of business units or the entire firm to a competitor).

In arriving at this decision banks are likely to have analyzed their position as creditors in a bankruptcy situation. They will already know that a decision not to lend is almost certain to lead to distress/default and a sharp discount in the amount they will recover in liquidation or reorganization, so the decision they ultimately take will be based on knowledge of near-certain losses (unless all banks are properly secured

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by valuable assets, or an eleventh-hour corporate acquisition can be arranged).

The decision we refer to in this section relates primarily to a company’s lead bankers. While it is common for a company of reasonable size to feature a number of banking relationships (say, five to ten), lead banks are primarily responsible for driving the relationship and the key funding decisions, and organizing the syndicate of second-tier banks. Although a secondary bank might choose to withdraw at any time and for any reason, such an action is unlikely to be interpreted negatively by the mar-ketplace. The same is not true with regard to the lead bankers: if a lead decides not to commit further funds or support the relationship, the sig-nal is negative.

Rating agencies

The major global rating agencies (Moody’s Investors Services, Standard and Poor’s, and Fitch) play a central role in the corporate process by examining the financial status, performance, and outlook of companies (and sovereigns), and assigning ratings that reflect creditworthiness, or perceived ability to meet obligations. The best investment grade credits are considered to have very strong financial capacity to meet payments as they come due; weaker credits, such as those rated sub-investment grade (for instance, below BBB–/Baa3) do not have the same capacity. For rea-sons related to leverage, liquidity, earnings quality, market share, man-agement, competitive pressures, and asset quality, such firms are more likely to run into problems with their contractual obligations. Publicly rated companies rely on ratings to access the debt capital markets at the best possible rate. Investment grade credits enjoy broad and deep access and good funding levels, while sub-investment grade credits often face hurdles related to both market access and cost of funds. The weaker the credit, the more difficult and expensive the debt-raising process, up to the point where no further financing is possible.

It comes as no surprise that rating agencies wield considerable power when it comes to determining the fate of companies that are experienc-ing financial difficulties. We have indicated through our examples above instances when a rating agency may downgrade a credit as a result of illi-quidity and/or lack of financial flexibility. With each subsequent down-grade, investors and lenders relying on external ratings as part of their own debt investment strategies become increasingly nervous, sometimes to the point of withdrawing funds. The withdrawal can lead to more credit downgrades, triggering more capital flight, further downgrades, and so forth, accelerating the spiral. Financial deterioration might also


breach leverage or liquidity covenants contained in bond indentures or credit agreements, leading to downgrades as well.

Agencies have the ability to influence (although, in most cases, not directly affect) the speed of the downward spiral by considering a down-grade action. If an agency believes a company in financial distress can arrange for sufficient financing to keep operating on a reasonable basis, it may preserve the rating and inject confidence into the marketplace. This might be enough to halt the downward spiral. Conversely, if the agency believes the outlook is bleak and continues with its downgrade actions, it might simply accelerate the spiral.

Management reaction

The reaction of management to internal and external forces that lead to, and accelerate, the liquidity spiral is exceptionally important in determin-ing whether or not the spiral can be halted, or at least slowed, until other plans can be developed. Management that has developed a contingency plan (such as we discuss in Chapter 10) and can deal forcefully with the problems that have generated a crisis might be able to restore stakeholder confidence and raise the funds required to exit the spiral. There is no guarantee, of course, that strong management action alone can halt a slide: in some instances exogenous forces are so overwhelming that even a strong executive team operating through the most robust contingency plan can fail to achieve a successful end. Nevertheless, the chances of suc-cess are greater when management reacts quickly and decisively. If these ingredients are lacking, and executives are unable or unwilling to execute an emergency recovery plan, migration into severe financial distress is a virtual certainty.

Financial Distress

A company unable to escape from a liquidity spiral enters a state of finan-cial distress. 5 Once in this phase, there is often little that can be done to preserve the company in its original form. The end game generally involves one of two scenarios: insolvency or regulatory/private intervention.

When a firm’s cash position has been so badly impaired, and the events of the liquidity spiral have taken their toll, a firm must either file for bankruptcy or sell to (or receive assistance from) a competitor or invest-ment group. In the special case of banking institutions, primarily those considered to be “too big to fail,” a regulatory intervention or bailout might occur (to wit, those arranged particularly in 2008–2009). For the remainder of companies lacking such a regulatory “safety net,” a common

120 Liquidity Risk

course of action is to file a bankruptcy petition and opt for liquidation or reorganization.

If a company is deemed to have sufficient value in its asset base, and has simply failed to manage its cash position properly, then creditors and administrators may feel that an attempt at reorganization is worthwhile. Although shareholders will lose their investments and creditors will sus-tain considerable losses, the firm will be able to continue to operate in some form once it emerges from the bankruptcy process. It is common in such cases for the bankruptcy court to appoint an administrator to oversee the firm’s operations. If no such administrator is appointed, the courts may permit existing management to continue operating the firm as debtors-in-possession, under the monitoring of both the bankruptcy court and creditors. The reorganization process, which might take any-where from months to years to complete, culminates in a reorganization plan and the re-emergence of a new corporate entity.

However, if the company is not believed to have enough value, the courts may opt for liquidation. Corporate assets will be sold and proceeds distributed to creditors in order of priority, with secured creditors receiv-ing the largest pay-out and equity holders the smallest. The company will cease to operate as a going concern.

Short of a bankruptcy filing, there are instances where directors have enough time, and the company has enough value, to arrange for the sale of the firm to a third party. By doing so, the acquiring company assumes the liabilities of the distressed company or provides enough of a cash injection for the latter to continue operating under its control. Such situ-ations are rather more rare than bankruptcy motions, but they can occur when it is clear that the firm, but for its cash strain, is a worthy fran-chise that can continue to create value for investors, and an interested acquirer can react to the opportunity quickly enough. Although the end-ing is not as dramatic as the liquidation or reorganization scenarios, it is clearly still one of financial distress and loss of corporate identity and independence.

Joint asset/funding liquidity risk is a significant problem, yet one that is sometimes overlooked. Indeed, it is tempting to isolate the potential loss events that can occur when problems arise either within the asset or fund-ing portfolios. But the approach can fall short, as it fails to examine the damage that can be wrought when the effects are working in tandem.

Contagion

Our discussion of liquidity spirals and financial distress has focused pri-marily on the plight of individual institutions. Such a micro focus helps


to understand how and why problems can occur. But we would be remiss in not extending the concept further, into the realm of the macro, or the systemic level. In fact, the spillover effects from one institution to others appears to be relatively rare. Just because one company has a liquidity problem that can lead to financial distress does not mean that other com-panies must suffer a similar fate – even if the distressed company is large and strategically important. For instance, energy trading company Enron (which we discuss at greater length in the next chapter), was a very large and important multinational firm, playing a significant role in the energy trading sector and featuring many clients and unsecured creditors. When it collapsed in 2001, primarily from liquidity-driven pressures, it did not create a spillover effect to others in the energy trading sector or, indeed, in the financial sector. Its problems were relatively self-contained and its systemic linkages were simply not deep enough to create a liquidity contagion effect.

However, in some rare cases the extreme liquidity problems and result-ant financial distress of a large firm can cause a broader “toppling of the dominoes.” This appears to occur primarily when the firm has an impor-tant systemic role (e.g., a “too big to fail” bank or a very large insurer/reinsurer with a significant book of business) and when its failure could trigger liquidity problems elsewhere. The best examples are drawn, not surprisingly, from the financial sector, where each large financial insti-tution is part of a transmission or intermediation chain that alternately relies on, and is relied upon by, others. Failure of a large bank from liquid-ity problems can lead to widespread contagion – lack of confidence, silent bank runs, and further instances of financial distress can follow. For example, in July 2008 the failure of US mortgage specialist IndyMac led to silent runs on Washington Mutual (WaMu); the second silent run, com-ing in September 2008, forced WaMu into an acquisition by JP Morgan. That silent run seems to have led to similar silent bank runs at Wachovia (which had to be rescued by Wells Fargo) and Merrill Lynch (which was ultimately purchased by Bank of America). Thus, the collapse of one insti-tution from liquidity pressures and large credit losses flowed through the system, creating severe liquidity problems for other large, systemically important firms. Again, though the contagion effect is rare, it can occur. Ironically, these problems may, in fact, by exacerbated by certain rules, such as mark-to-market asset pricing and pro-cyclical capital rules.

With background on liquidity spirals and financial distress in hand, we are now prepared to consider, in the next chapter, a number of actual case studies.

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7 Case Studies in Liquidity Mismanagement

In the last three chapters we have explored concepts of liquidity risk and the financial losses that can arise from such exposures. In this chapter we extend our discussion by exploring a select number of “real world” case studies that help illustrate different dimensions of liquidity risk and the degree of damage that can be wrought.

The examples we have chosen represent the apex of liquidity risk: financial distress leading to bankruptcy. But our sampling is necessar-ily small. Many institutions have failed or been rescued over the years, solely or largely as a result of liquidity problems. Still others have encoun-tered liquidity-induced financial problems but managed to avert massive losses and even bankruptcy by taking “evasive action” at a late hour. For instance, in the 1980s and 1990s Continental Illinois, 1 Development Finance Corporation of New Zealand, Bank of New England, Colorado Utilities, British and Commonwealth Merchant Bank, and Peregrine Securities, among others, succumbed to liquidity problems and had to be restructured or liquidated. Others, such as the Bank of New York, Salomon Brothers, and Citibank, suffered significant losses as a result of liquidity problems, but managed to avoid the final stages of financial distress. 2

Many other examples have appeared in the millennium: Enron, Swissair, IndyMac, and Lehman Brothers (among others), collapsed solely or prima-rily due to liquidity problems, while Bear Stearns, Wachovia, Washington Mutual, Northern Rock, Dexia and Merrill Lynch (again, among others), had to be rescued through acquisitions or restructurings. There is, unfor-tunately, no shortage of individual institutional examples.

In some instances entire sectors have been impacted by the same pres-sures, creating system-wide losses and institutional failures: the British sec-ondary banking crisis of the mid-1970s, the US savings and loan crisis of the mid- to late-1980s, the global stock market crash of 1987, 3 the Swedish banking crisis of the early 1990s, the Mexican banking and corporate


Case Studies in Liquidity Mismanagement 123

crisis of 1994 and 1995, 4 the Turkish banking crisis of 2000, the global airline industry dislocation following the September 2001 attacks, and the global financial crisis of 2007–2008 created liquidity-related losses for numerous institutions. 5 While other factors were also at play (e.g., credit risk, sovereign risk, market risk), liquidity risk played a leading role in each one of these systemic crises.

Although all of these examples are important and instructive, space considerations require us to focus on a limited number of examples. Accordingly, in this chapter we consider case studies related to indus-try/services (Enron, Swissair), finance (Drexel Burnham Lambert, Askin Capital, Long Term Capital Management, General American, Lehman Brothers, Northern Rock) and government (Orange County). We find that in each situation liquidity problems were caused by unique factors. For example, with Enron we note instances of financial fraud and inter-nal control failure; with Drexel we find a breach of fiduciary duties and lack of effective risk and funding management; in General American we discover mismanagement of funding sources; in Askin Capital and Lehman Brothers we see concentrated funding built on risky and illiquid investments; in Northern Rock we note a risky and aggressive asset gath-ering strategy funded through unstable, often short-term, liabilities; and so forth.

Although each features different root causes, they all share a common theme: lack of access to sufficient cash to continue operations, leading ultimately to the liquidity spirals and financial distress discussed in the last chapter. This does not mean that sufficient liquidity would have altered the fate of each entity: for example, there is little to suggest that Enron could have carried on for another 6 or 12 months even with liquid-ity access, as its financial fraud ran deep. But the end result in some cases might have been different. An examination of these cases is therefore an important step in understanding the practical effects of liquidity risk, and will allow us to consider, in Part III, the construction of a risk man-agement process that can cope with such exposures.

Drexel Burnham Lambert (1990)

Drexel Burnham Lambert (DBL), which started out as a second-tier Philadelphia firm and grew into a Wall Street power, dominated the mar-ket for high-yield (or junk) bonds for most of the 1980s. Through the efforts of trader/originator Michael Milken, DBL began focusing in the late 1970s on “out of favor” investments, such as real estate investment trusts, convertible bonds, preferred stock, and, most important, fallen angels – investment-grade bonds that had been downgraded to “junk” status (i.e., below BBB–/Baa3).

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Milken analyzed default probabilities and returns on these securities, and concluded that spreads were too wide given default experience. He realized that investors holding diversified portfolios of high-yield bonds would be exposed to a greater amount of default risk, but less than was apparent from a pure examination of credit ratings (certainly when com-pared with the spreads that could be earned). In 1978 DBL set up an office in Los Angeles to expand the high-yield bond business. Milken and his team started developing an investor base for high-yield bonds (including large institutional investors such as Mass Mutual, Lord Abbett, Reliance Insurance, First Executive Life, and American Financial Corporation). Simultaneously, DBL’s bankers called on lower-rated companies, prom-ising to originate bond deals for them. Through these joint efforts, the bank became the top underwriter of junk bonds, a status it held until its downfall in 1990.

The high-yield business of the early 1980s was active but benign: the bonds were not yet viewed negatively, and companies issued them mainly for growth (two-thirds of bonds were used for corporate expansion). However, by the mid-1980s they began to be used for hostile transactions and leveraged buyouts (LBOs), and acquired a negative patina. During this period DBL made a strategic decision to provide junk bond financing for hostile transactions and LBOs, and create “war chests” for companies seek-ing to acquire others. The bank also developed the “highly confident” let-ter, a loose underwriting commitment given to companies that were eager to purchase competitors and needed to demonstrate funding availability.

As the market continued to grow Milken ran afoul of securities laws, and the bank put itself in conflicted situations related to front-running and unfair pricing on internal partnership positions. DBL also began accumulating a larger amount of risk positions. Many new junk issues were arranged on a fully underwritten basis, and some of the highly con-fident letters the bank issued ultimately turned into firm underwritings as well. As the market moved into a speculative phase and the credit qual-ity of issuers became increasingly marginal, DBL had greater difficulty placing the bonds: the bank was evolving from a relatively flexible and liquid securities firm into a semi-permanent lender with an illiquid bal-ance sheet.

By the late 1980s the bank routinely carried billions of dollars of junk bonds in its portfolio, and funding the positions was becoming increas-ingly difficult. While a typical Wall Street bank with a liquid portfolio of government securities and high-grade corporate bonds can finance them under normal market conditions in the repurchase agreement market at haircuts of up to 50 basis points (government bonds) and 5–10 percent (corporate bonds), high-yield bonds are treated much more conservatively,


commanding a 50-plus percent haircut (based on changes in US securi-ties laws enacted in 1986). As we have noted earlier, this requirement reduces financial flexibility.

As the market moved through its most difficult stage in the late 1980s, regulators investigating DBL and Milken discovered evidence of corrupt sales practices, insider trading, self-dealing, and conflicts of interest. Under the threat of criminal Racketeer Influenced and Corrupt Organization (RICO) charges, Drexel settled by paying a $650 million fine and ousting Milken and several of his associates. (Milken himself was charged on 98 counts and pleaded guilty to six felonies.)

DBL’s punishment coincided with a downturn in the US economy and a rapid rise in corporate default rates. The bank, holding a multi-billion dollar portfolio of risky junk bonds that were being financed at 50 per-cent haircuts, began experiencing a serious liquidity squeeze. As other Wall Street banks grew nervous about DBL’s strained funding position, they began withdrawing their Treasury repo and short-term unsecured bank facilities. Investors in DBL’s CP stopped rolling over their capital as paper matured. In addition, falling junk bond prices triggered margin calls on the repo financing, which forced the bank to put up scarce cash to preserve the financing. As cash dwindled, some repo lenders liquidated the underlying collateral, creating further downward pressure on asset prices.

As the liquidity strain mounted in January and February 1990, the com-bination of short-term line cancellations, margin calls, forced bond dis-posals, and reputational damage pushed the bank into an accelerating liquidity spiral. With insufficient access to cash, the bank defaulted on $150 million in interest payments under one of its facilities, which trig-gered cross-defaults on other obligations and forced the bank to file for bankruptcy protection.

DBL represents an example of how an illiquid portfolio of assets funded at significant discounts, coupled with management and reputational prob-lems, can create severe financial distress. Although the bank’s problems had been years in the making, it was able to sustain its operations as long as other securities firms and banks were willing to provide funding, and investors were willing to roll over CP. Although the 50 percent haircut on the high-yield portfolio was burdensome, the financing was manage-able as long as the bank maintained the confidence of other institutional investors and the market for high-yield securities remained buoyant. But when the bank’s reputation suffered and management could no longer contain negative press, the concentrated high-yield positions and lack of funding alternatives took their toll; external selling pressure in the junk market exacerbated the situation.

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Reverting to our discussion from earlier in the book, DBL suffered on various fronts:

Excessive concentrations in risky, illiquid high yield assets ●

Use of a large amount of short-term financing that could easily be ●

withdrawn or cancelled (such as CP and Treasury repos) Heavy reliance on collateralized financing based on very large dis- ●

counts to carrying value Insufficient liquid assets to meet redemptions and other obligations ●

Lack of alternative funding sources for emergency draw-down ●

Absence of a robust contingency plan to deal with a disaster scenario ●

based on erosion of lender/investor confidence and deterioration in the high-yield market.

Askin Capital (1994)

Askin Capital, a hedge fund group operating a number of sub-funds, was formed in 1992 when David Askin, a mortgage-backed securities (MBS) specialist associated at one time with Merrill Lynch, DBL, and Daiwa Securities, joined, and then acquired, an investment fund known as Granite Partners. Between 1992 and 1994 Askin Capital expanded the operation and restructured it into three separate funds: Granite Partners, Granite Corporation, and Quartz Hedge Fund. Askin’s strong track record allowed him to attract investment funds from a number of top institu-tions, including AIG, Rockefeller Foundation, and McKinsey. Total assets under management expanded rapidly, from $130 million in 1992 to $300 million by mid-1993 and $600 million in March 1994.

While at DBL and Daiwa, Askin had developed MBS modelling and investment strategies based primarily on the most esoteric elements of the mortgage market (derivative tranches of collateralized mortgage obli-gations (CMOs)), and he applied the same approach to the new funds. Askin assembled interest-only (IO)/principal-only (PO) strips and other CMO tranches into “market neutral” portfolios that were meant to per-form well in either rising or falling interest rate environments.

Askin Capital relied primarily on Wall Street banks for its supply of investments. Since the Granite and Quartz funds were invested prima-rily in esoteric CMOs, the banks and the fund were heavily dependent on each other. The banks created “tailor-made” CMO tranches to meet Askin Capital’s specifications, giving them an outlet for the riskiest, and most troublesome, components, and in exchange provided the fund with collateralized financing facilities. In fact, most of Wall Street’s major houses 6 lent to Askin Capital on a collateralized basis, using the portfolio


of CMOs as security. The fund then used the loans to acquire more CMO derivatives, and so on, until the portfolio was leveraged between four and five times. (To be sure, this type of “mutually beneficial” bank/hedge fund relationship reappeared in the mid-2000s, this time based on col-lateralized debt obligation residuals, many of them backed by subprime mortgages).

The close relationship between Askin and the banks ultimately created problems. Since the CMOs were so complex, Askin Capital was initially dependent on the banks for upfront pricing and ongoing mark-to-model valuation (to measure investment performance and ensure a sufficient margin on the collateralized financing). However, the fund regularly dis-puted the pricing it received, and eventually began valuing securities on its own and communicating performance figures to its investors directly. (Pricing for repo purposes remained the responsibility of the banks, and the two sets of prices eventually diverged.)

By mid-1993 the three sub-funds were more than 95 percent invested in esoteric MBS, supported by a cash cushion of only 5 percent. The concen-trations were well in excess of those held by other MBS “specialty” funds, which generally limited their holdings of esoteric securities to a maxi-mum of 20 percent. In fact, the concentrated position in highly illiquid securities proved to be Askin Capital’s primary weakness and led eventu-ally to its downfall.

As the Federal Reserve began raising rates in early 1994, Askin Capital’s market-neutral strategy appeared to suffer. (The Granite portfolio might only have been market neutral within a relatively small 10–15 basis point range.) In fact, as rates had begun edging up in advance of the formal Federal Reserve hikes, dealers providing repo financing urged Askin Capital to lower its leverage, but the fund refused. Calls for repayment of collateralized loans intensified as a number of smaller dealers began liquidating their own CMO portfolios.

With the rising interest rates of 1994, the record number of refinanc-ings and repayments that had occurred in October 1993 came to a sudden halt. Prepayments slowed dramatically, meaning the duration of MBS and CMOs lengthened substantially, causing the prices of many securities to drop by a significant amount. The most esoteric and volatile securities (and those most sensitive to slowing prepayment speeds) suffered badly; in fact, many issues within the Askin Capital portfolios plummeted in value. The fund, however, continued to preserve its positions and lever-age, even through the earliest rate hikes.

Thereafter, events deteriorated rapidly. As Wall Street grew nervous about the $600 million fund and the $2 billion-plus credit it had extended, it lowered the prices of the CMOs held as collateral, triggering a series of

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margin calls. Askin disputed the calls, protesting that the value had not fallen as low as Wall Street firms had indicated. Nevertheless, the funds were required to post $120 million of fresh capital in order to preserve the portfolios. As Askin Capital attempted to raise new money, it apparently refused an offer from one dealer to buy the portfolio outright, still believ-ing that sufficient money could be raised in time to meet the margin calls. But investors were unwilling to post additional capital, meaning Askin Capital was unable to meet its obligations. Banks liquidated the collateral positions in an orderly, if heavily discounted, manner, repaying their loans and driving Askin Capital out of business.

When the sales were complete (a process that took a number of weeks), Askin’s investors had lost their full $600 million. A number of banks sus-tained credit losses as they had failed to take sufficiently large haircuts on their repos (while some had discounted the esoteric CMOs by as much as 50–70 percent, others had only done so at a 15–20 percent level, which was insufficient to cover the losses on disposal).

In the aftermath of the crisis, Askin Capital sued a number of banks, claiming that they had unfairly lowered prices on the securities in order to trigger margin calls and cover their loans. The court considering the affair focused on whether the sales prices were “commercially reason-able” and concluded that they were, leaving the fund with no further recourse. Investors in the Askin funds sued the fund manager, claiming that the prices conveyed through proprietary models were inaccurate and misleading, and not representative of the true value of the portfolio.

The case of Askin Capital illustrates the effects of limited asset mar-ketability arising from complex and highly customized investments that lack pricing transparency, and the damage that can be caused by hold-ing concentrated positions driven by a single risk factor (such as inter-est rates). The fund’s strategy was only viable in a benign interest rate environment; as rates rose, the losses grew. In addition, the fund relied heavily on financing via the repo market and had no meaningful backup financing sources. Furthermore, it was impacted by exogenous factors: not only was Askin dealing in an interest rate environment that hurt the value of its portfolio, it was forced to dispose of assets in a marketplace that was already unstable and illiquid. Many other institutional players had been caught off guard by the sharp rate hikes, suffering losses of their own. In fact, disposal occurred at the worst possible time, meaning liqui-dation value could not be maximized. Askin Capital was thus affected by a number of liquidity-related problems:

Excessive concentrations in risky, illiquid MBS and CMO assets ●

Inability to effectively price the assets in the investment portfolio ●


Heavy reliance on repo financing at a large discount to carrying value ●

Insufficient liquid assets to meet obligations (e.g., only 5 percent cash ●

on hand) Lack of alternative funding sources for emergency draw-down ●

Lack of a contingency plan to deal with a disaster scenario based on a ●

sharp rise in interest rates.

Orange County (1994)

Orange County (OC), a prosperous region of Southern California, was the site of significant leverage and liquidity-induced problems that led to its bankruptcy in late 1994. The county’s problems emanated from the Orange County Investment Pool (OCIP), a municipal investment fund managed by long-time county treasurer Robert Citron. Over the course of 22 years Citron built a solid record as a capable investment manager that was routinely able to outperform the market and return attractive yields to county investors (including school districts, water councils, towns, and so on); OCIP boasted a long-term average yield of 9.4 percent versus an average 8.4 percent for other state funds.

In order to achieve attractive returns over the medium term, Citron invested OCIP funds in the US fixed income markets (primarily in Treasuries, agency securities, and structured notes), which he then lever-aged. The OCIP portfolio started 1993 with a cash balance sheet value of approximately $7.5 billion. But Citron arranged a large number of repur-chase agreement transactions with firms such as Merrill Lynch ($2.1 bil-lion), Morgan Stanley ($1.6 billion), CSFB ($2.6 billion), and Nomura ($1 billion), leveraging the portfolio several times. He also purchased a significant amount of structured notes that contained embedded leverage (such as 20-year inverse floating rate securities, paying higher coupons as rates fall and lower coupons as rates rise). The combination of repurchase agreements and structured notes meant that OCIP’s $7.5 billion portfo-lio of securities had the same sensitivity to interest rates as a $21 billion portfolio – a considerable exposure to the direction of interest rates and the shape of the curve. Although the extra leverage provided OCIP with above-market yields, it also raised the fund’s risk profile dramatically and left it extremely vulnerable to a rise in rates. In fact, that vulnerability was both to price risk and liquidity risk.

As noted above, the Federal Reserve began the first of several interest rate increases in February 1994, which impacted investors holding long, unhedged bond positions. Though concerned, Citron and others initially ignored the rate hikes; the treasurer operated under the assumption that since OCIP was a “hold to maturity” fund that did not have to mark its

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portfolio to market, it would ultimately crystallize a known value when all of the investments in the portfolio matured. However, such a strategy only works if the fund’s assets and liabilities are properly matched and it has sufficient cash to meet obligations as they come due (margin calls on repurchase agreements, fees, payments, and so forth). In the absence of cash to meet outflows a fund such as OCIP is forced to access any remain-ing unsecured funding or dispose of assets to raise cash. In fact, OCIP had no meaningful access to additional unsecured funds. The large majority of its “repoable” securities were already pledged in support of the leverage program that was generating such handsome returns. Only its structured note portfolio was unencumbered, although its value became increas-ingly uncertain in the rising rate environment.

OCIP continued to lose money as interest rates rose throughout 1994, and by September the fund had unrealized losses amounting to several hundred million dollars. By November Citron and other fund officials were in desperate negotiations with banks about preserving the repo financing. As OCIP’s remaining cash drained away, the likelihood of being unable to meet margin calls on the Treasury repos increased dra-matically. The relative lack of liquidity within OCIP meant that the “hold to maturity” strategy was in danger of failing: the sale of Treasury collat-eral by the banks to repay the loans they had extended would crystallize losses in the fund.

By early December it became clear that the fund lacked the cash needed to meet further margin calls, and officials were forced to announce that OCIP had suffered $1.5 billion of paper losses. In order to provide tem-porary liquidity and attempt to carry the fund through its margin calls, JP Morgan examined the unencumbered structured note portfolio and offered to buy it for $4.4 billion (a $100 million profit to OCIP based on where they were valued, but almost certainly a low bid). County officials declined the offer and forced Citron to resign.

Several days later Nomura noted that OCIP was in technical default on $5 million of bonds, CSFB demanded repayment of $1.25 billion of repos, and a run on the fund commenced. All of the repo lenders, except Merrill, liquidated their collateral, forcing OCIP to crystallize more than $1.5 billion of losses; the county had to file for bankruptcy. Over the course of the ensuing weeks, the portfolio was unwound; $4.7 billion of proceeds were returned to the county and the rest went to repay credi-tors. The final loss within OCIP reached $1.7 billion, including $360 mil-lion from fixed-rate notes, $600 million-plus from inverse floaters, and $600 million-plus from repos. In the aftermath of the event, county offi-cials brought a number of legal actions against Citron and the banks that had provided the county with leverage. 7


Orange County exemplifies the problems associated with an operating strategy based on a “hold to maturity” horizon. We noted in Part I that institutions that can match and hold assets and liabilities until maturity, and have enough of a buffer to meet cash calls, face little liquidity risk. Rarely, however, is this approach tenable, as OCIP discovered; the exces-sive market risk exposure the fund held in an adverse environment cre-ated cash outflows that could not be met. In addition, the concentrated repo funding OCIP maintained meant it had no real financing alterna-tives once lenders decided to withdraw their collateralized lines. The fund therefore suffered on various fronts:

Excessive exposure to a single market risk factor (such as US interest ●

rates) that created significant losses Insufficient cash to meet obligations and absorb the growing losses ●

False comfort in not having to mark obligations to market and reveal ●

unrealized losses Lack of diversified funding sources ●

Improper monitoring of liquidity positions and stress scenarios (such ●

as the effect of rate rises and margin calls on the funding position); insufficient transparency related to risk positions Lack of a contingency plan to deal quickly and effectively with a dis- ●

aster scenario (such as sharply rising rates or withdrawal of financing facilities).

Long Term Capital Management (1998)

John Meriwether, former head of fixed income arbitrage at Salomon Brothers, founded Long Term Capital Management (LTCM) in 1993. The fund, which included a number of well-regarded quantitative experts and academics, raised over $7 billion of capital by 1994 and commenced lev-eraged investing, focusing initially on its fixed income arbitrage exper-tise. During its first two years of operation LTCM generated exceptionally good returns of 43 percent and 41 percent. By 1997, however, the team found that it was increasingly difficult to uncover profitable opportuni-ties. Rapid growth in the mutual fund and hedge fund sectors meant that many institutions were pursuing the same investments (particularly in the corporate credit markets, where credit spreads tightened considerably as bond and loan investors demanded lower-risk premia – the lessons of the Mexican and Asian crises having been temporarily “forgotten”). In response, LTCM migrated into other areas, including those where it lacked the same degree of expertise or where risk levels were significantly higher, including equities (such as selling equity volatility and creating equity risk

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arbitrage positions on 75+ stocks), and esoteric and illiquid fixed income spreads (such as long-dated callable bunds versus Deutschemark swaption volatility, Danish mortgages versus Danish government bonds, Italian treasury bills versus Lira deposits, and Russian carry trades). Importantly, LTCM built large positions in many of these risk classes, becoming more concentrated, leveraged, and illiquid in the process.

In late 1997 LTCM’s managers returned $2.7 billion of capital to inves-tors as they were unable to find enough profitable investment opportuni-ties; they did not, however, reduce their risk positions by a commensurate amount, meaning the fund became more leveraged and illiquid than ever before.

By mid-1998 the financial markets had become increasingly fragile; the Asian crisis of 1997 had left some institutional participants with losses and reduced risk appetites, and corporate earnings had started deterio-rating. In July 1998 Citibank began unwinding its large fixed income arbitrage book, which caused LTCM – holding similar positions – to sus-tain reasonably large losses. This was followed by news in August that Russia could no longer sustain the value of the rouble; the Russian central bank declared a domestic debt moratorium and devalued its currency. This event was the catalyst for much broader problems: equity volatilities soared, issuance and trading in the corporate bond/loan markets tempo-rarily ceased, convergence trades diverged, and liquidity in many asset classes evaporated (all of which would be repeated again, in even more dramatic fashion, in 2007).

While these conditions proved problematic for many institutions, LTCM was particularly susceptible because of its extremely large and leveraged positions – positions that would have been considered too big under normal market circumstances, and that were enormous in rela-tion to a market with rapidly draining liquidity. Virtually all of LTCM’s trading strategies became money-losers during this crucial period: pro-prietary credit and carry trades in Russia, swap and credit spread con-vergence strategies, short equity volatility positions, and esoteric fixed income spreads all reversed course, causing LTCM to lose significant amounts of money. By late August the fund had lost $550 million; sev-eral weeks later total losses had reached $2.5 billion (down 52 percent for the year) as flight-to-quality, divergence, and volatility remained in full force.

As the crisis continued during September (including another $500 mil-lion loss for the fund on September 21), the fund’s liquidity pressures increased, prompting financial regulators to intervene and inspect LTCM’s books (even though, as a hedge fund, it wasn’t technically under the jurisdiction of regulators). They discovered that the fund had lever-aged positions that were well in excess of the market’s ability to absorb


them in the event of unwinds. Balance sheet leverage had reached 30 times (for instance, $125 billion assets supported by $4 billion of equity), but off-balance sheet derivative notionals of $1 trillion meant actual lev-erage was greater than 300 times.

The sheer size and concentration of LTCM’s asset portfolio meant that it was effectively “too big to fail” – any collapse of LTCM would have tremendous systemic implications for other financial institutions (many carrying the same positions and/or acting as credit providers to LTCM). As regulators and banks came to realize this, a number of differ-ent groups put forth proposals to finance or acquire the fund. Interested parties moved with speed and care, as they knew a single default within the portfolio would trigger cross-defaults and force liquidation of huge positions into a thin market. After intensive and rapid negotiations, a 13-bank group arranged $3.6 billion of bailout financing in exchange for 90 percent of the fund, intending to unwind the entire portfolio gradu-ally through an oversight committee so as not to further damage already strained markets. There can be no doubt that the bailout helped prevent what might have been a devastating crisis. 8

After a few more weeks of losses markets stabilized, and the fund started generating earnings. By June 1999 the fund’s earnings were up 14 per-cent, leverage was down through orderly liquidation of positions, and the fund was able to repay investors $300 million and the bailout group $1 billion. The entire fund was ultimately unwound.

LTCM was not alone, of course. Many financial institutions and insti-tutional investors suffered similar losses during the same period as they delevered their own portfolios and liquidated assets; in some instances the liquidations were voluntary, in others cases they were triggered by standing stop-loss orders and internal/external capital and risk require-ments. In many cases illiquid market conditions meant asset disposal prices were well below those predicted by ex-ante haircuts and collater-alization levels.

In the aftermath of the crisis, it became clear that LTCM’s managers had relied too heavily on the assumptions underpinning their pricing and risk models and ignored the concentrated positions they had built – effectively failing to take account of the illiquidity they were injecting into their operations. The losses investors sustained were proof of a flawed approach to business and a general disregard of illiquid risk positions. Of course, banks with lax risk management standards aided the fund. 9 Many banks sustained significant losses in the process and were forced to re-evaluate their own standards and policies related to risk management, concentrated lending, and liquidity measurement; unfortunately, many of these revised standards and policies would prove absolutely inadequate during the financial crisis of 2007–2008. 10

134 Liquidity Risk

As noted, one of the most significant problems arose from the use of flawed risk models – those used to compute market and credit risks and, by extension, liquidity risks. For instance, many financial institutions control their market risks through value-at-risk (VAR) models, which, as we discuss in the next chapter, have certain shortcomings. During the LTCM crisis these flaws exacerbated matters by causing actions that increased volatility and drove out asset liquidity. In fairness, banks and securities firms were simply adhering to the regulatory rules that they were (and are) required to follow. (For instance the 1996 BIS Market Risk Amendment requires banks to use VAR models to manage their risk capital levels, flaws notwithstand-ing; these have subsequently been amended, though perhaps not really repaired.) But the fundamental assumptions underpinning VAR models proved dangerous. Many firms believed that the statistical properties driv-ing the models would remain stable in all market environments – hardly a realistic view of the world. Since participating institutions adhered to the same models, they all had similar responses: shifting from high- to low-volatility assets and from speculative to safe-haven investments. This meant a mass migration out of certain securities and contracts, turning two-way markets into one-way markets, magnifying price volatility, and dramatically lengthening liquidation horizons. Thus, an average size investment-grade corporate bond position that might have taken an hour to liquidate at carrying value took several days to sell at prices 10–25 per-cent below carrying value; risks that were more speculative suffered even greater delays and discounts. The resulting losses were thus much larger than any ex-ante statistical measure would have suggested.

LTCM represents an excellent example of how internal and external forces can join to produce significant liquidity problems for an individual institution and the marketplace at large. Excessive leverage, concentrated and illiquid risk positions, and flawed models meant prudent liquidity risk management was ignored. The fund (as well as a number of other financial institutions) thus suffered on various fronts:

Large, leveraged concentrations in risky, illiquid assets, including eso- ●

teric spreads and equity arbitrage positions Concentrated use of collateralized, short-term financing that could ●

easily be withdrawn or cancelled and off-balance sheet leverage that could not easily be unwound or transferred Lack of sufficient liquid assets to meet redemptions ●

Reliance on flawed risk measures, which significantly understated liq- ●

uidation periods and volatilities, and did not properly account for the possibility of changing relationships between assets Lack of a contingency plan to deal with a disaster scenario (e.g., asset ●

illiquidity, forced asset disposal).


General American (1999)

General American (GA), a US insurance group that owned and operated the GA Life Insurance Company, was formed to offer life insurance poli-cies throughout the United States. At its peak in the late 1990s the insurer featured more than 300,000 policyholders and held a solid A1 credit rat-ing from Moody’s; at least one reason for the strong credit rating came from the fact that GA was protected against capital losses through rein-surance agreements it had in place with Reinsurance Group of America (RGA).

From a funding perspective, GA arranged much of its financing through ARM Financial, an intermediary that helped the insurer estab-lish more than $7 billion of financing facilities with 40 institutional investors (primarily money market funds). Unfortunately, the bulk of the financing was short-term in nature, and it featured an excessively large percentage with embedded options giving investors the right to call back their money at very short notice. While most insurers use similar funding arrangements, GA was a dominant player, holding 20 percent of the total short-term insurer funding market and 60 percent of the sev-en-day putable funding market. The insurer was thus at significant risk of having funds called away and being unable to replace them without sustaining a significant cost. In retrospect, it appears that GA’s manage-ment did not believe that investors would call back their funds (or at least would not do so simultaneously); indeed, they had not done so for a period of several years, and management apparently had little reason to believe that the situation would change. This portion of the funding base was thought to be “sticky” based on past history (and recalls our discussion on the differences between behavioral maturities and con-tractual maturities).

In the spring of 1999, however, certain investors grew nervous as a result of rumors related to the financial strength of RGA and ARM Financial, both central to GA’s operating strategy. On 5 March Moody’s downgraded GA from A1 to A2 over concerns about the insurer’s financial standing, funding status, and financing and reinsurance strategies. With rumors and concerns intensifying over the next few months, GA’s management announced on 29 July that it would absorb $3.4 billion of funding obliga-tions under existing financing arrangements. The intent was to quell any negative press related to the reinsurance strategy or the funding structure. But on 30 July Moody’s downgraded GA from A2 to A3 on the grounds that the insurer’s financial flexibility would be compromised through the redemptions.

The move triggered a rapid spiral into financial distress. Following the downgrade, 11 money market funds put their short-term obligations

136 Liquidity Risk

back to GA, requiring the insurer to repay funds within seven days. By 2 August more investors exercised their 7- and 30-day puts, intensify-ing the repayment cycle and the funding liquidity spiral. Although GA started liquidating assets in its portfolio to meet the scheduled repayment demands, it soon became clear that it would not have enough cash to complete the task; the insurer had been prepared to meet up to $3.5 bil-lion of liabilities, but not the full $7 billion investors sought. On August 9, just ten days after announcing its intent to recapture the funding obli-gations, GA filed for protection with the State of Missouri’s Department of Insurance.

GA represents an important example of the speed with which a liquid-ity spiral, created by a funding profile heavily skewed towards very short-term liabilities and actions fuelled by market rumor, can create financial distress; in only ten days a solidly-rated insurer discovered that it had insufficient cash to repay its financial obligations. With the benefit of hindsight it is clear to see that GA’s funding program was severely flawed, and that its credit rating should have been lower in the first instance. GA was impacted by a number of difficulties, including:

excessive share of a single funding market ●

use of a large amount of financing with short-term optionable char- ●

acteristics, including those requiring payment in only one week, and inadequate analysis of the “stickiness” of the financing insufficient liquid assets to meet redemptions ●

lack of alternative funding sources for emergency draw-down ●

lack of a contingency plan to deal with a disaster scenario based on mul- ●

tiple credit downgrades and very rapid erosion of investor confidence.

Swissair (2001)

SAirGroup (SAG) – the holding company that owned Swiss national airline Swissair, domestic and short-haul carrier CrossAir (70 percent), AirGourmet catering, and majority/minority stakes in various other European airlines – was originally founded in 1930. After decades of successful operations and relatively conservative growth, SAG’s manage-ment, led by CEO Philippe Bruggisser, commenced an aggressive, mul-ti-year expansion plan (the “Hunter strategy”), to give SAG a stronger footing in pan-European and regional flight routes. Since Swissair already controlled a reasonable and stable share of international long-haul traffic to North America, South America, and Asia passing through Switzerland via its Zurich hub, as well as a fair amount of European short-haul travel passing through Basel via CrossAir, management believed that the only


viable expansion opportunity was through other airlines. Directors felt that the company would need to acquire other airlines and develop alli-ances if it wanted to remain Europe’s fourth largest carrier in an increas-ingly competitive environment.

Unfortunately, SAG’s management found that purchasing existing high-quality airlines was an expensive and complex strategy. Accordingly, the company began acquiring stakes in second- and third-tier regional carriers, in some cases building up to majority interests over a period of time. These included Sabena (Belgium), TAP (Portugal), AOM/Air Liberté (France/Africa), LOT (Poland), and Air Littoral (France). The company’s policy of paying a full price for such carriers (which often operated with outdated physical equipment that ultimately needed to be replaced through a debt-based capital investment program) was a key factor in SAG’s downfall.

In 1998, with the acquisition strategy in full motion and global eco-nomic business conditions remaining healthy, the company’s share price reached a peak of CHF500 ($308). As the company expanded (for instance spending on airline stakes, new capital equipment, staffing, and head-quarters), it continued to finance itself primarily through debt. Leverage grew steadily, and by the turn of the millennium it was becoming a con-siderable burden on cash flows. In addition, by 2000 it became increas-ingly clear that air traffic within the Hunter portfolio was deteriorating rather than improving. The onset of the global economic slowdown and extreme competition from pan-European cut-rate carriers placed consid-erable pressure on all of the company’s routes. And since SAG was one of the industry’s highest-cost carriers, it soon found itself experiencing seri-ous cash flow strains. 11

As the company’s financial standing deteriorated, the board dismissed Bruggisser and abandoned the Hunter strategy. Directors also requested new funds from UBS and Credit Suisse, the company’s main bankers. Before injecting additional liquidity, however, the banks demanded internal reorganizations. In March, nine out of ten board members were ousted; the remaining director, Mario Corti, was appointed CEO. One month into his new role, Corti announced a $1.8 billion loss, the first in the airline’s 70-year history. Much of the loss – which reduced capital to dangerously low levels and squeezed liquidity – was attributable to the firm’s bloated costs and interest burden; total debt had increased from $4 billion in 2000 to $9.2 billion in 2001 while interest expense had more than doubled. Lack of earnings from the poorly performing Hunter car-riers compounded the loss (for instance, Sabena lost $180 million, TAP $92 million, AOM, Littoral and Liberté a combined $360 million). Corti put forth a restructuring plan centered on cost cuts, asset sales and a

138 Liquidity Risk

delay in previously committed purchases of TAP and Sabena shares. This move preserved cash, allowing Corti to work on a more comprehensive plan, including arranging a more robust and reliable banking facility to ensure ongoing availability of funds.

Shortly thereafter, however, SAG was forced to deal with the collapse of Air Liberté and a massive restructuring at Sabena. Corti presented the board with a second reorganization plan on 24 September, just two weeks after the terrorist attacks in the United States brought international air travel to a temporary halt. The restructuring called for the creation of a new carrier, Swiss Airlines, comprised of Swissair and CrossAir (based on the latter’s low-cost model), along with staff reductions to help bring costs under control and conserve cash.

However, the company was using its available cash resources at a very rapid rate. Since revenues from new travel were not replenishing cash, the firm’s overall liquidity position grew increasingly fragile. (Indeed, the defensive interval, a measure of a firm’s ability to manage cash out-flows without access to new funding or revenue inflows, was decreasing quickly.) By late September several small banks cut their credit lines to SAG. At this stage the company had less than $120 million in liquid assets on hand, barely enough to keep flying for a few days.

With a liquidity disaster already well in progress, UBS and Credit Suisse agreed, on 29 September, to purchase a $160 million stake in CrossAir and grant an interim credit of $150 million, guaranteeing flights through October 3. With the ownership stake in hand, the bank syndicate was expected to arrange for more stable credit facilities for the period extending beyond 3 October. In a curious turn of events, how-ever, execution of loan documents and dispersal of funds were delayed, meaning SAG literally ran out of money and could no longer fly. On 3 October SAG cancelled all outstanding flights and filed for bank-ruptcy protection (leaving 39,000 ticket holders to join the creditors’ queue); shares plunged from CHF100 to CHF1.27 in a single day. UBS and Credit Suisse were maligned in the national press for not providing funds on time or being more effective in preventing what many termed a “national tragedy.”

On 3 October the Swiss Bundesrat (upper house of parliament) granted temporary credits so that the airline could fly in limited form until a reor-ganization plan was developed. As events unfolded, it became increas-ingly obvious that SAG’s board and management, as well as politicians, had been aware of the company’s fragile financial position for weeks (and in some cases months), and knew that very drastic actions would be required – including politically unpopular wage and staff cuts. Although some members of the Bundesrat later admitted that they knew about SAG’s financial weakness, most indicated that they had not expected the


final stage to unfold as quickly as it ultimately did. The leading finance representative of the Bundesrat was later quoted in the Neue Zuricher Zeitung as saying that the government “underestimated the internal dynamics of such a liquidity crisis and thus the speed at which the situa-tion could come to a head.” Corti disputed that claim, noting that he had approached the Bundesrat members prior to 1 October with details on the firm’s growing illiquidity and a request for $300 million in credit. When the Bundesrat failed to take action at that point, SAG and the banks were on their own.

A restructuring operation followed the bankruptcy filing. Corti and most of the board were dismissed and a new CEO was appointed. CrossAir absorbed two-thirds of Swissair’s existing flights in order to keep traffic moving. A 70 percent stake in CrossAir was taken up by the two lead banks for $150 million, and the Swiss federal and cantonal governments agreed to contribute funds as well – at a total cost to taxpayers of nearly $2.5 bil-lion. (The final shareholding split, agreed by shareholders in December 2001, included approximately 65 percent to individual and institutional investors (including 10 percent each to UBS and Credit Suisse), 20 percent to the federal government, and 12 percent to the cantonal governments.) CrossAir was transformed into the new Swiss International Airlines in December 2001.

The SAG situation reflects a series of strategic management problems that resulted in the implementation of a flawed expansion plan using a very large amount of debt financing. The leverage placed considerable financial strain on the firm’s operating income. When this was coupled with poorly performing airline subsidiaries (most with negative cash flow), external events that sharply reduced international travel dur-ing a critical time in the company’s attempts at reorganization, politi-cal infighting, and lack of aggressive management in the face of rapidly declining cash balances, SAG was left without liquid resources when it needed them the most. Unlike the Enron case discussed below, however, there is widespread belief that with sufficient cash on hand and a more aggressive turnaround plan in place, SAG could have reversed its fortunes without being forced to enter bankruptcy. Ultimately the airline suffered on various fronts:

Excessive leverage and resulting interest burden that detracted substan- ●

tially from cash flow Poorly performing subsidiary operations that absorbed valuable cash ●

resources Lack of sufficient liquid assets to meet daily operating requirements ●

Heavy dependence on the actions of two large lenders to arrange ●

financing

140 Liquidity Risk

Insufficient unencumbered assets on hand to secure emergency ●

funding Lack of alternative funding sources for emergency draw-down ●

Lack of an aggressive crisis management plan. ●

Enron (2001)

The case of Enron, the Houston-based energy concern, has been widely reported and analyzed in the press, given its position as one of the largest bankruptcies in US corporate history. Although there is much to con-sider in relation to flawed governance, we shall focus primarily on the firm’s liquidity crisis – a general by-product of fraud and poor internal controls. 12

Enron was created in 1985 through the merger of natural gas pipeline companies in Nebraska and Texas; Ken Lay assumed the role of chairman and CEO, a position he held through most of the next 16 years. Although Enron focused on the integrated gas sourcing and delivery business for several years, it began realigning its operations in the early 1990s, prima-rily by matching buyers and sellers of gas and taking fees for intermediat-ing. On the surface, Enron’s model appeared successful and became the basis for subsequent trading and risk management endeavors.

The process accelerated when Jeff Skilling, future president (and, for a time in 2001, CEO), joined the company. Under Skilling’s direction, Enron shed more of its physical properties, converting from an asset-inten-sive natural gas pipeline to an “asset-light” trader – resembling, in many ways, a financial trading institution. During its conversion the company actively monetized many of its fixed assets: selling plant and equipment used in the core energy business to realize current period cash, rather than preserving assets for the long term to generate ongoing operating cash flow. (Indeed, the lack of cash flow proved to be a perpetual problem for the company, and one that led the firm’s executive officers to engage in fraudulent behavior.) Given the firm’s strong trading focus, it is worth recalling our remarks from Chapter 2: financial trading firms are highly leveraged institutions that must preserve a large amount of liquid assets in order to meet obligations and supply liquidity to others. Enron lacked a strong buffer of liquid assets, a fact that became all too clear in its final months. Trading business is also driven by reputation, and any damage to that reputation can result in loss of flows and revenues and, from a liquidity perspective, vital cash. Again, Enron discovered the importance of reputation as its fortunes turned.

As the US energy market deregulated and energy prices grew more vola-tile, Enron’s model appeared sound: revenues grew rapidly and permitted expansion into new areas. During the boom years of the late 1990s the


company positioned itself as a trader of virtually any type of asset – pulp and paper, weather, commodities, credits, and so on. It also expanded into areas that it thought would benefit from rapid growth, including water distribution, fibre optic capacity/Internet bandwidth, and so on. These were capital-intensive businesses that were not profitable (and were often cash flow negative); indeed, the company ultimately lost an esti-mated $7 billion on its ill-advised investments in bandwidth and water (as well as energy operations in Brazil and India). Still, analysts and inves-tors remained positive about Enron and its prospects. Quarter after quar-ter of improving earnings in the 1990s caused the stock price to increase steadily (including doublings in 1998 and 1999).

In early 2001 Enron reported revenues of $100 billion and ranked sev-enth on the Fortune 500 list of the largest global companies. With a record stock price near $90, Enron’s market capitalization reached $60 billion – far greater than many industrial companies and financial institutions. Even as it reached these lofty heights, however, the company was in des-perate need of cash; in fact, it had actively engaged in large “prepay” swap transactions with Citibank and JP Morgan for a number of years in order to generate enough cash to pay for its operations. Since prepays are off-balance sheet transactions that act as loans but do not impact balance sheet or leverage ratios, Enron was able to secure the cash it needed with-out alerting investors, rating agencies, and other creditors to the fact that its actual cash position was extremely weak.

In early 2001 the company’s problems started mounting: the Internet and telecom bubble burst, calling into question the firm’s aggressive and expensive expansion into the broadband sector. With a slowing economy and a sliding stock market, Enron’s own stock price started falling. The decline in the stock price triggered certain covenants in disclosed and undisclosed financial contracts that added to the com-pany’s financial pressures. In August 2001 CEO Skilling left the com-pany for “personal reasons,” unsettling investors even further; former CEO Lay returned to his old role. While this was under way, whistle-blowers within the firm – aware of widespread financial improprie-ties – attempted to convey information to the board of directors; one employee was finally successful in alerting certain board members that all was not well.

The house of cards began collapsing shortly thereafter – disclosure of financial errors and internal manipulation radically changed the finan-cial profile of the company. Much of the problem centered on obscure and complex dealings between Enron and various special purpose enti-ties (SPEs); 13 although these were meant to be “arm’s length” dealings, they were intricately entwined with Enron’s own financial structure and performance.

142 Liquidity Risk

In mid-October 2001 the company announced a $544 million after-tax charge against LJM2, an SPE created and managed by Enron CFO Andrew Fastow. The firm also announced a $1.2 billion reduction in shareholders’ equity as a result of improperly accounted transactions between Enron and an SPE. The news shocked investors and analysts, who had come to believe and support the Enron strategy and growth story (and ever-esca-lating share price). The company’s reputation suffered, and various trad-ing counterparties altered their credit terms: while Enron had previously traded primarily on an unsecured basis (even with its BBB+ rating), it was now being asked by some of its dealing counterparties to post collateral, an action that consumed precious resources and encumbered its balance sheet. The rating agencies placed the company on negative credit watch.

One month later the firm was again forced to restate its earnings from 1997 to 2001 as a result of accounting errors; 14 the restatements reduced net income over the four-year period by nearly $1 billion, lowered share-holder’s equity by $2 billion and brought an additional $2.58 billion of debt onto the balance sheet – changing, rather dramatically, the com-pany’s already significant leverage profile and making clearer the fact that Enron’s supposedly strong record of earnings was largely a fabrica-tion. The news was accompanied by the fact that Fastow and several other Enron employees had profited handsomely from the partnership transac-tions. These events caused the rating agencies to downgrade the company to the borderline of junk status, and caused even more counterparties to pull back on their credit facilities to the firm. The firm’s reputation suf-fered a marked blow, and trading flows all but ceased.

Enron’s downfall accelerated from this point on. Citibank and JP Morgan remained committed to lending Enron additional cash throughout much of November, granting $1 billion of fresh money against Enron’s last unencumbered assets (two pipeline systems in the western United States). Even as the banks were lending, however, Citibank’s due diligence team uncovered the fact that by the end of the first quarter of 2002, based on no new “prepay swaps” or asset sales, Enron would have a negative cash position of nearly $1.6 billion; by the end of 2002 the gap would grow to negative $10 billion. (Enron officers did not concur with the assess-ment, as they believed that they would be able to secure $6 billion-plus of prepays in 2002 and could supplement the cash position with another $3 billion in asset sales.) By any reasonable measure, the company’s cash position was in massive deficit.

During the Thanksgiving weekend Citibank and JP Morgan attempted one more time to raise additional funds for the company, but the effort was for naught; the gap was too large to be filled, and no further hard assets remained to be taken as collateral – the two banks were unwilling


to provide further funds. The final act took place in late November when other banks started cancelling Enron’s remaining liquidity facilities; rumors of imminent bankruptcy were rampant. The firm’s core trad-ing business was no longer generating cash, and collateral calls could no longer be met. When it became clear that Enron lacked cash and could no longer survive the crisis of confidence, Lay attempted to team up with cross-town rival Dynegy for an eleventh-hour merger; however, even Dynegy did not like what it uncovered in its due diligence and scuttled the deal days later. With no more cash on hand to meet current obliga-tions, Enron filed for bankruptcy protection on 2 December.

During the reorganization process the company sold off a number of remaining fixed assets and conveyed the remainder of its energy trading business to UBS. Most stakeholders suffered considerably: shareholders saw the value of their investments vaporize almost completely, thou-sands of employees lost their jobs, and creditors lost billions of dollars. Investigations ultimately revealed that the company suffered from wide-spread financial misrepresentation, mismanagement (including misman-agement of liquid resources), fraud, self-dealing, conflicts of interest, and unethical behavior, as well as weak controls and a flawed corporate gov-ernance process. 15

Enron serves as an important illustration of how a firm that is engaged in a leveraged trading business without sufficient liquid resources or credit standing can soon find itself in dire straits. Fraud aside, in the last three years of its existence the company relied heavily on trading rev-enues to keep its operations functioning, but it mismanaged the process by holding insufficient liquid and unencumbered assets. When market confidence eroded and funding sources began evaporating, its trading business could no longer be sustained, meaning cash flows from its only truly profitable operation came to a halt.

The case also illustrates how quickly a crisis of confidence can sub-sume a company, leading to a halt in business (and the vital cash flows that result) and the withdrawal of funding alternatives. From October to November 2001 the company tried desperately to assuage its investors and creditors by “confessing” to accounting errors and internal fraud; such actions were insufficient, however, partly because the firm had no effec-tive crisis management program. Although the creditor team attempted to bridge the gap for a time by providing access to additional funds, even that proved insufficient for the marketplace at large. Of course, it is not clear that Enron could have survived over the medium term, even with additional liquidity injections from the banking community, or from a hasty merger with Dynegy. The financial fraud that destroyed the com-pany’s reputation ran very deep and had a material impact on the firm’s

144 Liquidity Risk

credit profile. It seems likely, however, that the firm could have existed for at least several more months with appropriate access to liquidity; whether some alternate restructuring solution might have surfaced over that time to help prevent large losses for the community of stakeholders is unknown.

Reverting to our discussion from earlier in the book, Enron suffered on various fronts:

Near-total reliance on market/reputation-based trading business to ●

generate cash flows to meet obligations Use of a large amount of short-term financing that could easily be ●

withdrawn or cancelled Insufficient liquid or unencumbered assets to meet obligations or the ●

collateral calls necessary to continue operating its trading business Squandering of cash resources on capital-intensive, but negative cash ●

flow, business ventures Lack of alternative funding sources for emergency draw-down ●

Lack of a contingency plan to deal with a disaster scenario based on ●

rapid erosion of lender and investor confidence.

Northern Rock (2008)

Northern Rock, a large financial institution that had become a “household name” throughout the UK in the 1990s and into the millennium, was the product of a series of mergers between several small building societies between 1965 and the 1980s. After achieving a critical mass of assets and establishing itself as a known brand name in the mid-1990s, it decided to demutualize in 1997 by floating on the London Stock Exchange. The additional capital it raised through the process allowed it to continue expanding its residential mortgage portfolio, and by the turn of the mil-lennium it had become one of the country’s top 5 mortgage lenders, with 90 percent of its balance sheet comprised of mortgages. It became a con-stituent of the FTSE 100 Index in 2001 and continued steady expansion of its balance sheet in the low interest rate environment. Between 2002 and 2006 the market value of the bank nearly doubled to £5 billion, based partly on the 20 percent average return on equity it was producing for its shareholders.

Northern Rock’s peak balance sheet of £100 billion in assets (2006) was supported by significant borrowing from the international capital markets and institutional depositors; in the lead-up to the crisis period, between 70 and 75 percent of the bank’s liabilities were drawn from these institutional sources (e.g., securitization, wholesale deposits, covered


bonds), with the bulk of those concentrated in short-term maturities. Retail deposits accounted for 25–30 percent of total funding, a figure that would decline further as the financial crisis commenced. Given the bank’s financing profile, the stage was set for funding instability and liquidity pressures.

Northern Rock used its access to capital markets financing to fund not only conventional residential mortgages (with standard loan-to-value (LTV) ratios in the 70% to 80% range) but also those of a more speculative nature, including buy-to-let loans (e.g., mortgages for investment proper-ties) as well as a range of subprime (e.g., lower credit quality/higher risk) mortgage equivalents, like no documentation/self-employed loans (i.e., “self-certs”) and highly leveraged loans (e.g., 125% loans); this portion of the bank’s portfolio was very similar to the subprime portfolios origi-nated by various US banks prior to, and during, the crisis. Interestingly, Northern Rock also entered into an arrangement with Lehman Brothers in 2006 where it lent its name to subprime mortgages underwritten by the US investment bank (we consider the Lehman case in the section below). The bank grew very rapidly during the early 2000s, and in 2006 its mort-gage loan growth reached a rather remarkable 30 percent. Unfortunately, these long-term assets were funded primarily with short-term funds, and were supported by a very thin capital base (i.e., capital to assets of only 2%) – both of which made it extremely vulnerable to risk dislocations.

The bank’s business and risk strategy centered on the “originate to dis-tribute” model: rather than holding the mortgages on its balance sheet, Northern Rock had the pools securitized and rated by one or more rat-ing agencies, selling the resulting securities to a base of investors. By the end of 2006 the securitization portfolio had reached a rather significant £40.3 billion. Unfortunately, and in common with other banks perform-ing similar functions, Northern Rock had an increasing amount of trou-ble distributing tranches of all issues or, indeed, securitizing its conduits, meaning that its own holdings of assets that would ultimately become highly illiquid grew rapidly heading into 2007. In addition, the bank supplemented its risky mortgage lending and securitization with addi-tional investments in portfolios of mortgage-backed securities. Though ostensibly held for investment purposes (and, arguably, as something of a liquidity buffer since most were AAA and AA rated and therefore thought to be quite marketable), the securities portfolio would ultimately add to the bank’s considerable challenges since the portfolio’s performance was completely correlated with the performance of its core business .

Despite these facts, statements by Chairman Matt Ridley in early 2007 reflected confidence in both the business model and in the bank’s ability to properly manage its credit risks and balance sheet risks. In fact, there

146 Liquidity Risk

was little concern about the state of the market in early 2007, with Ridley noting that “we continue to see little prospect of a severe house price correction … support for the housing market remains strong.” 16 During this critical period the bank continued originating mortgages at a very rapid pace: in the first half of 2007 it accounted for 25 percent of all UK mortgage origination, sharply outpacing either its deposit growth or its ability to sell down its securitization pipeline – and setting the stage for a severe liquidity squeeze. Growing instability in global housing and credit markets, which appeared during the first quarter of 2007, acceler-ated over the summer; the value of US, UK, and European residential housing declined sharply, putting many mortgages “underwater” (e.g., mortgage balances greater than the worth of the property). As noted in Chapter 1, by August 2007 major dislocations in asset markets were occur-ring, and the first casualties of the financial crisis of 2007–2008 were appearing on the radar screen. Indeed, Northern Rock has the dubious distinction of being among the first of the major financial institutions (along with Industriekredietbank (IKB) of Germany) to stumble – mov-ing into a stage of critical financial distress months before events hit Bear Stearns, Lehman Brothers, IndyMac, Washington Mutual, AIG and various others.

Northern Rock’s downfall began on 13 September 2007, when the Bank of England announced that it had provided the institution with liquidity assistance (despite Northern Rock’s claim in February 2007 that funding had been expanded and diversified). The move struck analysts as a curi-ous one, as Northern Rock was not considered to be systemically impor-tant or, indeed, “too big to fail.” In fact, Bank of England’s announcement created instability rather than reassurance: news of the bank’s weak liquidity position and its need for central bank assistance created a panic amongst depositors, causing retail customers to queue up to withdraw their savings. The vivid “bank run” images shown on television created nervousness amongst other depositors, leading to more than £3 billion in retail deposit withdrawals between 14 and 17 September. In order to halt what would have become a full-fledged bank run, the Chancellor of the Exchequer stepped in on the 17th to declare that deposits would be fully insured (rather than just covered up to the £35,000 level set by the Financial Services Compensation Scheme). 17 A bank run was halted only because of government intervention.

Interestingly, while the retail withdrawals were real and of concern, the bank’s true funding problems came from its institutional customers: sophisticated international money managers and other interbank players stopped their rollovers/renewals of CDs and other bank liabilities (despite the Treasury guarantee) in a “silent run.” In fact, of some £10 billion of


deposits lost during the critical September–November period, more than two-thirds came from institutional depositors.

By late 2007 Northern Rock was attempting to weather a storm that was hitting it on three fronts: losses from write-downs of its mortgage-backed securities portfolio (which no longer served as a meaningful source of liquidity, either due to prior encumbrances or to the declining creditworthiness and value of the assets), losses from bad loan charges to its mortgage portfolio (and in particular the subprime component), and continuous difficulties in raising funds. As the situation moved to a critical stage, the bank’s directors and executives held discussions with at least two other banks about being acquired, but no agreement could be reached. By February 2008 it was clear that the bank could no longer survive on its own; funding shortfalls and operating losses had become untenable. Accordingly, HM Treasury stepped in with £27 billion in res-cue funds (plus additional loan guarantees), assuming “temporary pub-lic ownership” of the bank (which at least some politicians and analysts criticized, since Northern Rock had always been known as a “high risk” institution). As part of the government intervention, the bank agreed to repay the government within four years through deleveraging, cost cut-ting and a renewed focus on prime mortgage lending business. The bank was able to reduce the balance owed to the government to £9 billion by 2009, after which it received permission to borrow once again from the Treasury in an effort to expand prime mortgage activities. Northern Rock was ultimately sold by the government to UK conglomerate Virgin in 2012, ending the multi-year saga. A Treasury Committee analyzing the disaster ex-post had scathing words for the bank’s directors and managers: “The high risk, reckless business strategy of Northern Rock with its reli-ance on short- and medium-term wholesale funding and absence of suf-ficient insurance and a failure to oversee that risk meant it was unable to cope with the liquidity pressures placed upon it by a freezing of interna-tional capital markets in August 2007.” 18 An examination of its downfall reveals a number of liquidity-related problems:

A general policy of funding long-term mortgage assets (both prime and ●

subprime) with short-term funds Significant reliance on volatile, short-term, wholesale funding ●

A risky business model that required a liquid and well-bid securitiza- ●

tion market in order to succeed An investment portfolio that contained an excessive concentration in ●

risky, correlated securities that were ultimately illiquid and could only be repoed at a fraction of their stated value Lack of alternative funding sources for emergency draw-down ●

148 Liquidity Risk

Lack of a contingency funding plan to enact prior to the onset of ●

deposit withdrawals.

Lehman Brothers (2008)

US investment bank Lehman Brothers, originally founded in 1850, oper-ated as an independent commodity trading and securities firm during its early history. In 1984, as the family partnership structure faded away, the firm sold itself to the combined Shearson/American Express finan-cial giant, becoming the Shearson Lehman Brothers investment banking subsidiary, offering a full range of banking, sales and trading services; the acquisition of retail broker EF Hutton in 1988 further expanded the bank’s reach (known at that point as Shearson Lehman Hutton). In 1994 American Express, under pressure to streamline operations and improve its own performance, divested portions of its financial empire, selling the Shearson/Hutton retail brokerage operations to Primerica and floating the Lehman Brothers trading and investment banking operations through a separate IPO.

The newly independent Lehman continued to strengthen its franchise in bond trading and made further inroads in equity trading and invest-ment banking. The bank expanded aggressively and profitably under the leadership of CEO Dick Fuld during the latter half of the 1990s, becoming one of the top US investment banks in various business lines, including advisory, capital markets and trading. In the period leading up to the 2007 financial crisis, Lehman had also become increasingly involved in commercial mortgages and real estate, including originating, structuring and then securitizing mortgages (using the same “originate to distrib-ute” model noted above). It also operated a significant residential mort-gage origination/securitization business, which included dealings in the subprime sector (both in the US and the UK). Given its fixed-income expertise, the bank also carried large portfolios of mortgage securities, structured credits and leveraged loans on its balance sheet.

Unfortunately, the combination of these assets, along with a flawed funding plan, would ultimately come back to haunt the bank. In fact, Lehman was somewhat unique in being one of a very few “systemically important” institutions that was permitted by regulatory authorities to go bankrupt during the financial crisis (even as others received some sort of bailout, arranged acquisition or temporary capital). In the end, Lehman was not “too big to fail,” though its collapse in late September 2008 set in motion a series of emergency measures by global regulators who were afraid that other institutions would soon follow Lehman into bankruptcy. While the causes of the bank’s rather swift demise were


varied and complex, lack of sufficient liquidity and market access in the critical days of September were certainly at the heart of the matter.

While Lehman suffered in 2007 like all of its peers – posting losses on its massive fixed income portfolios and securitizations – its downfall came in 2008, accelerating after Bear Stearns’s own rapid decline (as noted in Chapter 1, Bear found itself short of cash and without the confidence of its trading partners in March 2008, and succumbed to an arranged acqui-sition by JP Morgan (which enjoyed a partial US Treasury backstop on part of the Bear operation)). Despite the sobering example of Bear, Lehman apparently believed its own liquidity management processes were suffi-cient to cope with the growing market stress. In fact, throughout this crit-ical period Lehman touted the prowess of its internal treasury function, which was responsible for arranging the bank’s short- and long-term debt issues, managing the equity plan, developing short-term liquidity projec-tions and reporting on its liquidity pool, cash capital and secured fund-ing. 19 The treasury function, which had been developed in the aftermath of the LTCM crisis (above), functioned on the basis of several core princi-ples, which included remaining in a state of constant liquidity readiness, avoiding any reliance on asset sales or unsecured debt access during cri-sis periods, and communicating regularly with stakeholders; the bank’s management believed that these conservative approaches would deliver a competitive advantage of sorts. In fact, Lehman’s philosophy on liquid-ity management appears to have been sensible: maintaining a large cash/cash equivalent position, declining to believe the balance sheet could be reduced in times of stress, creating reliable secured funding through counterparty relationships (available in all market conditions), and rais-ing separate cash capital for each legal entity. From Lehman’s perspective liquidity management centered on three distinct elements: the liquidity pool (designed to cover cash outflows over 12 months), cash capital (for funding of illiquid assets and contingent risks, primarily through equity, medium- and long-term liabilities and core stable deposits at its bank-ing subsidiaries), and secured funding (for coverage of all collateralized financings). The firm’s management team established a target level of cash to ensure liquidity of $2 billion+ after a 90-day stress event, which would be sufficient to cover all outflows for one year. The firm also pro-moted funding diversification (by type, current and market) and sought to manage rollover risk by limiting unsecured short-term financing in the commercial paper market. Unfortunately, it did not adhere to all of these seemingly sensible directives.

Like other banks, Lehman experienced a difficult summer 2008 as the markets continued to fall and capital accounts were gradually eroded. The bank reported a nearly $3 billion loss in June from its mortgage portfolios,

150 Liquidity Risk

leveraged loans, and other fixed income products, and began a process of deleveraging – apparently failing to realize that reducing the balance sheet in times of market stress is exceedingly difficult and very costly, and effectively contravening its own philosophy on the matter (as noted above). Throughout this period financial analysts questioned the valua-tions being applied to the bank’s rather illiquid leveraged loan, structured credit, and mortgage portfolios, which were being marked-to-model in the absence of liquid pricing benchmarks. There was at least some con-cern that Lehman was not being as aggressive in recognizing losses on its positions as some of its competitors, suggesting overvaluation and lax risk management controls – both of which became particularly evident during the ex post bankruptcy proceedings, when mismarked deals, enor-mous amounts of risk, and some questionable repo transactions (whose sole purpose was to make the bank’s balance sheet appear more attractive, in shades of Enron), were uncovered.

During mid-2008 Lehman was faced with the growing realization that it was running short of capital. Steady write-downs in 2007 and 2008 (and with the promise of more to come) had shrunk the bank’s capital to critical levels. Unfortunately, attempts to raise additional capital during the summer led nowhere as Fuld reportedly drove a hard bargain with would-be investors. Intensive discussions with the Korea Development Bank in August and September were eventually put on hold by the Korean bank – meaning Lehman’s last realistic attempts to raise capital and shore up investor confidence had failed, a fact that shook the market.

Of course, lack of capital wasn’t the bank’s only problem. Though, as noted above, the bank had a liquidity management process that was intended to create a sufficient cash buffer, even under difficult condi-tions, the process ultimately failed to adequately protect the bank’s bal-ance sheet or its operations. In addition to holding an excess amount of difficult-to-value illiquid assets, Lehman relied too heavily on short-term unsecured and secured (repo) funding. Though the bank had attempted to wean itself off of the CP market, knowing that it was an unstable source of financing, it failed to do so in the earliest stages of the crisis (again in contravention of its stated policy). For example, in 2007 its aver-age outstanding balance was $3.1 billion (already up from $1.6 billion in 2003), but by the second quarter of 2008 it had reached $8 billion as other sources of financing dried up. Its overnight repo book had also grown dramatically and was becoming burdensome to roll over every day; rollovers were highly dependent on the comfort level of counterparties, who could choose at a day’s notice not to roll over their capital. While Lehman’s holdings of high quality (i.e., US and European government) liquid securities were still repoable in the second and third quarters, the


illiquid nature of much of the rest of the bank’s asset portfolio did not help matters: it was virtually impossible for the bank to borrow against highly illiquid leveraged loans, mortgages or mortgage-backed securities, as the required haircuts would have yielded Lehman cents on the dollar – insufficient to fund its obligations.

By late August rumors of imminent collapse were gathering force. Reports of a nearly $4 billion third-quarter loss surprised the market, and by 8 September a large number of counterparts had cancelled their repo lines and pulled other financing facilities. The bank’s funding shortfall was growing, and its struggle to manage daily net cash outflows intensi-fied ; in fact, the $45 billion liquidity pool that management had boasted of during the summer had effectively evaporated, with only $1 billion on hand in the lead-up to the fateful weekend of 13 September.

Whilst at least some market participants pinned their hopes on an 11th-hour government-orchestrated “arranged marriage” similar to that of JP Morgan/Bear, there was little appetite in government circles to support such a deal. Officials believed that Lehman lacked enough good collateral to allow for a Treasury guarantee structure (such as was used for Bear and, later, for insurance giant AIG). Even though a few banks, including Barclays, had a look at acquiring Lehman on 13 and 14 September, there were ulti-mately no takers. According to CEO Fuld, “by the end of that Sunday, it was obvious that the Federal Reserve had made a decision it would not pro-vide support for a transaction involving Lehman Brothers. Had that deci-sion been different, further dislocations in the markets might have been avoided.” 20 In fact, the filing of bankruptcy petitions in multiple jurisdic-tions on 15 September spelled the end of Lehman, and the beginning of a very tense and volatile time for the financial markets – which included the rescues/bailouts/recapitalizations of AIG, Fannie Mae and Freddie Mac, and many large US and international banks. In the end, Lehman’s liquidity risk process was simply not up to the task of coping with a true stress event. Fuld, on the record, remained insistent that Lehman could have survived had it been granted the necessary “liquidity bridge.” Lehman ultimately became a prime example of a liquidity-induced collapse:

Use of an excessive amount of short-term financing that could easily ●

be withdrawn or cancelled (such as CP and Treasury repos) Large concentrations in risky, illiquid mortgages, mortgage securi- ●

ties, leveraged loans and structured credit products that could not be posted as collateral in refinancing, or which commanded extremely large haircuts Insufficient liquid assets to meet accelerating redemptions and other ●

obligations

152 Liquidity Risk

Lack of alternative funding sources for emergency draw-down ●

Lack of lender confidence in the bank’s balance sheet and its asset val- ●

uation process Mishandling of capital-raising issue at a critical juncture. ●

The cases we have presented in this chapter are representative of problems that can arise when asset, funding, or joint liquidity difficulties appear. As we have noted, they represent the most extreme instances of liquid-ity problems, culminating in severe financial distress and/or insolvency. Although each case is unique, certain common threads run through all of them: lack of sufficient unencumbered assets to pledge as a “last stop” measure; reliance on a limited number of funding sources; insufficient analysis of the potential downside liquidity disaster scenarios; and lack of truly robust, and aggressive, crisis management plans to deal with rapidly accelerating crises. In fact, the inability to deal forcefully with liquidity pressures and attempt to shore up investor and/or creditor confidence is a “fatal” problem in each case. As we consider the effective management of liquidity risk in the next part of the book, we shall recall some of the practical instances of distress and failure and how these can be overcome with a robust risk management framework.

Part III

Managing Liquidity Risks

155

8 Measuring Liquidity Risk

In the first two parts of this book we have considered why liquidity is so vital to corporate operations and illustrated what can go wrong, in theory and practice, if it is mishandled. The degree of financial dam-age that can arise varies. In some cases it may be limited to losses from higher funding costs or asset disposals at prices below carrying value; in other cases it may be more serious, extending ultimately to instances of financial distress and insolvency. Every entity exposed to liquidity risk must therefore attempt to avoid damage through a liquidity risk manage-ment process. An effective framework, our topic in this part of the text, is based on a number of fundamental elements. In this chapter we discuss the measurement of liquidity risk through various tools, in Chapter 9 we consider ways of managing liquidity risk as part of the corporate process, and in Chapter 10 we discuss the development and implementation of a liquidity crisis management plan. In Chapter 11 we consider various new regulatory initiatives that have been developed in the wake of the finan-cial crisis of 2007–2008; we summarize key thoughts on active liquidity risk management in Chapter 12.

Common Liquidity Measures

Measuring liquidity risk can be challenging, primarily because the under-lying variables that drive exposures can be dynamic and unpredictable. Indeed, liquidity risk is often considered to be more difficult to measure than other dimensions of financial risk precisely because it is so fluid. Although some aspects of asset and funding liquidity risk are readily iden-tifiable and quantifiable, others are not; this is particularly true when we consider joint asset/funding risks and off-balance sheet/contingent trans-actions. Despite these challenges some attempt must be made to estimate the relative magnitude of risk, focusing particularly on the composition of corporate liquidity and the cash flows created by the balance sheet


156 Liquidity Risk

and contingencies. If this can be done properly, then the next step in the process, controlling risk through limit mechanisms and other aspects of governance and process, can be successfully accomplished. In common with other risk measures, it is generally worthwhile to use a combination of accounting information (which despite being historical and “backward looking” still serves a purpose in establishing trends) and forecasts, such as scenarios or stress tests (which can give a picture of what might happen under different future scenarios).

Although specific measurement techniques vary by company and industry, we can consider several broad approaches, including liquidity ratios and cash flow gaps. Liquidity ratios convey a picture of an institu-tion’s liquidity position by measuring items from the corporate balance sheet, income statement, and statement of cash flows to determine the sufficiency of resources; whilst relatively ease to implement, they must be used with caution as they are backward, rather than forward, looking. Cash flow gaps, in contrast, focus on known and projected (estimated) cash inflows and outflows over various time horizons to determine pos-sible surpluses or deficits. Known cash flows represented on the balance sheet and from operations measure the current “stock” or “inventory” of cash, while future cash needs from projections represent the “flow” con-cept. Both are essential to the measurement process.

Companies (especially those from the financial sector) often supple-ment these metrics with specialized financial asset liquidity measures that examine the risks associated with extensive on and off-balance sheet financial contracts and risk portfolios. All of these metrics can be strengthened through the use of stress testing. In fact, stress testing (with a particular focus on liquidation horizons, cash flows, assets disposals, secured and unsecured funding, collateral, haircuts, and other key mar-ket parameters) emerges as perhaps the single most effective way of trying to corral the economic effects of liquidity risk.

Regardless of the specific tools used, liquidity risks must be measured at a granular level (that is, for individual business units, regional groups, and/or legal entities) and must be aggregated to the top level of the organ-ization (e.g., a holding company or other parent company entity); this gives an indication of both the disaggregated and aggregated liquidity picture, and is especially important when considering the potential for trapped liquidity – that is, liquidity residing in a legal entity that cannot necessarily be transferred to other legal entities in the group as a result of regulatory or legal restrictions. An ex ante requirement in any financial measurement process is a robust accounting backbone that is built on clean, granular data. A firm must be able to gather and collate detailed data for financial measurement with ease and accuracy; if it cannot do

Measuring Liquidity Risk 157

so without significant effort, the measurement task will be of limited use. While granular measurement is helpful for all risk analysis, it is especially critical for liquidity risk analysis, where institutions may be required to measure relevant liquidity positions on an intraday basis. Although the measurement process within any large global organization is likely to be challenging, it is a worthwhile endeavor because it allows development of a multi-dimensional picture of corporate liquidity risk. By measur-ing liquidity risk from the “bottom up” and the “top down”, a firm can uncover pitfalls and opportunities. It might discover areas where cash can become trapped or raised in a more cost-effective manner, it might find that it is vulnerable to large contingent cash flows if particular events occur in remote subsidiaries, and so forth. The multi-faceted picture that emerges can be extremely informative.

Figure 8.1 summarizes the common liquidity measures we discuss in the chapter.

Liquidity ratios

Dissecting a firm’s financial position is an essential starting point in meas-uring liquidity risk. By understanding the composition of a firm’s assets, liabilities, and off-balance sheet cash flows, we can develop a useful view

Liquidity ratios Cash flow gaps Financial assetliquidity measures

Stress tests

Granular detail

Consolidated results

General measures

Figure 8.1 Common liquidity measurement techniques

158 Liquidity Risk

of liquidity. 1 In fact, the best approach is holistic: measures that provide information on assets, liabilities, and associated contingencies jointly pro-vide a more accurate picture than a simple examination of each category on its own. For instance, a company might have a great deal of short-term liabilities coming due that might appear to be a concern, but if they are properly matched by an equally large amount of short-term assets, the concern is at least partly mitigated. Or, a company might have a portfolio of seemingly illiquid assets maturing over the intermediate term, but if its liabilities also carry medium-term maturities and contain no optionable features, concern is again reduced. The reverse can also occur, so a joint examination is useful.

Since significant liquidity problems arise from short-term lack of funds, metrics that reflect short-term asset and liability positions are an essential dimension of the measurement process. The state of a company’s liquid-ity position can be determined by examining a number of measures from the balance sheet, income statement, and statement of cash flows. While these are generally “point-in-time” estimates of liquidity that soon become outdated (they are, of course, historical records), they can still be useful: when historical point-in-time information is accumulated, trends can be observed to determine whether a firm is becoming more or less liq-uid over time. In this section we consider a number of essential corporate and financial liquidity ratios.

Working capital is an essential indicator of corporate liquidity. Gross working capital is defined as current assets plus current liabilities. Current assets, as noted in Chapter 3, include cash and equivalents, marketable securities, receivables, and inventory; current liabilities include short-term debt obligations (including CP, notes, and deposits), the current portion of long-term debt, and payables. The time horizon for current assets and liabilities is often set arbitrarily at one year, and any contracts falling out-side the one-year horizon are considered non-current. Net working capital (or simply working capital) is equal to current assets less current liabilities, and it indicates how well current assets cover current liabilities – that is, whether the cash flows from maturing current assets are large enough to cover outflows associated with maturing liabilities. The net working capi-tal figure should be positive if a firm is to be considered liquid.

The working capital ratio, simply working capital divided by total assets, is a common measure that indicates whether a firm is becoming more or less liquid as it grows or contracts; a ratio that increases over time suggests that working capital remains stable as the balance sheet is shrinking, or that working capital increases more rapidly as the balance sheet is grow-ing. The current ratio, or current assets divided by current liabilities, is another popular measure that expresses working capital in ratio form: a


ratio above 1.0 indicates that a firm has sufficient current assets on hand to meet current liabilities, while a ratio below 1.0 suggests possible pres-sure, or even problems. A more conservative version of this ratio excludes inventories from the current asset computation under the assumption that inventories might not be saleable near carrying value, when needed. Specifically, the quick ratio (also known as the acid test) divides current assets less inventories by current liabilities. A further refinement excludes receivables from the computation to yield the cash ratio: this, as the name suggests, is simply cash and marketable securities divided by cur-rent liabilities, and reflects the most liquid asset accounts available to meet liabilities coming due. Current, quick, and cash ratios that increase over time are a sign of strength; those that decrease continuously may be indicative of financial problems.

A variation on the theme, the liquid coverage ratio (a type of defen-sive interval computation), compares a firm’s quick assets to average daily operating expenses; this ratio is a balance sheet/income statement hybrid intended to estimate “survivability,” or how many days a company can continue meeting expenses using only its current resources (with no new funding or revenues) – the greater the cover, the stronger the survivability horizon. Similarly, a review of the hybrid operating cash flow coverage ratio, or cash flow from operations divided by current liabilities, provides a measure of how well core operating cash covers obligations coming due; the higher the ratio, the stronger the position.

Some firms also compute a current liability ratio by comparing cur-rent liabilities with total liabilities, equity, or total assets; this indicates the burden of short-term obligations on various aspects of the broader corporate balance sheet – the lower the ratio, the lower the short-term liability burden. Since trade credit forms a key source of funding for many companies, the behavior of payables can also be considered; the length of the average payables maturity, or average accounts payable divided by purchases, indicates whether credit extensions are coming due more rap-idly over time. If maturities are declining, a firm faces more short-term funding pressure.

Average payables turnover, which measures how quickly or slowly a firm is repaying its payables, is determined by dividing purchases by aver-age annual payables; the slower the turnover ratio, the greater the use of trade credit. Receivables can be viewed in a similar light. Since receivables are an important means of providing liquidity to others, a firm that finds its receivables are lengthening might be suffering from collection prob-lems; if this is, in fact, the case, its own asset portfolio is likely becom-ing less liquid, a situation that might demand corrective action. (Note that the collection problems might also have a negative impact on the

160 Liquidity Risk

value, and thus saleability, of the receivables portfolio.) The length of the average receivables maturity, computed as average accounts receiv-able divided by sales, is thus a key measure. Similarly, average receivables turnover, or sales divided by average annual receivables, measures how quickly accounts are being replaced and indicates whether customers are paying slowly or rapidly; longer turnover periods indicate less liquidity in the receivables portfolio.

Table 8.1 summarizes key corporate liquidity ratios. Financial institutions use various liquidity ratios that are specifically

calibrated to their operations. Although the ratios measure similar types of risks as those presented above, they are based on slightly different defi-nitions; we consider some of the most common ratios in this section.

Since financial institutions rely heavily on the state of their unsecured funding to generate liquidity and credit for their clients, some of the most important measures are based on the liability accounts. Certain borrow-ing ratios – such as total deposits divided by borrowed funds, volatile funds divided by liquid assets (where volatile funds are typically cen-tered on institutional/wholesale, rather than retail, monies), and volatile funds minus current assets divided by total assets minus current assets – measure a bank’s need to use volatile borrowings to support business, and the degree to which cash and equivalents can be used to repay “hot

Table 8.1 Corporate liquidity ratios

Gross Working Capital = Current Assets + Current LiabilitiesNet Working Capital = Current Assets – Current LiabilitiesCurrent Assets = Cash + Marketable Securities + Receivables + InventoriesCurrent Liabilities =

Short-Term Debt Obligations + Current Portion of Long-Term Debt + PayablesWorking Capital Ratio = Net Working Capital/Total AssetsCurrent Ratio = Current Assets/Current LiabilitiesQuick Ratio = (Current Assets – Inventories)/Current LiabilitiesCash Ratio = (Cash + Marketable Securities)/Current LiabilitiesLiquid Coverage Ratio =

(Current Assets – Inventories)/Average Daily Operating ExpensesCurrent Liability Ratio 1 = Current Liabilities/EquityCurrent Liability Ratio 2 = Current Liabilities/Total AssetsCurrent Liability Ratio 3 = Current Liabilities/Total DebtAverage Payables Maturity (days) = (365 * Average Payables)/PurchasesPayables Turnover = Purchases/Average Annual PayablesAverage Receivables Maturity (days) = (365 * Average Receivables)/SalesReceivables Turnover = Sales/Average Annual ReceivablesCapital Expenditure Coverage = Operating Cash Flow/Capital Expenditures


money” that might be presented for repayment on very short notice. 2 High ratios indicate a larger amount of deposit turnover or volatile fund-ing in a bank’s total plan, which can create liquidity pressure.

The loan to deposit ratio, or total loans divided by total deposits, indi-cates the degree to which a bank can support its core lending business through deposits; a refinement of this ratio excludes from total deposits the more stable (or “sticky”) retail component, to demonstrate the degree to which credit business is truly supported by “hot money.”

Cash balances are also important as they indicate how well a bank can meet “hot money” calls without curtailing credit business. Common bank cash liquidity ratios – which are simply variations on corporate working capital ratios – include cash divided by total assets and quick assets divided by total assets; the higher the ratios, the more liquid the asset portfolio.

In addition to these well-established measures, the banking sector is now also required, under the post-crisis Basel III framework, to compute two additional measures, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR is defined broadly as the stock of a bank’s high-quality liquid assets divided by its cash outflows over 30 days. The NSFR, in turn, is computed as the amount of available sta-ble funding over one year divided by the total amount of required stable funding. We shall discuss both measures in greater detail in the context of new regulatory changes in Chapter 11.

Within the securities firm sector, measurement of the matched book ratio, or repurchase agreements divided by reverse repurchase agree-ments, indicates the degree to which a firm’s leveraged position is prop-erly matched and can be reduced or completely unwound. A higher ratio reflects a greater liability mismatch and potentially more difficulty in unwinding the operation, should that prove necessary.

Short-term liquidity in the insurance industry is measured through insur-ance liquidity ratios, such as marketable securities divided by surrenderable liabilities and 30-day saleable assets divided by surrenderable liabilities. Surrenderable liabilities are demand liabilities with uncertain time horizons; to determine the financial impact of surrender, an insurer may examine a portfolio of demand liabilities, multiply each facility by a probability of sur-render, and sum across individual contracts to obtain an estimate of the total. In either case, the higher the ratio, the greater the ability to meet call liabilities. Table 8.2 summarizes key financial institution liquidity ratios.

The drawback with measuring current corporate or financial institution liquidity through pure working capital measures is that the process ignores other sources and uses of liquidity, such as reserve borrowing power via unen-cumbered fixed assets (a possible source for the borrower), a committed but undrawn revolver (source for the borrower), an operating lease (source for the lessee), a guarantee (use for the guarantor), and so forth. And apart from the

162 Liquidity Risk

bucketed gap ratios (discussed in the next section), these measures indicate very little about the maturity or duration of obligations, meaning liquidity problems might still exist. For instance, a portfolio of liabilities that matures in two days is considered current, and a portfolio of assets that comes due in 30 days is also considered current. However, unless other financing is avail-able or the current assets can successfully be pledged for immediate cash, a liquidity squeeze could appear. Cash flow gap measures, which we consider in the section below, seek to overcome such shortcomings.

Cash flow gaps

Asset–liability gaps are important in the effective management of liquid-ity risk (and aspects of market risk). A firm might have stable funding and/or asset liquidity sources, but it must still manage the gap between the two if it is to create a proper liquidity profile. Indeed, firms often measure cash flow mismatches because any gap that leads to a funding deficit will place immediate demands on the firm’s liquidity program; it is important to consider just how severe such deficits can become and whether cash cushions should be accumulated in advance. Equally, any mismatch that creates a surplus can serve to reinforce the liquidity buffer in anticipation of future deficits or emergencies.

Cash flow gaps can be measured in basic form through discrete time buckets, or through more advanced measures such as duration (i.e., the weighted average maturity of cash flows, as described in greater detail in

Table 8.2 Financial institution liquidity ratios

Borrowing Ratio 1 = Total Deposits/Borrowed FundsBorrowing Ratio 2 = Volatile Funds/(Cash + Marketable Securities)Borrowing Ratio 3 =

(Volatile Funds – Current Assets)/(Total Assets – Current Assets)Loan to Deposit Ratio = Total Loans/Total DepositsCash Liquidity Ratio 1 = Cash/Total AssetsCash Liquidity Ratio 2 =

(Cash + Short-Term Investments + Funds Sold)/Total AssetsCash Liquidity Ratio 3 = Marketable Securities/Surrenderable LiabilitiesCash Liquidity Ratio 4 = 30-day Saleable Assets/Surrenderable LiabilitiesMatched Book Ratio =

Repurchase Agreements/Reverse Repurchase AgreementsActual Gap = Rate-Sensitive Assets – Rate-Sensitive Liabilities Gap Ratio = Rate-Sensitive Assets/Rate-Sensitive Liabilities Liquidity Coverage Ratio = High-Quality Liquid Assets/Net Cash Outflows Over 30 Days Net Stable Funding Ratio = Available Stable Funding Over 1 Year/Required Stable Funding


Appendix); 3 indeed, simple maturity gaps may be too coarse to effectively capture the nuances of cash flows, unless a firm’s operations are particu-larly straightforward.

The starting point in any measurement exercise is gaining a good under-standing of the company’s cash flows. This begins with an examination of the contractual flows from assets and liabilities, and can be supple-mented by examining the cyclical history of new business and maturing business (and the collective effect on balance sheet flows). The analysis must also focus on off-balance sheet contingencies (stock) as well as how these may change in the future (flow).

With this information, it is relatively straightforward to gain an under-standing of cash flow gaps. Fundamentally, we know that liquidity risk (LR) is simply the supply of liquidity (near cash resources) less the net funding requirement (NFR, or cash inflow minus cash outflow) for a given period of time. If LR is less than 0, then NFR is greater than avail-able liquidity and some cash access will be required; if LR is greater than 0, then NFR is less than the available liquidity and some buffer exists. This simple calculation can be repeated for every single time period, and although distant cash flows can be more difficult to measure with certainty, an NFR profile can be developed to illustrate the gap between inflows and outflows. For a generic firm, the NFR at each relevant time horizon can be computed as shown in Figure 8.2.

These can, of course, be decomposed to even more granular levels (for example, operating outflows might include interest payments, cost of goods sold, and overhead; a five-year fixed payer interest rate swap can be

Operations +Maturing assets +Early asset retirement +Asset sales +Assets pledged +Credit draw-downs +Off-balance sheet activities

Less

Operations +Maturing liabilities +Early liability calls +Off-balance sheet activities

Cash inflows from:

= Net Funding Requirement

Cash outflows due to:

Figure 8.2 Computation of the net funding requirement

164 Liquidity Risk

decomposed into a short position in a five-year deposit and a long position in a floating rate note, and so on). An example is illustrated in Figure 8.3.

It is important to stress once again that all cash flows – including those arising from off-balance sheet transactions – must be properly included in any gap computation; as we have already noted, cash inflows and outflows from commitments, derivatives, leases, and so on, are just as important in the overall corporate funding picture as those from the visible balance sheet. 4

Figure 8.4 reflects a matrix of cash sources and uses against a time hori-zon based on simple maturity or more precise durations. The end goal is to measure the net cash balance requiring funding at any time horizon. The granularity of time horizons must be considered carefully. While an

Operations +Maturing assets +Early asset retirement +Asset sales +Assets pledged +Credit draw-downs +Off-balance sheet activities

Less

Operations +Maturing liabilities +Early liability calls +Off-balance sheet activities

Cash inflows from:

= Net Funding Requirement

Cash outflows due to:

Operating revenuesInterest receivableCapital gainsPortfolio dividends

Maturing investments,receivables

Sales of investments,receivables, inventory, fixed assets

New financing via receivables,notes, bonds, loans

Derivative gains/benefits

Pension fund requirementsTax paymentsInterest paymentsPreferred dividendsCost of goods soldOverheadMandatory capital expenditures

Maturing CP/ECP, MTNs, loans,other debtEarly redemptions/putableliabilitiesSinking fund paymentsMandatory preferred stockredemptions

Lease obligationsDerivative obligations

Figure 8.3 Decomposition of the net funding requirement


extremely detailed cash flow breakdown – perhaps daily for 30 or 60 days, then weekly for several months after that – can provide valuable informa-tion, it can also generate a certain amount of confusion in interpretation. This is particularly true if a firm is operating in a very dynamic environ-ment, where cash flows arising in two or three weeks might change radi-cally by the time they move to the immediate sub-one-week bucket. A firm needs to gain experience with the optimal level of time granularity before it uses such measures in its risk management process.

Figure 8.5 illustrates the net funding requirement measurement.

Cash flow source/Use

5day

2week

3week

1day

2day

3day

1month

3month

6month

Assets–––Liabilities–––OBS–––NFR

Figure 8.4 Cash flow sources/uses by maturity bucket or duration

$ Net funding requirement

Cash outflows

Cash inflows

Maturity/duration

Figure 8.5 Net funding requirement

166 Liquidity Risk

Basic bucketing or duration approaches can be refined through statisti-cal analysis by examining the likelihood of accessing liquidity at different points in time (and at different costs) to meet cash flows. Recalling our discussion from Chapter 2, we know that cash flow and timing variables must be considered, each of which can be certain or uncertain:

Certain net cash flows at a certain time horizon ●

Certain net cash flows at an uncertain time horizon ●

Uncertain net cash flows at a certain time horizon ●

Uncertain net cash flows at an uncertain time horizon. ●

To deal with the uncertain variables (NFR and/or time), a firm can use statistical probabilities to assess the likelihood that cash will be required at a particular horizon (i.e., a net cash flow deficit will arise). For instance, dealing with uncertain cash flows at a certain time horizon demands the use of a probability distribution reflecting possible cash flows with a specific horizon; the same is true for certain cash flows at an uncertain time horizon, and so forth. The probability of having sufficient liquid-ity (which can be viewed as the probability of accessing liquidity times the amount of liquidity available) is then given as the probability that a particular net cash flow occurs at time horizon t , multiplied by the prob-ability that the asset sold or the funding accessed provides the expected value, aggregated across all time horizons.

We can refine this discussion a bit further in the context of the finan-cial sector. Banks and securities firms routinely measure the difference between their rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs) primarily for interest rate risk purposes, but also with an eye on liquidity. (Note that these measures typically include the impact of off-balance sheet cash flows.) There is, of course, a subtle difference between rate gaps and liquidity gaps: rate gaps focus on repricing risk by maturity, while liquidity gaps focus on cash flow expectations (cash in and cash out) by maturity. 5 Sometimes these may be similar, other times they may be different, depending on the degree to which contractual, rather than behavioral, maturities dominate the balance sheet, or the degree to which any behavioral maturities behave in a way that approximates contrac-tual definitions. 6 Behavioral maturities reflect how a company’s creditors act when the contractual due date of a liability arrives: in some cases they will extend the liability continuously (or not choose to exercise the option to withdraw), while in other cases they will present the liability for redemption. The classic banking example is the holder of a demand deposit: while the depositor can theoretically present for redemption at any time, in practice the deposit will remain in situ for an extended


period of time – particularly if the depositor is a retail or local small busi-ness customer. 7 Regardless, the rate gap concept is well established and applicable as a liquidity proxy in many instances (particularly with some modifications as necessary, e.g., placing demand deposits in a maturity bucket that reflects their historical “sticky” maturity rather than in the overnight bucket).

The gap ratio, simply RSA divided by RSL, equals 1.0 for the perfectly matched portfolio of assets and liabilities (although a ratio of 1.0 does not mean that interest rate risk is eliminated, as the asset and liability rate movements might not be well correlated). When a bank’s RSAs are lower than its RSLs (a gap ratio of less than 1.0) it has an asset duration that is shorter than its liability duration and is said to be running a negative gap (i.e., it is liability-sensitive). While this can be profitable as long as the yield curve is positive and rates are stable, it is a risky strategy: as inter-est rates rise, the negative gap means a bank assumes more market-based interest rate and liquidity risk, and experiences a compression in its net interest margin (interest earned less interest paid). When a bank’s RSAs are greater than its RSLs, it has a liability duration that is shorter than its asset duration (a gap ratio greater than 1.0) and is said to be running a positive gap. These relationships are highlighted in Table 8.3. Banks typi-cally compute an overall gap ratio to provide a picture of the total liquid-ity position; they may also supplement this with gap ratios by maturity bucket/duration, as discussed in the cash flow section below. The actual gap, defined simply as RSA less RSL, can be computed in total and for each maturity bucket. Further information on RSAs, RSLs and the gap process is included in Appendix.

It is important to note that in some jurisdictions, financial institu-tions are required by regulators to produce specific liquidity measures as evidence of their financial strength. These might be duplicates of those already produced and used internally, or they might be supplemental. For instance, in the UK and United States, banking regulators engage in regu-lar “CAMEL (S)” reviews (capital, asset quality, management, earnings, liquidity, sensitivity to market risk); the liquidity portion of the review focuses on the volume and volatility of deposits, overall reliance on inter-est-sensitive funds, frequency and amount of borrowings, structure of liabilities, and access to cash through the asset portfolio.

Table 8.3 RSAs, RSLs, and interest rates

Rising in terest rates Falling interest rates

RSA > RSL Positive gap Earnings increase Earnings decreaseRSA < RSL Negative gap Earnings decrease Earnings increase

168 Liquidity Risk

Financial instrument liquidity measures

It is critical for firms that deal actively in financial instruments, including marketable securities and derivatives, to measure the amount of liquidity inherent in such contracts. Not surprisingly, these measures are of partic-ular interest to banks, securities firms, funds, and insurers because finan-cial instruments comprise the bulk of their accounts and create or absorb most of their cash. A firm attempting to manage its financial asset liquid-ity risk needs to develop a strategy where it can sell or pledge a quantity of assets with particular liquidity characteristics while minimizing the value reduction in all remaining assets. It seeks to maximize the asset cash flows it receives, where each asset is governed by a specific price and liquidation horizon. To do this two factors must be considered: a forecast of changes impacting the market risk component of a portfolio’s risk (that is, determining the change in asset value due to market-wide movements, with no influence by the firm’s own actions), and a determination of pos-sible price declines owing to the firm’s own selling actions.

An extensive body of research has focused on three different dimen-sions of financial asset liquidity measurement, including depth, tight-ness, and resiliency. 8 Depth is the amount of trading volume in a market, or the volume of trades that can be accommodated before prices change; tightness is the spread between the bid and offer of an asset, or how far transaction prices diverge from mid-market prices; and resiliency is the speed at which price movements disappear, or the time it takes for a mar-ket to return to “normal conditions” after having absorbed a large buy or sell order. By measuring these three dimensions, a firm with financial assets is able to evaluate the magnitude of liquidity risk inherent in its investment or trading portfolios. Although there is no consensus on the best measures for these indicators, various alternatives exist.

Depth can be measured by the amount of orders in an exchange trad- ●

ing book or the buys and sells flowing through an OTC-traded product line. The greater the amount of orders and volume, the deeper the mar-ket, and the more likely it is that an institution will be able to liquidate its position at, or near, carrying value. It is worth noting that absolute market size is not necessarily an indication of depth (for instance the Japanese Government Bond market is extremely large, but does not feature much depth away from the five- and ten-year benchmark secu-rities – many non-benchmark issues are extremely illiquid). Tightness can be measured through observable bid–offer spreads: the ●

tighter the spread, the greater the activity, depth, and thus, liquidity. Resiliency is considerably more difficult to gauge, as meaningful data ●

is hard to obtain; in fact, there is no agreement on the most effective


measure of resiliency, although some favor speed as a proxy, i.e., the time that it takes for the bid–offer spread on a particular asset to return to its “normal” level. In general, the more resilient the market, the greater its ability to absorb liquidation of a large block of assets.

These indicators can be combined to generate a measure referred to as friction, or the initial quoted spread (that is, the full bid–offer spread 9 before a transaction occurs) adjusted for a temporary price impact that disappears at a speed reflecting resiliency. This figure is simply the com-pensation to market makers that are willing to absorb the market and liquidity risk embedded in an asset. 10 Of course, there might be a per-manent price impact due to ongoing divisions in the mid-market quote for the asset; this is likely to be attributable to an informational change related to the asset rather than any temporary compensation to dealers. The price impact of an asset trade can thus be measured by friction.

Various other measures of financial asset liquidity exist, including:

Number of trades in an asset: in general, the greater the absolute ●

number of trades in an asset, the greater the liquidity. This, however, is simply a rule of thumb, and allowance must be made for trade size; for instance, 100 trades at $100 each might or might not signify greater liquidity than 50 trades at $200, although they are likely to suggest better liquidity than one trade at $10,000. Monetary volume of trades in an asset: in general, the larger the mon- ●

etary volume of trades in an asset, the greater the liquidity. This meas-ure helps address some of the shortcomings found in a pure tabulation of the number of trades, as it takes account of the actual market value turnover. Frequency of trades in an asset: in general, the more frequently an ●

asset trades, the better its liquidity. Those that trade several times per minute or second are more liquid than those that trade “by appoint-ment only,” irrespective of monetary volume. Turnover in an asset: in general, an asset that turns over rapidly is more ●

liquid than one that turns over slowly (where turnover is defined as average volume divided by outstanding securities). Number of market makers: in general, the greater the number of market ●

makers quoting two-way prices in an asset, the greater the liquidity in that asset. This presumes that market makers are obligated to fill either side of the trade at the level quoted and cannot renege or back away.

Not all of these measures are applicable in every market setting – each asset market has unique characteristics and dynamics, so asset liquidity

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measurement must be tailored accordingly. Indeed, some measures are more robust than others (depending on the market system and conven-tions) and might be most useful for “conventional” assets rather than those that are highly customized or specialized.

Asset liquidity cannot always be computed through bid–offer spread movement or turnover statistics. Certain contracts and portfolios lack sufficient turnover and/or transparent market prices as a result of their structural complexity or unique features, meaning that insti-tutions must rely on models to estimate value and liquidation prices (e.g., so called “marked-to-model” prices). Models possess a systemic characteristic that assumes a significant role in liquidity management. In the absence of transparency, institutions must measure, price, and manage their assets and liabilities and off-balance sheet risks based on assumptions related to stochastic processes and price independence. While these assumptions might be acceptable during normal market conditions, they might not hold true during a dislocation; this was, in fact, a significant problem during the financial crisis of 2007–2008. Assumptions regarding independent and continuous price movement might break down, leading to errors in measurement and management. In addition, identical institutional responses (some forced by particular regulatory rules) might occur, magnifying the relative volatility and liquidity characteristics of the marketplace, again altering underlying assumptions.

Risk is not a separate stochastic variable underpinning a model; the distribution of risk changes in a stress situation as firms implement risk protection strategies (e.g., hedging, deleveraging, and so on). Consider, for example, that regulators in many countries require banks to use value-at-risk (VAR) models, market risk quantification processes that attempt to estimate how much an institution’s portfolio of risks might lose over a stated time horizon, to a specified degree of statistical con-fidence. (The process is also applicable to a portfolio of collateral an institution might be holding to secure counterparty exposures.) 11 While such models are by now widely accepted and form part of the regula-tory schema for most banks, they contain several fundamental flaws, including:

no gauge of tail risks and losses ●

no consistent method of aggregating risks across different classes ●

difficulties capturing the non-linear price characteristics of many ●

derivatives dependence on assumptions related to volatility, correlation, and liquida- ●

tion horizon – and reliance (in some methodologies) on historical data separate modelling of asset prices and portfolio size. ●


These flaws draw into question the efficacy of the VAR process, especially during systemic dislocations – which is precisely when an institution needs a robust gauge of its risks. In fact, the financial crisis of 2007–2008 revealed all of these weaknesses: the markets exhibited soaring volatil-ity, breakdown in historical correlations, and disappearance of liquidity – all key VAR inputs that were not properly reflected in modelling efforts. Interestingly, in a crisis situation, firms managing to the same VAR process (for example the 99 percent confidence level, or the ten-day liquidation horizon promulgated by the BIS under its 1996 Market Risk Amendment) are likely to take similar defensive actions in order to reduce risks. This is a manifestation of the positive/negative feedback trading scenarios we mentioned earlier – mass migration from high- to low-risk assets can cause some asset liquidity to evaporate and liquidation horizons to lengthen. As a result, ex-ante VAR loss estimates might be understated in comparison with actual experience (to wit, the model-related problems apparent dur-ing the LTCM crisis and the 2007–2008 financial crisis).

VAR models are not unique in this regard: many other financial mod-els, including those used to value exotic derivatives and dynamic credit risks, may be subject to the same statistical shortcomings, meaning the same caveats apply. The use of models has to be properly considered, and shortcomings must be understood; one way of achieving this is to ensure that model assumptions and limitations are thoroughly discussed by management and directors. It is also important to introduce judgment and experience into management response, and to not blindly rely on model output as the end of the decision-making process.

We have mentioned some of the flaws contained in the standard VAR computation. Risk management under normal market conditions focuses on the distribution of portfolio value changes from moves in mid-market prices, disregarding any element of friction. VAR assumes that a bank’s entire position or portfolio is unwound (or otherwise neutralized, e.g., hedged) in a single trade at a fixed mid-market price at the liquidation horizon, regardless of size or complexity. This, not surprisingly, is a rather unrealistic assumption. The common approach to VAR liquidation peri-ods is based on an orderly process that assumes a sale occurs at the end of the defined period, and that a single liquidation period holds for all assets; this approach ignores liquidity trade-offs and costs. While tradi-tional models assume static and constant liquidation periods of one day, five days, two weeks, and so forth, these often prove unrealistic in times of market stress; they are also a “blunt instrument” as they are uniform and constant across all market conditions and asset classes. For example, the operating assumption is that it will take a bank one day (or five days, or two weeks) to sell a $100 million block of securities at the quoted mid-market price, regardless of whether the securities are US Treasury bonds

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or A-rated subprime mortgage securities, and whether the general market environment is benign or hostile.

To refine the measure, and make it at least slightly more useful in the context of market and liquidity risk management – with due cau-tion regarding all of the embedded limitations – several VAR adjustments have appeared in recent years. One basic approach involves the use of an “add-on” to the mid-market price that reflects relative liquidity or illi-quidity. The add-on can be determined via:

an empirical adjustment to match a stated liquidation period, taking ●

account of asset class and position size. This technique requires VAR to be rescaled to one day, and is intended to provide a “worst case” esti-mate add-on to the mid-market price of an asset. an estimated adjustment to the current or expected value of the bid– ●

offer spread based on the size of the risk position, thus adding to VAR the expected costs from the quoted spread.

While these adjustments make VAR somewhat more useful, they require significant data sourcing and management efforts. In addition, simply extending VAR by adjusting the bid–offer spread ignores the market impact factors we have discussed above and in Chapter 5, which are an important dimension of liquidity risk.

Another approach centers on the concept of liquidity-adjusted VAR (LAVAR). As the name suggests, this process involves recalibrating the VAR computation to take account of liquidity characteristics directly. Although there is no single accepted method of computing LAVAR (just as there is no single way of calculating VAR), 12 several analytical alterna-tives exist, including:

A volatility scaling factor incorporated within the variance/covariance ●

matrix, which applies greater volatility estimates to positions that are believed to carry greater liquidity risk (such as those with large size or thin trading volume). The scaling factor essentially increases VAR for any portfolio with predefined characteristics. A time scaling factor added to the liquidation period. In this instance ●

large positions, as well as those based on fundamentally illiquid assets, are “penalized” through a scaling factor that shifts the liquidation horizon from one, five, or ten days to relevant multiples – once again increasing VAR. In order to scale the liquidation period, an institution can divide its risk portfolios into various sub-portfolios that reflect specific liquidity characteristics; different time horizons can then be assigned according to the expected ease or difficulty of liquidation (or


risk neutralization via hedging). In this sense LAVAR can be viewed as VAR with an asset-specific sampling horizon and a liquidation period that is synchronized to some exogenously determined trading fre-quency; a link between saleability, depth, and liquidation thus exists.

These approaches improve conventional VAR, as they reflect the funda-mental reality that different assets do, indeed, face different liquidation horizons under a range of scenarios. However, they still have shortcom-ings; for instance, there is no indication of the correct volatility adjust-ments or time scaling factors, and no explicit accounting for how the market price impact function relates to the correlation between an insti-tution’s activities and systemic supply or demand. That said, some finan-cial institutions use LAVAR in order to circumvent some of the problems and shortcomings that became so apparent during the financial crises of the past decade.

Stress tests

Liquidity problems are often characterized by a low probability of occur-rence but a potentially large financial impact. A strong regimen of endogenous and exogenous stress testing that reveals the potential for tail-based losses is thus a critical element of any measurement process. As indicated at the beginning of the chapter, stress testing may be the single most effective mechanism for trying to understand the potential for liquidity-related losses and to reveal areas of weakness ex-ante rather than ex-post . Stress testing of this type is absolutely essential for banks and insurers: by definition and practice, we know that these intermedi-aries tend to hold a lower amount of liquid assets during normal times in order to maximize revenues – meaning they may have insufficient liquid assets during the onset of a stressed period. But such testing is also applicable to non-financial corporations, particularly those with com-plex structures, offshore subsidiaries, multi-currency operations, and so forth.

Stress testing can be accomplished by creating multivariate scenarios reflecting extreme movement in each relevant parameter. 13 Care must be taken not to underestimate the “fat tails” that characterize liquidity events. 14 The “fat tails” essentially indicate that in an historically derived statistical distribution tail events have a greater probability of occurrence than is commonly understood; failure to recognize this fact will lead to an underestimate of potential risk effects. In fact, there is ample evidence from the 2007–2008 crisis to suggest that many institutions failed to properly consider such effects in their own testing, and therefore missed

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events that occurred with greater magnitude than expected. Since most historical data sets lack the information to reveal such extreme points, simulations may be the most appropriate way of capturing the “fat tail” impact.

Alternatively, stress tests can be developed by “replaying” certain disas-ter events that have occurred in the past (such as the 1987 stock market crash, the 1998 Russia/hedge fund crisis, the 2001 technology-media-tel-ecom meltdown, or the 2007–2008 financial crisis) and examining the effects on internal financial structure and liquidity patterns. When using past disasters as a guide, it is important to remember that each one was driven by different dynamics and risk factors – such differences must be explicitly understood and considered. Stress scenarios can also be created by manipulating macro-economic variables through an entire cycle, i.e., economic slowdown, loss of consumer confidence, rise in inflation, slow-down in earnings, and general deterioration in corporate credits (reflected through downgrades; this may lead to increased non-performing assets in the banking sector, depositor nervousness and eventual withdrawals, and so forth). Each link in the cycle yields a certain impact on a firm’s liquid-ity. Event risk scenarios and joint scenarios can provide perspectives on even more severe tail events.

Regardless of approach (e.g., customized historical/simulation or repeat of history), stress tests need to be designed carefully. Importantly, liquid-ity stresses tend to reflect a structural change in a market environment, rather than a simple scaling or magnitude change in one or market vari-ables. In fact, the exercise should not be viewed strictly as a probabilistic analysis (i.e., what is the probability that a liquidity event will occur) but as a deterministic one (i.e., a liquidity event of some duration and inten-sity will occur, with certain resulting effects). Stress tests should be driven by conservative and consistent assumptions about the interrelationships/correlations between risk factors and the potential for “toppling of the dominoes” in ways that may not have been thought possible. 15 This should be obvious: it is vital for the relationships to be internally consist-ent because a liquidity event will be driven by, and create, other market effects.

Ideally, testing should be measured over short-, medium-, and long-term horizons several times per year, and the results should be linked into daily management processes and the contingency plans we consider later in the book. In order to properly benchmark the results, a company should first run a series of tests under its normal operating baseline case to determine how its positions perform in the absence of endogenous or exogenous stresses; this provides a gauge of just how sensitive a firm becomes in the face of specific disruptions or what pockets of weakness


actually exist. It can then apply scenarios to stress market parameters, cash flows, asset disposals/pledging, funding, covenants, collateral, cur-rency exposures, and so on – any stock or flow variable that can impact a firm’s liquidity position and access, over a range of time periods (e.g., two weeks to one year). A range of stresses should be applied to capture a spectrum of market situations, e.g., a mild stress (high probability), a seri-ous stress (lower probability) and an extreme stress (lowest probability) – each with its own defined market parameters and link to contingency planning. In practice, the stress testing process relies on a variety of tools, including simulation analysis, mathematical programming, and forecast-ing models, to produce desired results.

Stress testing framework

The process of creating a stress test is, of course, institution-dependent. Individual firms may favor one framework or process over another and, in the main, regulatory authorities (i.e., in the financial sector) do not prescribe specific approaches for the creation of stress tests (though they may mandate specific time horizon or variable manipulation). The sam-ple multi-step framework presented immediately below can thus be con-sidered generic in nature.

Step 1: Define the stress testing scenario, i.e., what will happen with each critical risk variable during the liquidity event. This can include market variables (interest rates 16 , credit/funding spreads, currencies, volatilities, correlations) as well as other variables (asset liquidation horizons, fund-ing withdrawals, actions of counterparties and rating agencies, phase of the economic cycle, and so forth (see the section below for further dis-cussion on some of these inputs)). As noted above, several events can be created, from mild to extreme, and from idiosyncratic to market-wide. Regardless of the specific stress, the movement of variables must be internally and externally consistent, i.e., linkages between credit, mar-ket and liquidity risk must feature in the model. While it is easy enough to design mild stress tests and use them in daily management (under the assumption that they may indeed come to pass), it is far more difficult to do the same with serious or extreme stresses. It appears that some (and perhaps many) institutions are reluctant to create “impossible” scenarios and use them to guide their actions, since the results tend to appear so extreme. But failing to do so means they may be unprepared for the next real crisis. It is far better to design and implement a severe stress (regardless of the output) so that the results can be considered and protective steps can be taken – or, at a minimum, so that the con-tingency plan can be properly tailored. Severe stresses should include

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systemic shocks that impact asset liquidity, funding and collateral for an extended period of time.

Step 2: Determine the cash flows affecting the institution during a set horizon, which can span two weeks to a year or more; obviously, as the duration of the liquidity event grows longer, the precision of future cash flow estimates diminishes. The cash in/out analysis should include all on- and off-balance sheet flows, including those with contractual maturities and those with behavioral maturities (assumptions must be made as part of step 1 in defining what occurs with behavioral flows). It is important to remember as part of this step that good approximations are sufficient for the exercise; to quote a wise old (risk management) saying, “it is bet-ter to be approximately right than precisely wrong” (a fact that VAR and other models proved during the crisis).

Step 3: Compute the net cash position by combining the cash in and cash out in Step 2 per time bucket. Each bottom line figure represents the liquidity required for that time period under that particular stress event. It is quite reasonable to assume that the more severe the stress test assumptions, the more severe the cash flow impact, the greater the liquid-ity requirement at any given point in time.

Step 4: Determine the total amount of cash that can be obtained from the liquidity portfolio to cover any deficit in the net cash position in Step 3. If this proves insufficient, identify other sources of borrowing that can be accessed, either on an unsecured basis (which may be possible only in mild stress events) or on a secured basis (the most likely case for increas-ingly severe stress events).

Step 5: Compute the defensive interval for the institution under each specific stress event, i.e., the number of days the institution can survive without accessing additional cash or otherwise changing its operations.

Step 6: Analyze the results and incorporate any points of concern or weak-ness into tactical and strategic plans and in contingency funding plans.

To be truly accurate, the stress tests should be conducted by relevant currency, which is especially important for any multinational operation which regularly funds and operates in multiple currencies. The stress test should also be parameterized to take account of any legal entity upstream/downstream/sidestream restrictions. Figure 8.6 summarizes the generic stress test framework.

Market parameters

Stress tests can be used to examine market liquidity parameters that are often troublesome, including variables that VAR-type models ignore


(that is, how much might be lost via market, credit, and liquidity risks in a disaster, rather than the minimum amount lost on a “losing day” 17 ). Key variables that should form part of any stress measurement include:

liquidation horizon ●

cash flows ●

asset disposals, secured funding and haircuts ●

unsecured funding ●

Step 1: Define the stress test scenarios (mild, serious, extreme)

Step 2: Determine cash in/out per stressed market parameter

Step 3: Compute net cash position per time bucket

Step 6: Analyze results and adjust tactical, strategic, contingency plans

Step 4: Determine cash obtainable through liquidity portfolio/borrowings

Step 5: Compute defensive interval

Figure 8.6 Generic stress test framework

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covenants and terminations ●

collateral ●

currencies ●

joint event risks. ●

Liquidation horizon

Liquidation horizon, as we have noted above, is an essential input into many models and is a frequent source of problems – primarily because there is a tendency to underestimate, during times of market dislocation, the length of time that it will take to sell (or otherwise neutralize) a posi-tion (this was certainly evident during the last financial crisis, where many institutions severely underestimated liquidation horizons across many asset classes). Stress tests must abandon “common thinking” and extend liquidation horizons to include those that appear almost incon-ceivable. Assets that are liquid under normal market conditions become less liquid as the severity of the dislocation intensifies; increasingly severe scenarios drain more asset liquidity from the market, until the point where an asset that might have been saleable at the mark price in one day may now only be saleable in 20 or 30 days – even at a discount. This can lead a firm to consider responses that it might otherwise disre-gard. For instance, if a company knows with certainty that it will have to make a large payment in three weeks and is seeking to fund the pay-ment through asset sales, it might identify a portfolio of corporate bonds that it believes will take no more than one week to sell. If, however, it cannot sell them in time, it will face a liquidity squeeze and be forced to seek other, more expensive, alternatives. The firm should question the liquidation assumption by considering that it will take one month to sell the bonds, and run stress scenarios on that basis. It may discover that it will have to begin selling the bonds earlier than anticipated or plan for some other contingency funding if it wants to meet the cash payments on time.

Cash flows

Stress testing must be applied to cash inflows/outflows and the resulting NFR referenced earlier in the chapter. By manipulating operating cash flows, and sources and uses of liquidity, across time horizons, different scenarios can be computed, some of which may reveal areas of vulner-ability. The results can be incorporated into broader management and contingency plans. For instance, the regimen can be based on measuring cash inflows from operating revenues, credit draw-downs, asset sales, asset roll-offs, and contingent off-balance sheet receipts, and cash outflows


related to liability redemptions, putability, roll-off, and contingencies. A focus on intraday cash spikes can also be examined, as these can be the source of significant financial pressures when in deficit. Conservatism is, of course, important. Inflows shouldn’t be counted if there is any possi-bility that they will not arise or occur – for whatever reason. For example, if a bank assumes that it will renew a maturing loan, it cannot count that temporary cash inflow as liquidity gained. Similarly, cash expected to be raised from its securitization activities should not be counted, as it is likely that in a stressed environment the securitization market will close down. Equally, not all cash outflows can be halted, or else business will cease to exist. A bank cannot stop making new loans (cash out), just as an industrial company cannot stop making new products (cash out). To assume that all cash outflows can be minimized is neither realistic nor conservative.

The cash flow element of stress testing can also be used to measure a firm’s ability to survive without accessing new sources of cash; we have already mentioned that the defensive interval (or survival horizon) is an important gauge of a firm’s ability to continue operating for a defined period of time with no new cash inflows. Stressing the amount of cash outflows by injecting additional unexpected payments or withdrawing existing funding lines can help demonstrate the strength or fragility of a company’s defensive interval. A test based on maximum cumulative out-flow, or the maximum amount of short-term unsecured funding needed to finance outflows in the event of a disaster scenario, can also provide important insight into the liquidity position.

Cash flow stress testing of off-balance sheet activities is particularly important for financial institutions. A bank or securities firm must be aware of what might happen to the corporate balance sheet if derivatives are exercised, revolving credit facilities are drawn, margins are required, guarantees are called on, or a structured vehicle has to be funded back on the balance sheet; the cash flow effects arising from the optional-ity embedded in callable or putable securities must also be taken into account. Scenario analysis must measure the impact of such contingen-cies. While there is no fool proof way of conducting such tests, a firm can begin by examining historical activity in the face of dislocation and then supplement this with judgment and hypothetical behaviorsgiven particular market events.

Asset disposals, secured funding, and haircuts

Stress testing can measure the sensitivity of a firm’s asset accounts gen-erally, its liquidity warehouse specifically, and the values that can be

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realized in the event of market dislocation. While the conservative firm is already likely to discount by a certain percentage the amount that it believes it can obtain through outright disposal or secured funding/pledging under normal market conditions, the stress test must focus on more severe haircuts (discounts), such as the new carrying value of the portfolio that results if all markets decline by 5 percent, 10 percent, or 25 percent, or become offered-only as a result of exogenous events. Asset portfolios that are concentrated or have limited marketability (as a result of riskiness or complexity, such as structured credit securities) should be discounted even more heavily in the test to reflect the fact that realiz-able cash value (whether through sales or pledges) will almost certainly be far smaller than expected during difficult times. Experience particu-larly from the last crisis suggests that in a stressed market environment lenders (and central banks) will demand larger haircuts on any collat-eral they accept in support of funding. Accordingly, mild to extreme stress tests should reflect haircuts on securities and other unencumbered assets that reflect these higher requirements; these can be calibrated for the type of security being posted as collateral (e.g., government bonds versus corporate bonds versus structured credit assets). For instance, if a firm, operating in normal market conditions, can obtain financing on a AAA-rated government bond based on a 1 percent haircut, it may raise the requirement to 3 percent (mild), 5 percent (serious) and 10 percent (extreme). Or, if it has a AAA-rated corporate bond that is normally pledged based on a 5 percent haircut, it may increase the requirement to 10 percent (mild), 20 percent (serious) and 40 percent (extreme) to more accurately reflect stress market realities. Naturally, the greater the discount a firm faces in such stress scenarios, the less funding capacity it has embedded in its balance sheet. 18 Haircuts can be measured in vari-ous ways, but are typically based on asset quality and type, with a spe-cific focus on the price volatility of the asset, the liquidation horizon, and the degree to which the asset can be rehypothecated. It is generally true that more volatile assets carry larger haircuts. Price volatility, in turn, might be directly or indirectly influenced by the depth, tight-ness, and resiliency of the market. Those that are deeper, tighter, and more resilient can absorb a greater amount of activity without much visible change in the quoted mid-market price; accordingly, they exhibit less volatility. Those that are shallower lack the same absorption capac-ity, and are more likely to demonstrate greater price volatility, and thus larger haircuts.

Any computation must also take account of the liquidation horizon. Again, it is generally true that the longer the time available for liquida-tion, the smaller the haircut (though the greater the likelihood of larger price movements between measurement date and liquidation date). A


firm that has a portfolio of assets that can be liquidated/pledged over 30 days will not necessarily face the same value discount as the firm that must dispose of, or pledge, the assets within 24 hours. Although the con-servative approach might assume instantaneous disposal/pledge value, more realistic time horizons should be computed.

The ability to rehypothecate securities taken as collateral in a financ-ing transaction can also influence the level of the haircut: those that can easily be accepted and then re-pledged in the market are likely to carry smaller haircuts than those that cannot, as they create greater flex-ibility and liquidity within the asset portfolio. High-quality government securities are routinely rehypothecated – this feature (along with other liquidity characteristics like high volume and low volatility) helps gener-ate smaller haircuts.

An illustrative range of financial asset haircuts, shown under normal market circumstances, is reflected in Table 8.4a. Stressed market condi-tions will necessarily generate larger haircuts as a result of greater price volatility and longer liquidation time horizons. Accordingly, the stress test exercise must centre on use of conservative discounts. Once again, an institution can set different haircut levels for each of the mild, seri-ous, and extreme stress scenarios. The most extreme discounts, shown

Table 8.4a Illustrative financial asset haircuts, normal market conditions

Asset class Haircut ranges (%)

Short-term government securities <1High-quality money market securities 1–5Generic agency and mortgage-backed securities 10–20High-quality corporate bonds 10–20High-yield corporate bonds 25–50Emerging market bonds 30–50+ Structured credit bonds Large capitalization equities

30–50+ 30–50+

Table 8.4b Illustrative financial asset haircuts, extreme stress market conditions

Asset class Haircut ranges (%)

Short-term government securities 2–5High-quality money market securities 5–10Generic agency and mortgage-backed securities 20–35High-quality corporate bonds 20–35High-yield corporate bonds 50–75+ Structured credit bonds Emerging market bonds

50–75+ 50–75+

Large capitalization equities 50–75+

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for illustrative purposes in Table 8.4b, reveal the reduced flexibility a firm faces when liquidating or pledging financial assets. It is also worth noting that although each institution with a financial portfolio 19 may perform its own normal and stressed haircut computations, regulators sometimes impose minimum haircut levels of their own; this tends to happen when central banks, for example, assume the role of liquidity provider during times of market stress. While these may be determined in a similar way (for instance by volatility or time), there is no guaran-tee that they will match the figures generated by market participants – indeed, there is every reason to believe that the regulators will be even more conservative.

Unsecured funding

Unsecured funding sources must be a central focus of stress testing. Indeed, a sharp rise in funding costs or the disappearance of existing facilities is often the first sign of a stress liquidity problem, and can lead to more serious problems. In addition to outright increases in fund-ing spreads, the behavior of customers, clients, investors, depositors, or other creditors that provide funds should be considered in the testing. This moves from the endogenous to exogenous, and is intended to con-vey what might occur if depositors suddenly withdraw a large portion of funds, investors refuse to rollover CP/ECP in order to reallocate their funds to other opportunities, trade creditors encounter difficulties of their own and change the payable credit terms they offer their clients, and so forth. This dimension is important because it attempts to capture an idea we discussed earlier: a firm can manage its own operations very prudently but still remain susceptible to external forces. History suggests that some/all of a firm’s unsecured financing will disappear in the face of a market dislocation and that some portion of its committed facilities may be withdrawn through invocation of MAC clauses or downgrade triggers, so these facts must be incorporated in the stress test.

A mild to serious stress test might focus on the economic loss sus-tained if all funding costs rise by 100, 200, or 500 bps on committed facilities, along with the cash flow effects arising from a withdrawal of all uncommitted facilities. A more extreme stress might include the cash flow effects and incremental funding requirements arising from the instantaneous withdrawal of all of a firm’s short-term unsecured funding (e.g., CP, ECP, short-term notes) and its uncommitted banking facilities, along with a certain percentage (e.g., 5%, 10%, 20%) of its committed facilities (cancelled, for example, because of MACs or ratings downgrades).


Financial institutions in particular should incorporate into their stress tests some modelling of depositor behavior. We have noted earlier that certain classes of demand deposits, which can theoretically be withdrawn at will, possess a certain “stickiness” which causes them to remain in situ , particularly when the market environment is benign. Contractual and behavioral maturities on such liabilities are thus quite different. As the market environment begins to worsen and/or as idiosyncratic events impact a bank, that behavior may begin to change: previously sticky deposits may start to flow out. The stress test should make assumptions about the stickiness in mild, serious and extreme scenarios, perhaps dis-tinguishing between those that are historically most sticky (e.g., insured retail, uninsured retail and local small business deposits) and those that are least sticky (e.g., wholesale deposits from funds, insurers, other banks, broker dealers, and other non-local customers). Each group can be sub-jected to separate stress assumptions, though all might be subject to some increased rate of withdrawal (e.g., under a serious scenario normally sticky deposits might run off at 7% instead of 1%, while wholesale depos-its might run off at 30% instead of 10%).

In some instances, of course, very strong companies can benefit from a flight-to-quality movement if their credit standing is sufficiently strong to attract the funds of nervous investors or depositors. As noted, in a systemic dislocation some institutions gain additional liquidity, giving them con-siderably more financial flexibility. This phenomenon, while limited to a relatively small number of AAA- and AA-rated financial institutions, must be recognized as a possibility, and can be included in relevant tests.

Covenants and terminations

We have indicated that many bank credit agreements and bond inden-tures contain financial covenants and market events that are designed to ensure debtor firms remain prudently managed. These are generally well intended and designed to protect both parties, and their stakehold-ers, from mismanagement. Since the triggering of covenants can create a “chain reaction” of funding events (such as cancellation or repayment of facilities), a thorough understanding of what might occur is an important part of stress measurement.

The funding scenarios can be stress tested by considering a firm’s obli-gations under its financing facilities should covenants be breached or the firm’s credit rating be downgraded to a threshold that leads to step-up funding costs, posting of collateral, and/or repayment of outstanding facilities. In some instances this might reveal the need for significant amounts of new funding or a redirection of cash flows from alternative

184 Liquidity Risk

sources. Similarly, a firm can examine its portfolio by taking account of early terminations embedded in financial contracts, allowing one or the other of the parties to end a transaction. In some instances early termi-nation is possible at will; in other cases it must be triggered by a specific event, such as counterparty default or a rate movement. In either case, a firm should understand the positive and negative cash flow implications of early terminations.

Collateral

There are situations when firms accept or deliver collateral in order to secure credit-sensitive transactions. Since the collateral forms an impor-tant element of the credit risk management process, and since credit risk can have an impact on liquidity risk, the collateral portfolio should be subject to stress tests. In fact, several aspects need to be explored: receipt versus delivery of collateral, delays in receipt, and discounts in collateral value. In the first instance, a company might wish to create stress sce-narios that involve the delivery of collateral to other institutions, either as part of the normal course of business or as a result of a credit downgrade that requires it to post security. The implications of having to source or reallocate assets to secure a credit exposure must be examined in detail, as the action will have a direct impact on the firm’s liquidity and finan-cial flexibility.

Next, a firm must consider collateral that it is expecting to receive from another party through the same types of agreements. Receipt of collateral, which can then be rehypothecated, is an important source of cash, but only to the extent that a firm can manage the collateral process and as long as it is viewed strictly as a temporary infusion. Note that if a firm’s stress test assumptions call for a permanent or semi-permanent withdrawal from certain activities that require continuous posting of collateral, then the model should properly credit the collateral to the liquidity buffer – meaning it is available for further disposal or rehy-pothecation without constraint. Of course, issues related to the timing of collateral delivery should be analyzed, including instances where col-lateral that is meant to be received is delayed and the firm is forced to take actions to cover the credit exposure. Finally, the value of the col-lateral should be stressed by applying the very asset haircuts we have described in the section above. If the firm’s counterparty defaults and the stress value of the collateral proves insufficient, a cash shortfall may arise. The deficit might have to be funded through alternate sources, and must therefore be incorporated into a contingency plan. A stress meas-urement of these collateral arrangements is most important for firms that have a great deal of assets flowing into, or out of, the balance sheet


as part of corporate operations. While this is generally associated with financial institutions, certain large companies have similar collateralized business as well.

Currency exposures

Institutions with global operations holding a certain portion of cash flows and balance sheet accounts in a foreign currency must measure the economic effects arising from a depreciation/devaluation of the local currency, as well as those arising from a lack of local currency access. For instance, a stress scenario might examine the cash flow impact of a currency devaluation of 10, 25, or 50 percent, or a large spike in local interbank rates that might occur in defence of a currency (and which would impact a firm’s local currency borrowing costs). In addition, sce-narios might be constructed to consider the financial impact owing to an inability to source or convert local currency (perhaps as a result of capital controls, an event risk we consider immediately following).

Event risks and joint scenarios

In some instances a firm is exposed to event risks that can alter access to cash or the way in which business is conducted. These might be consid-ered structural changes – highly improbable legal, political, or sovereign events that can dramatically change the firm’s liquidity profile. Although such exogenous structural changes have a low probability of occurrence, they are worth considering in the context of a stress liquidity measure-ment exercise.

Candidates for event-related stress testing include currency convertibil-ity controls placed on an important local marketplace, freezing or seizure of capital within a country, destruction of an uninsured plant, regulatory changes prohibiting a legal entity from upstreaming cash to the parent, and imposition of double leverage constraints at the holding company level. Each one of these events can sharply curtail a firm’s access to cash and place increased demands on existing facilities.

The regulatory and rating agency view of institutional liquidity should be a central focus of any event risk testing. These bodies com-mand considerable influence in determining appropriate levels of sec-tor liquidity, and it is prudent to hypothesize on their behavior during a market dislocation. For instance, if regulators are concerned about a systemic financial crisis, they might require financial institutions to increase their level of liquidity to particular minimum thresholds (we consider this point further in Chapter 11). Or, if rating agencies are worried about growing leverage and declining revenues in a particular industrial sector, they might penalize, via a lower credit rating, firms

186 Liquidity Risk

that fail to preserve a larger than normal cash buffer. As we noted in Chapter 6, a regulatory sanction or credit downgrade can exacerbate a liquidity crisis and help fuel a spiral. Anticipating such institutional changes through stress testing is an important element of anticipatory risk management.

The stress scenarios we have noted above can also be considered in combination. In fact, this is a realistic approach when considering disas-ters, as shocks can often impact assets, funding, and contingencies simul-taneously. For instance, it can be useful to consider what might occur to the firm’s cash position if the value of its investment portfolio or liquidity warehouse falls by a particular percentage at the same time as the cost of its committed funding sources rises by several percent, uncommitted funding is completely withdrawn, and currency controls are imposed on its primary offshore market. Naturally, results obtained from such joint scenario analysis must be considered carefully; although the results might reflect rather significant financial losses and large cash outflows, it is important to recognize that these are very low probability events, and daily management to such unlikely events will not result in an optimal use of resources.

Table 8.5 provides a simplified view of the stress testing process. The output from each one of these variables and scenarios might be a change in a market parameter leading to a change in the way cash flows are computed, and/or an actual change in the timing or magnitude of the cash flows – each of which can affect the firm’s need to access additional funding.

The measurement process is a central component of any liquidity risk management framework. Before an institution can actively manage its liquidity risk exposure, it must understand how large such exposures are, and how significant they might become under normal and stressed mar-ket conditions. With this information in hand, an institution’s executives and directors can control liquidity risk in a manner that is consistent with internal guidelines and overall risk tolerance levels, topics which we consider in the next chapter.


Table 8.5 Summary stress testing grid

Variable Baseline

Stress 1 Market crash

Stress 2 Economic slowdown

Stress 3 Sovereign event risk

Stress 4 Joint

scenarios

Market parameters VolatilityCorrelationsLiquidation horizonSpreadsHaircutsLAVAR

Cash flows AssetsLiabilitiesOBS ItemsNFR

Asset disposals Portfolio 1Portfolio 2Portfolio 3ReceivablesInventoriesPP&E

Funding CP/ECPPayablesMTN/EMTNLoansPutable arrangementsBonds

Covenants Liquidity ratioLeverage ratioMAC

Collateral ReceivedDelivered

Currency Currency 1Currency 2Currency 3

188

9 Controlling Liquidity Risk

We know from our discussion in previous chapters that active manage-ment of liquidity risk is central to a company’s success. A well-struc-tured approach to managing risks that have been identified, measured, and stress-tested helps a company avoid the cash flow surprises that can lead to problems. Liquidity risks can be managed through a multi-stage process that is based on developing proper governance practices, defin-ing and implementing a liquidity risk mandate, assigning management duties and responsibilities, creating and implementing liquidity risk controls, and monitoring the liquidity risk profile. We consider each of these essential points, summarized in Figure 9.1, in greater detail in this chapter.

Governance Structure

In order to control liquidity risks, a firm must start by creating an effec-tive risk governance structure. The board of directors, acting as agent of the shareholders, must delegate authority for liquidity risk management to the executive team (that is, CEO, COO, CFO, and/or treasurer) and authorize the creation of an independent committee or department (or unit within an existing department) to oversee the implementation of a liquidity risk management process. We term this function the liquidity committee (LC) for ease, though it is commonly known as an asset–liabil-ity committee (ALCO) in some financial institutions. The LC, in its capac-ity as the operating arm of the board on all matters relating to liquidity, should include senior representatives from relevant disciplines, includ-ing business units, finance, treasury, and risk management. If a separate treasury function already exists to manage daily balance sheet funding and short-term liquidity risks, as is common in many enterprises, close cooperation must be fostered between the two groups. The duties of the executive team and the LC must be very clearly defined, and the audit


Controlling Liquidity Risk 189

committee of the board should ensure that internal and external auditors regularly review the efficacy of the functions.

The LC, as a process and policy-making unit, should be responsible for:

defining, in conjunction with the board of directors and senior execu- ●

tives, the firm’s liquidity risk mandate, and communicating elements of the mandate to all interested stakeholders developing a business and liquidity risk strategy that is consistent with ●

the company’s stated liquidity risk mandate creating an internal funds transfer pricing mechanism that explicitly ●

charges a business or operating unit for the use of liquidity so that the true cost of bearing liquidity risk is factored in (as with financing, hedging and equity charges) creating a liquidity crisis management program ●

ensuring appropriate risk measures are developed and promulgated ●

evaluating the liquidity impact of new products and business lines to deter- ●

mine how they can be supported within the firm’s control framework delegating duties and authorities related to the management of liquid- ●

ity risk to the business units and control functions (depending on the degree of decentralization that is sought) reviewing for the board and senior executives the status of liquid- ●

ity risks and recommending periodic adjustments to the mandate to accommodate changing corporate or market circumstances.

Senior executives, as part of the management group, should be responsible for:

ensuring prudent daily management of the firm’s liquidity process, ●

including short- and long-term funding, asset structure, and bank/ investor relationships

Developing aproper

governance structure

Defining andimplementing

liquidity riskmandate

Assigningmanagement

duties and responsibilities

Creating andimplementing

liquidity riskcontrols

Monitoring theliquidity risk

profile

Figure 9.1 Controlling liquidity risks

190 Liquidity Risk

allocating and directing resources in support of a sound liquidity ●

environment managing closely the daily (and intraday) cash positions ●

making certain that the operational activities of the institution are ●

being managed securely, accurately, and efficiently, including effec-tive management of cash payments and receipts, collateral posting and acceptance, error control, cash reconciliations, and so forth ensuring that new products, strategies, and business lines with liquid- ●

ity risk implications are submitted to the LC for consideration making sure that all relevant cash flow projections and stress tests are ●

conducted by the risk management team on a regular basis (by legal entity and consolidated group), and that the results are discussed and properly incorporated in contingency planning testing the liquidity crisis management program and invoking and ●

directing it when needed (in conjunction with others on the crisis management team).

The board, senior executives, and the LC must consider whether liquid-ity risks should be managed on a centralized or decentralized basis. Each approach has advantages and disadvantages. Decentralization permits local units to manage liquidity according to local market practices and conditions, and in a manner consistent with legal entity or regulatory restrictions, but gives the head office less direct control. Centralization allows for strong headquarters control and a consolidated and consistent view of exposures, but might not promote proper awareness of unique local market issues. In some firms a balanced approach can prove opti-mal: regional or product units can be granted responsibility for daily liquidity management but must adhere to certain centralized directives developed by the LC, central treasury, finance, or risk groups (such as limits, controls, and reporting); this is particularly beneficial for com-plex organizations with multiple operating subsidiaries. In times of crisis, daily responsibility may shift temporarily to a centralized mode, as we shall note in the next chapter.

In general, preserving some modicum of local/business flexibility is important, as it permits those with the best knowledge of a region, mar-ket, or product to take appropriate actions in managing daily liquidity needs. When this flexibility exists, communications back to the central function must be strong, or an inaccurate picture of firm-wide liquid-ity might develop. Regardless of the approach, local and centralized responsibilities must be well defined for both normal and crisis scenarios. Ultimately, a firm’s risk governance structure must ensure that the liquid-ity risk management process is robust, well designed, and capable of mini-mizing liquidity-induced problems.


Liquidity Risk Mandate

Directors and executives, acting through the LC, must define the com-pany’s approach to, and tolerance for, liquidity risk. The process can be formalized through a liquidity risk mandate – a definition, or crystal-lization, of a firm’s approach to risk. For many companies this may be an extension to an existing risk process: if a company has already estab-lished a framework for risk management – and many major firms operat-ing in the marketplace of the 21st century have – then liquidity risk can be regarded as another risk variable to be considered and defined within the firm’s overall risk operations. If no such process exists, it should be developed as a matter of priority.

The liquidity risk mandate is created through a comprehensive risk plan and must be supported by relevant risk resources. Since the funding and asset liquidity exposures we have considered in previous chapters are an element of most corporate activities, a firm must be prepared to accept some amount of exposure in its operations. This is a critical point to stress: liquidity risk can never be eliminated entirely. But corporate lead-ers still have the ability to define an overall approach to, and tolerance for, risk. If the firm wants to minimize asset and funding exposure in order to reduce the likelihood of loss and remain focused on core opera-tions, it should state so through a formal notification to stakeholders and ensure that its controls are strong enough to allow adherence to such a philosophy. Conversely, if it prefers to maximize liquidity risk in hopes of generating additional returns, its mandate should convey that posi-tion and stakeholders should be aware that a more significant amount of exposure is embedded in corporate operations.

Risk plan

The liquidity risk mandate should be based on the firm’s overall plan for sourcing cash through operations, assets, liabilities, and off-balance sheet activities, and should be consistent with general corporate opera-tions/strategy related to production, investment, and expansion. It should also factor in its willingness to be exposed to a low probability/high severity event. The LC, CFO, and treasurer should create a funding plan that addresses the firm’s ongoing needs and seasonal requirements, and is sufficiently large, flexible, diversified, and committed to provide cash when required; a number of the funding controls we consider below can help reinforce the essential components of such a plan. The same is true of the firm’s asset portfolio: an appropriate amount and mix of liquid and unencumbered assets must form part of the firm’s overall risk plan, and can again be reinforced by the right controls. Given the growing importance of off-balance sheet items, it is equally vital for the

192 Liquidity Risk

firm’s plan to include the correct balance of contingent inflows and outflows.

In practice, this type of planning function must occur within the con-fines of the board’s risk directives: the team must focus on how much liquidity the firm needs to operate its business under normal conditions, cyclical variations, and stressed market conditions, and where (and at what cost) it can access liquidity. While the risk plan is necessary for com-panies in all industries, it is especially critical for those in the financial sector, where institutions must determine how to maximize net interest earnings (as well as trading revenues) by balancing the cost of providing risk capacity to others. Considering potential business opportunities in light of current and future market cycles and the relative returns that can be earned from interest rate and credit-sensitive activities is one way of doing this. 1

From a pure liquidity perspective, the risk plan should indicate how asset and funding maturities will be managed as the yield curve turns positive or negative, foreign exchange volatilities rise, credit defaults increase, and so forth. The plan cannot, of course, view liquidity risk in isolation – other dimensions of risk must also be considered. We have indicated the close relationship that exists between market, credit, and liquidity risks; while each can be viewed in isolation, the holistic view is far more useful and helps ensure internal consistency. Thus, the firm that actively takes a great deal of market and/or credit risk must be prepared to assume a considerable amount of liquidity risk and manage all dimen-sions consistently.

Financial and human resources

Management must also consider the financial resources that are avail-able to support liquidity risk exposures (as well as all other financial and operating exposures). A firm that has insufficient financial resources to take a significant amount of liquidity risk should not do so. Capital, as the ultimate buffer against unexpected losses, is the primary driver of resource availability. Together with earnings power, funding access and maximum acceptable leverage needed to maintain a particular credit rat-ing, it can help define appropriate risk appetite (or risk tolerance) levels. Firms that are well capitalized (from both an economic (internal) and regulatory (external) perspective) and have strong earnings power and reasonable leverage have greater ability to assume financial and operat-ing risks, including those associated with liquidity. Such a risk appetite should define the maximum acceptable boundary for risk-related losses that a company is willing to absorb, in total and per risk class (including liquidity risk).


Naturally, any risk resource allocation must be disciplined: directors and executives must allocate scarce capital to ventures that yield the greatest return to shareholders while being consistent with the overall business mandate. Even a well-capitalized firm would be unwise to squander capi-tal resources on ventures that provide an inadequate return or are not associated with the business strategy. Accordingly, the disciplined man-agement process requires that capital be allocated on a risk-adjusted basis, with appropriate minimum hurdle rates and target returns. Risk-adjusting profitability across risk classes provides an opportunity for management to measure the real worth of risk-taking activities and direct resources where value can be maximized. The same applies to human resources and intellectual capital; a risk-taking firm must possess both, or it will soon jeopardize its resources.

A firm must also have an internal risk pricing mechanism in order to properly consider risk-adjusted opportunities. This applies to all classes of risks being assumed in the normal course of business activities, including those associated with liquidity risk. Such an approach is, of course, no different than the one commonly used for allocating equity and funding charges to individual business units or divisions. In fact, managers facing an explicit internal liquidity risk charge are likely to become more sensi-tized to the liquidity risk being taken; when a charge is levied on a busi-ness division, that division may become more focused and efficient in its use of scarce resources. The opposite is also true: absent such a charge, managers may simply take the liquidity risk allocation for granted, despite the fact that it is consuming some portion of the firm’s overall risk appe-tite. This may be suboptimal for the company as a whole.

Pricing of liquidity risk can occur at a transaction level for firms that have sufficient data granularity and technological capability. When the infrastructure isn’t available to support transactional-level allocation, then pricing must occur at an overall risk allocation level (e.g., if a busi-ness consumes 10% of the firm’s liquidity risk appetite, then it must bear charges equal to that percentage). Regardless of the approach, the meth-odology should be as transparent as possible so that business units can gain an intuitive understanding of what it means to assume additional liquidity risk.

Pricing methodologies can vary by firm, but generally center on the marginal cost of acquiring or guaranteeing access to incremental liquid-ity. Such a marginal cost can be estimated, for instance, by taking the dif-ferential between the firm’s swap rate and the marginal cost of funding. This process is relatively straightforward for on-balance sheet accounts where the actual or estimated amount of liquidity can be determined over specific buckets/time horizons. The task becomes relatively more

194 Liquidity Risk

complex for off-balance sheet contingencies where the amount of poten-tial risk is unknown ex-ante . In such cases it is common to try to gain an estimate by running probability-based scenarios for each underlying contingency and then applying the marginal cost of obtaining liquidity. While not perfect, it provides a general estimate and allows a degree of pricing consistency to flow through businesses taking liquidity risk.

Business divisions that have the ability to specifically pass on the liquidity risk charge to an external end-use customer through their own pricing may wish to do so. In some cases this is easily done as it is part of the business service being provided (e.g., liquidity provision, maturity transformation). 2 In other instances it may be rather more difficult to do so, and a business unit may have to absorb the internal charge as “a cost of doing business.”

Creation of a liquidity risk mandate ultimately ensures that manage-ment has:

analyzed the costs and benefits of running liquidity risks of varying ●

size determined how exposures influence corporate operations and profit- ●

ability defined an acceptable risk appetite and allocated financial resources to ●

support any losses that might arise under normal and stress conditions (and ensuring that an internal pricing mechanism properly transfers the resource costs) communicated its approach to interested parties, including investors, ●

regulators, creditors, and customers.

With a liquidity risk mandate in place, the firm’s LC can actively meas-ure and control liquidity risk in a manner consistent with the company’s overall philosophy.

Management Duties and Responsibilities

Managing liquidity risk is an important, and often complex, task that must be handled professionally and diligently. It is critical to remember that the exercise is not one of simply collecting data, measuring and then reporting results; true management involves creating an internal sensibil-ity and awareness on the topic and planning for how all manner of con-tingencies can be handled in practice. Effective management of liquidity involves operational, financial, and behavioral actions, with specific duties that relate to a company’s liquidity status – that is, whether it is operating in a normal environment with ample liquidity, whether it is


facing a troubled environment with an increasingly challenging liquidity position, or whether it is operating in a very hostile and volatile environ-ment with severe liquidity pressures.

In the normal course of business, the management of liquidity risk covers distinct time horizons that correspond to the nature of a com-pany’s business, its financial condition, and the strength of the external environment. Some functions must be performed every day, others every week, month, or quarter. Daily procedures typically involve:

managing current cash inflows and outflows by balancing positions ●

through cash management, rollovers, bank line draw downs, and other short-term funding sources examining cash surpluses and deficits arising over the key overnight ●

to one month horizon and developing appropriate short-term response strategies monitoring the cash flow position in relation to limits that have been ●

established examining liquidity crisis “early warning” indicators and invoking the ●

crisis management program when, and if, necessary.

Weekly, monthly, and quarterly management, in contrast, is centered on:

analyzing ongoing cash needs over the 1 to 24 month horizon ●

developing new sources of funding to meet anticipated changes in cash ●

flow patterns and continuing to diversify the funding base; building and deepening relationships with creditors to develop a mutual sense of trust restructuring the investment or asset portfolios to help fulfil liquidity ●

goals changing the current liability mix to suit future requirements or take ●

advantage of cost/market opportunities running stress scenarios on current and future portfolios to detect ●

areas of strength and weakness; weaknesses must be flagged and dealt with immediately, rather than waiting until a future point where they become too challenging to manage proposing adjustments to the liquidity risk mandate, consistent with ●

the firm’s liquidity risk appetite and business strategies, with a view towards maximizing returns for a given level of liquid holdings and committed financing.

As noted above, the LC must formalize delegation of daily and periodic responsibilities; there should be no doubt about which individuals, teams,

196 Liquidity Risk

or departments are responsible for managing individual aspects of the process.

Not surprisingly, as a company’s liquidity situation becomes more strained, behavioral actions intensify. It is naturally important for man-agement to determine whether the difficulties are endogenous, exoge-nous, or both. A mild internal event will demand actions to quickly repair the balance sheet and core operations, hopefully with good cooperation from external stakeholders. This must be done as a matter of priority in order to avoid slipping into a more serious situation – when restructuring operations becomes more difficult. If it is a more severe event , or indeed involves external pressures from some market dislocation, then a more formalized process, embedded in the liquidity crisis management pro-gram, must be put into effect. We discuss this topic in the next chapter.

Liquidity Risk Controls

In order to control liquidity risk in a manner that is consistent with the firm’s mandate, the LC must first develop and implement a set of poli-cies and procedures. Liquidity policies can be considered a “high level” expression of a company’s approach to liquidity risk, conveying strate-gies for dealing with methodologies and exposures. Examples of common liquidity policies include:

asset diversification ●

funding diversification ●

monitoring and control ●

limit setting and approval ●

stress testing ●

function of the ALCO ●

contingency funding plan ●

Liquidity procedures accompany the policies, providing practical detail on executing the policies – functioning, in effect, as a type of “user’s manual.” An effective set of procedures, based on the policy-related docu-ments above, assigns responsibilities, describes mechanical steps involved in tracking and controlling different elements of liquidity risk method-ologies and exposure, and serves ultimately to institutionalize the aspira-tional policy documents.

In practice, short and intermediate liquidity management is centered on the creation and use of tools that control asset, funding, and off-bal-ance sheet exposures. Depending on the nature of the firm, its scope of operations, and approach to decentralization, controls may be applied


on a consolidated basis, business unit/regional basis, and/or legal entity basis. Indeed, legal entity controls are vital when considering regulatory restrictions that may be applied to holding company activities, parent/subsidiary financing, and dividend/cash flow upstreaming; the liquidity relationships between cross-border, intragroup companies must be well understood or a firm might find itself in breach of local rules or suscepti-ble to trapped funds. 3

The LC must create a balance of controls: enough to cover the true sources of risk, but not so many that the resulting matrix becomes dif-ficult to implement or manage. In practice, firms may create overarching consolidated controls and then establish granular sub-limits by business unit/region/legal entity. To illustrate the mechanics of the process, we consider five general categories of controls under the broad umbrella of liquidity procedures:

Asset liquidity controls ●

Funding liquidity controls ●

Joint liquidity controls ●

Off-balance sheet liquidity controls ●

Other safeguards. ●

(Note that these should be supplemented by a comprehensive crisis management/contingency funding plan, which we consider in the next chapter.)

Many of the controls we consider in this section are limit-based. Limits, which can be denominated in different forms (for example, value or percentage), are useful in constraining different types of exposures in a manner that is consistent with a firm’s liquidity risk mandate and syn-chronized with the risk appetite. Indeed, they are a transparent way of gauging and corralling liquidity exposures, and can be implemented with relative ease once measurement has taken place (and presuming data and technology infrastructure are robust enough to capture distinct elements of risk exposure).

Asset liquidity controls

A company can use a number of controls to manage its asset liquid-ity risk, including those that divide the balance sheet between liquid and fixed assets, those that restrict different elements of the liquid asset portfolio, and those that establish ceilings on the amount of assets that can be pledged to creditors at any time. Firms in capital-intensive industries have less flexibility in the amount of liquid assets they can

198 Liquidity Risk

maintain. The bulk of their productive assets must be allocated to sourc-ing, processing, or creating raw materials/finished goods; the remaining liquid assets must often be held in receivables and inventory, which, as we have already noted, are characterized by varying degrees of market-ability. The control focus is therefore on ensuring enough high-quality liquidity in the remaining balance of assets on hand. Financial and non-financial service companies face the reverse situation: they hold a majority of assets in relatively more liquid form, suggesting they have a greater need to manage the liquid asset portfolio on a continuous, dynamic basis.

Liquid and fixed asset limits

At a broad level, a company must ensure that it establishes a minimum holding of liquid assets and that it sets a cap on its fixed assets. Setting limits on liquid and fixed assets is likely to be a twofold process: review-ing historical experience through multiple business/economic cycles, then projecting what might be required over various future intervals. History can provide important information on the level of liquidity needed to manage a business under normal market conditions and can demonstrate the effects of surplus or deficit liquidity. For example, a steel company might find that it must hold 10 percent of its assets in cash, investments, and receivables, 20 percent in steel inventories, and 70 percent in plant and equipment in order to operate securely and profitably under normal market conditions. This is a relevant starting point in calibrating liquid/fixed asset limits. Since history cannot nec-essarily predict future events, the results of the stress tests discussed in the last chapter should be used to consider liquidity demands under various growth/contraction assumptions. These results might reveal instances where the historical liquid/fixed asset mix proves insufficient; proper adjustments can then be made, bearing in mind the liquidity risk/return trade-off we discussed in Part I. If, after running a variety of scenarios that factor in certain events related to environmental liti-gation or import tariffs, the steel company determines that it might face unexpected cash demands over the next 12 months that cannot be properly accommodated by its funding program, it may then alter the mix of its liquid versus fixed assets slightly – increasing cash/marketable securities investments and receivables from 10 percent to 15 percent, reducing inventories by 5 percent in response, and keeping constant its plant and equipment.

The same type of broad asset mix exercise can be performed for com-panies in other industries. The end goal, in all cases, should be guid-ance limits on overall asset composition related to potential sources of


future liquidity. Again, this implies minimum amounts of liquid assets (including cash and receivables), a maximum amount of inventories (on the assumption that, although they are more liquid than plant and equip-ment, they are less liquid than cash and receivables), and a maximum amount of fixed plant and equipment.

Figure 9.2 provides an example of the fixed/liquid asset limit approach.

Liquid asset limits The liquid asset portfolio, or liquidity warehouse, is the core of a firm’s asset backup and must be constructed properly and managed carefully. A firm is well advised to place limits on maximum concentration, matu-rity, quality, complexity, and aging within the warehouse; this can help ensure appropriate balance under the risk/return framework and the firm’s liquidity risk mandate, and reduce the likelihood of a cash flow deficit remaining uncovered. Construction of the portfolio should reflect an appropriate degree of conservatism: it is not advisable to invest cash in less marketable assets simply for the sake of trying to earn a few extra basis points of yield.

While the liquid asset portfolio is important for all firms, it is particu-larly critical for those relying on volatile, short-term wholesale funding sources that can be withdrawn quickly; an even greater focus must be placed on creating a liquidity portfolio that is readily convertible into cash. Note that while regulated banks must construct their liquid asset

Assets Liabilities

Equity

Total liquid assetsMinimum of x% or x$ of total assets

Cash and marketable securitiesMinimum of x% or x$ of total assets

ReceivablesMinimum of x% or x$ of total assets

InventoriesMaximum of x% or x$ of total assets

Total fixed assetsMaximum of x% or x$ of total assets

Figure 9.2 Fixed/liquid asset limits

200 Liquidity Risk

portfolios with the same care, they are likely to be operating under even stricter definitional requirements, as we shall discuss later in the book in our coverage of new regulatory measures.

● Concentration: we noted in Chapter 5 that concentrations can lead to liquidation problems: a large position can be more difficult to liquefy at carrying value than a small position, all else being equal. Accordingly, the absolute size of any liquid asset held on the balance sheet should be capped. There are obviously exceptions to this rule: holding a large block of on-the-run Treasuries or benchmark gilts, for instance, is unlikely to create any meaningful liquidity-induced loss if the block needs to be sold or pledged quickly, so these should be accommodated in the limit process (either through specific exceptions or larger sub-limits). In general, however, concentrations have to be avoided through limits that cap the maximum amount of an issue, issuer, or asset class at a particular value or percentage of the total liquidity portfolio (and overall balance sheet). For instance, a firm might establish maximum asset concentration limits of $100 million for any single high-grade corporate bond issue, $200 million for any conventional prime mort-gage-backed security, and $1 billion for any on-the-run Treasury or gilt position. In developing appropriate limits, it is important to consider that individual assets that appear to be independent and uncorrelated might actually become correlated in times of market stress. For exam-ple, a high-yield bond position and an emerging market bond position, which might move independently during normal market conditions, might react in a similar fashion during a financial crisis; two previ-ously acceptable positions might now become a single, concentrated, high-risk position, so due consideration must be given to this fact when setting limits. ● Maturity: asset maturities should be tightly controlled. Assets with short-term maturities provide a firm with more immediate access to cash than those with long-term maturities (although they are exposed to greater reinvestment risk and may also be lower-yielding). Converting long-term assets into cash might result in a larger discount to carrying value, leading to losses/shortfalls, so an appropriate balance of short- versus long-term maturities should be instituted. General limits can be set to cap the value and/or percentage amount of liquid assets in specific maturity buckets. For instance, a firm may set a minimum of 10 percent of assets maturing within 30 days, a further 20 percent within 60 days, 20 percent within 180 days, and a maximum of 50 per-cent maturing beyond 180 days. The process cannot, of course, be done in isolation: if a firm is attempting to create a matched operation in


order to minimize liquidity risk, then asset maturities (or more accu-rate durations) must take account of liability maturities. Assets with an uncertain time horizon can obviously complicate the cash flow analy-sis by giving a potentially false picture of asset maturities, so care must be taken when tabulating maturity exposures. ● Credit quality: the quality of assets comprising the firm’s liquid portfo-lio should be carefully considered. Since liquid assets must be readily available to convert into cash or pledge as collateral, it is prudent to cap the amount that can be held in sub-investment-grade instruments that have a higher degree of price volatility and greater probability of default. Thus, a firm may limit by value and/or percentage the port-folio of securities and receivables in the sub-investment-grade ratings category (and even within individual sub-investment-grade bands). For example, it may set a maximum of 10 percent of the liquid asset port-folio in credit obligations of BBB–/Baa3 issuers/customers, 5 percent for those rated BB+/Ba1, and 1 percent for any rated below that level. Although the risk/return trade-off surfaces once again (that is, hold-ing a greater percentage of lower yielding/higher quality assets that are certain to provide a more stable liquidation value, versus higher yielding/lower quality instruments that might have questionable liq-uidation value), the conservative stance suggests tight limits should be placed on lower-credit, quality assets. A further note of caution must be emphasized. In particular, the financial crisis of 2007–2008 dem-onstrated that not all AAA- and AA-rated securities merit such ratings. For instance, 80 percent of all AAA-rated securitizations issued in 2006 were ultimately downgraded during the crisis, some to very low lev-els indeed. Accordingly, thorough, independent due diligence on the credit quality and proper credit rating of assets in the portfolio must be undertaken. Total reliance on third-party analysis is not advisable. ● Complexity: we know that asset marketability is important in managing liquidity. Assets that are simple and transparent can be valued with ease and typically have a broader base of buyers than those that are overly complex or opaque (e.g., structured notes with embedded derivatives). Accordingly, limits on the value and/or percentage of complex assets that can be held in the liquid portfolio can prevent over-investment in instruments that might otherwise be too difficult to sell or pledge. For instance, a firm may limit to 1 percent or 3 percent its holdings of assets it deems to be complex, such as structured notes or other exotic securities. Of course, a more prudent and conservative stance would be to disallow entirely from the buffer any such structured assets. ● Aging: every firm holding a portfolio of liquid assets for operating, investment, and liquidity purposes must ensure that the portfo-

202 Liquidity Risk

lio turns over regularly. When securities, investments, inventories, or receivables are not regularly being sold, renewed, replenished, or replaced, there is a significant chance that the assets are illiquid. This chance of illiquidity might be the result of mispricing, changing mar-ket conditions, excessive complexity, or regulations, and it calls into question carrying value . For instance, if a firm finds that receivables have historically turned over every 30 days but the horizon has gradu-ally lengthened to 60 days, then its portfolio has become far less liq-uid (and might be the source of credit, pricing, and market problems). The same can be applied to securities inventories that fall within the liquid portion of the balance sheet. It is therefore important for a firm to limit and monitor the value and/or percentage of the asset port-folio aged beyond specific time horizons. For instance, a firm may choose to set limits of 5 percent of liquid assets in the 90 day-plus aging category and 2 percent in the 180 day-plus category. By doing so it ensures that management addresses instances where holding peri-ods are lengthening.

In some cases it is useful to subdivide a liquidity warehouse into more granular portfolios that reflect specific liquidity risk and return charac-teristics. This approach preserves layers of liquidity while focusing on imperatives related to enterprise value maximization. For instance, a firm might create a liquidity warehouse with three subportfolios: portfolio 1, used for immediate cash needs and comprised exclusively of cash and near cash instruments with little or no yield; portfolio 2, a discretion-ary portfolio used to meet regular payments that cannot be covered by portfolio 1 (or other cheap funding), and comprised of very liquid assets with a low yield; and, portfolio 3, a stable portfolio to be used only for exceptional payments, and comprised of somewhat less liquid securities (or other current assets, such as receivables). Each one of these can be governed by the limits described immediately above.

Figure 9.3 summarizes the limit structure within the liquid asset portfolio.

Collateral/pledging limits

Since pledging assets for cash is often preferable to outright disposal, a firm must avoid a situation where all of its assets have unknowingly been pledged in support of other funding facilities. A limit structure can cap the maximum amount of assets that can be pledged, per asset account, in support of funding. Any breach of these limits should serve as a warn-ing signal that financial flexibility is declining rapidly, and broader prob-lems related to unsecured funding access are at work. For instance, in


order to ensure a sufficient liquidity buffer through future asset pledges, a company may limit its encumbered receivables to 40 percent of the total receivables portfolio, encumbered inventory to 50 percent, and encum-bered plant and equipment to 70 percent. If the firm finds that it is pledg-ing more assets to secure funding and is approaching any, or all, of its collateral/pledging limits, it should investigate the reasons as a matter of urgency.

Assets Liabilities

Equity

Total liquid assetsMinimum of x% or x$ of total assets

Subportfolio 1Subportfolio 2Subportfolio 3

ConcentrationMaximum of x% or x$ of liquid assets

MaturityMinimum of x% or x$ of liquid assets in

short-term maturity/duration, per bucket

Maximum of x% or x$ of liquid assets inmedium/long-term maturity/duration,

per bucket

QualityMaximum of x% or x$ of liquid assets

per ratings category

ComplexityMaximum of x% or x$ of liquid assets

classified as complex

AgingMaximum of x% or x$ of liquid assets

classified as aged (e.g.over 60,90,180 days)

Figure 9.3 Liquid asset limits

204 Liquidity Risk

Figure 9.4 summarizes the limit structure related to collateral and pledging.

Funding liquidity controls

A firm must control its funding profile closely in order to minimize the possibility of a funding liquidity loss. This is particularly true for firms that are very dependent on volatile short-term financing. Limits should be established to ensure proper funding diversification and commitment. As with assets, the funding profile is heavily dependent on the nature of the company and its operating industry: some firms rely more heavily on short-term funding, others on medium- and long-term funding. Ideally, companies should strive for a mix of liabilities in order to maximize the number of options and achieve an optimal cost of funding. That said, in some cases it can be beneficial to opportunistically issue or fund in the medium- or long-term markets in order to lock up a core of stable financ-ing; while this may indeed create a negative carry situation (e.g., cost of funding greater than invested return), it should simply be viewed as a form of “liquidity insurance premium.” As we have noted, having a mul-titude of options becomes particularly important during times of market stress. For example, if the medium-term loan market closes down, a firm that has historically match-funded its capital assets with medium-term

Assets Liabilities

Equity

Total liquid assetsMaximum of x% or x$ of total liquid

assets pledged as collateral

Cash and marketable securitiesMaximum of x% or x$ of total cash/

securities pledged as collateral

ReceivablesMaximum of x% or x$ of total

receivables pledged as collateral

InventoriesMaximum of x% or x$ of total

inventories pledged as collateral

Total fixed assetsMaximum of x% or x$ of total fixed

assets pledged as collateral

Figure 9.4 Collateral/pledging limits


financing must be able to quickly seek alternatives from the short-term market. While the risk management effort might be more involved (for instance, having to hedge short-term liabilities with medium-term assets), the important point is that the company preserves access to some type of financing. Ex-ante establishment of a range of facilities is thus a critical element of the management process and can be driven by a structure that limits usage in any particular financing sector.

Diversified funding limits

In order to create a balanced funding program that eliminates undue concentrations and over-reliance on single sources, a firm should create funding limits across markets, products, maturities, and lenders/ inves-tors. Naturally, the definition of what constitutes a funding concentra-tion is likely to vary by institution, industry, and national system, and might be influenced by the corporate governance process or mandated by regulators. 4

● Markets: the limit process can begin at a macro level through the estab-lishment of maximum amounts that can be drawn from any broad marketplace, such as the CP, MTN, deposit, loan, or long-term offshore bond markets. Limits can be established in both value and percentage terms. For example, a firm may cap market access at $250 million from any single marketplace, or not more than 40 percent of liabilities from the US market, 30 percent from the Euromarkets, and so on. Where relevant, geographic/national market restrictions can be imposed; this can be useful for funding that is sourced from marketplaces where reg-ulators might place controls, levies, or reserve requirements on non-domestic borrowers (i.e., sovereign risks). ● Products: the value or percentage of the funding portfolio can be limited by product type – a more granular representation of the market limits above. For instance, a bank might cap CP/ECP financing at 10 percent of all funding, short-term interbank deposits at 20 percent, repurchase agreements at 25 percent, subordinated debentures at 30 percent, and so forth. Following the logic immediately above, this process ensures a firm does not become overly dependent on a single source of product-based funding and decreases its vulnerability to financial loss should product-specific financing be suspended for a period of time. Note that there may be an occasional exception to this rule for certain institu-tions (e.g., banks), which may find it beneficial to have a more concen-trated exposure to a financing product if that product is proven over time (and stressed market conditions) to be highly stable (e.g., sticky retail deposits). This, however, must be viewed as exceptional.

206 Liquidity Risk

● Maturities: the contractual maturity of liabilities must be constrained so that a firm does not face an excessive repayment or rollover bur-den. As noted above, limits on funding maturities (durations) should not be considered separately from those set for asset maturities; a firm trying to match-fund a significant portion of its balance sheet must consider the two elements jointly. Where possible, however, it is criti-cal for maturities to be properly dispersed across a reasonably wide maturity horizon, with an appropriate mix of short-, medium-, and long-term funds. For instance, a firm may set a maximum of 10 per-cent of funding on an overnight basis and 10 percent up to one week, and a minimum of 30 percent from one week to one month, minimum 30 percent from one month to two months, and minimum 20 percent beyond two months. The actual composition will depend, of course, on the company, its business, its balance sheet composition, and so forth. Care must also be taken to consider the behavioral and contractual ●

maturities of the liabilities. This can be a complex task, and is gener-ally only possible with direct experience on how investors and lenders behave regarding rollovers, extensions or callability/putability. There is no precise way to determine, for instance, whether a short-term investor base will continue to rollover its CP, ECP, demand deposits, or overnight repos, or whether holders of insurance liabilities with short-term put features will exercise their options. When doubts exist, the preferred route is to assume a conservative, though still realistic, stance. Firms should always limit funding structures with embedded options, triggers, or clauses that give investors or creditors the right to call away their capital at short notice (for example, embedded market put options, ratings downgrade clauses, financial ratio triggers, and so forth). In addition, maturities on optionable funds must be appropri-ately staggered; while a putable feature increases funding liquidity risk, the severity of that liquidity risk depends on whether all of the puts are exercisable at a given time horizon (for instance, seven days from exercise) or whether they can be spread out (say, 7, 30, 60, or 90 days). Staggering reduces the spectre of a sudden funding withdrawal. 5 ● Lenders/Investors: the diversified funding program must take account of the number and quality of lenders/investors providing financing. A company must again limit the amount it draws from any single lender or investor, minimizing its reliance on any institution that may be unwilling or unable to supply funds at some future point. For instance, a firm may cap at 5 percent all funding derived from a single CP/ECP investor, 10 percent from any single commercial bank, and so forth. For some sectors, such as banking, it is important to limit the overall


amount sourced from the entire class of wholesale investors/deposi-tors (e.g., as a percentage of total liabilities), as this group tends to be sophisticated in its funding analysis, can shift capital relatively quickly, and can act collectively to withdraw funds precisely when they may be needed most.

When considering maximum value or percentage limits, it is impor-tant to take account of correlations between the firm and lenders/investors that might appear during times of market stress: if the firm is relying on a small number of institutions for liquidity, and those insti-tutions are exposed to the same exogenous factors that might cause the firm to demand liquidity, the supply of funds might not be available when required.

Apart from limiting exposure to name-specific lenders/investors, it is prudent to limit participation by broad credit rating, with value or amount that decreases as credit quality declines; this helps protect the firm from becoming overly exposed to borderline investment-grade or sub-investment-grade institutions that might be unable to provide funding if they encounter financial difficulties of their own.

It is worth noting that while lender diversification limits are important, a firm must still try to deal with a “manageable” number of institutions. This is important in the event the firm encounters financial difficulties and must restructure the financing relation-ship, or if it wants to have an active investor relationship effort that calls for timely communiques with debt investors and creditors. For instance, a firm wants to avoid renegotiating terms with dozens of banks that form part of a diversified syndicate; it is far better if it can deal with a relatively small number and reach agreement on new terms more rapidly. In this example, lender diversification is a balancing act; a compromise solution can be achieved by incorporat-ing a reasonably large number of banks under a single master credit agreement (presuming “unanimous consent” clauses in the agree-ment can be minimized).

Figure 9.5 summarizes diversified funding limits.

Committed facility limits

Limits that constrain the type of contingent funding commitment drawn from the loan markets represent another form of control. It is essential for a firm relying on bank lines to be confident that facilities will be available precisely when they are needed; this means explicitly limiting or minimizing those that might not be available under all mar-ket circumstances. Note that this type of control can more accurately be

208 Liquidity Risk

considered a hybrid of on-balance sheet funding and off-balance sheet contingent financing, as it is dependent on whether or not facilities have already been partially or fully drawn; we discuss the matter in this sec-tion for continuity.

● Advised facilities: recalling our discussion on theoretical and actual sources of liquidity, the conservative view assumes advised facilities will be withdrawn at the first instance of internal or external difficulty,

Assets Liabilities

Equity

MarketsMaximum of x% or x$ of total funding

from a single market

ProductsMaximum of x% or x$ of total funding

from a single product

MaturityMaximum of x% or x$ of total funding

in short-term maturity/duration,per bucket

Minimum of x% or x$ of total fundingin medium/long-term maturity/

duration,per bucket

Lenders/investorsMaximum of x% or x$ of total funding

from a single lender and per rating

Total funding sources

Figure 9.5 Diversified funding limits


meaning a source of funding will be lost. Maximum value and percent-age limits should therefore be applied to any facility that is considered to be advised, for which no commitment fee has been paid by the firm to the lender(s), and which is not governed by a formal credit agree-ment. In practice a firm should severely limit the amount of funding it obtains from advised facilities and be prepared to discount availability entirely in turbulent times. ● Committed facilities: these facilities, for which a firm pays standby and usage fees, and which are governed by credit agreements, are far more robust and reliable than advised facilities. Accordingly, a greater amount of a firm’s diversified loan program should be based on such lines. That said, the nature of the commitment must still be analyzed as some limits may be required. For instance, some commitments are subject to the fulfilment of positive and/or negative covenants. A bor-rowing firm might be required to maintain certain minimum finan-cial ratios, or agree not to engage in certain activities, in order to preserve its right to borrow under a facility. Some of these covenants are prudent and intended to protect both parties. However, a firm should cap the maximum amount of draw-down when covenants are too restrictive or conservative. If there is a significant likelihood that the covenants will be breached when the firm is experiencing financial pressure – precisely when it might require access to liquid-ity – the lender might withdraw the facility, compounding pressures. When financial covenants are less restrictive, and are unlikely to be breached even under difficult times, a firm can have greater confi-dence that the facility will remain intact, ready for draw-down when needed – and thus increase its percentage allocation under the fund-ing program. The same approach should apply when considering material adverse ●

change (MAC) clauses; if a facility contains “market-outs” that can be interpreted very liberally by the lender, tighter limits should be imposed. Conversely, when a MAC is defined very precisely and lim-ited to the onset of truly materially adverse conditions (that is, it is an “escape-proof MAC”), greater allocation can be considered. It is important to stress that financial covenants and MACs can quickly ●

magnify a small problem, so due care must be taken when consider-ing contractual language and the possible effect on liquidity access. 6 Note that similar covenants and ratio tests are periodically included in public debt offerings, meaning the same guidelines should be applied. (That is, if a covenant or ratio is breached, the company, as issuer of the securities, might be forced to redeem the bond, or commence or accelerate payments into a sinking fund.)

210 Liquidity Risk

Figure 9.6 summarizes committed facility limits.

Joint liquidity controls

While individual control of asset and funding risks is essential, it is equally important for a firm to control the risks arising from a combined view of the two. In practice this can be accomplished by setting limits related to cash flow gaps, overall balance sheet targets, and hybrid ratios.

Cash flow gap limits

In the last chapter we considered cash flow gaps arising from asset and liability mismatches (as well as those generated by off-balance sheet

Assets Liabilities

Equity

Advised facilitiesMaximum of x% or x$ of totalfunding from advised facilities

Committed facilitiesMaximum of x% or x$ of total funding

from committed facilities (dependent oncovenants, MACs*)

* may also apply to capital markets issues

Total bank funding sources

Off-balance sheetfunding commitments

Figure 9.6 Committed facility limits


activities). By dissecting corporate cash inflows and outflows over dis-crete time horizons, or through more intricate measures such as duration or probability-based statistical analyses, a firm determines whether it will face an NFR surplus or deficit. Establishing gap limits reduces the chance that a firm will have an NFR deficit that it cannot adequately meet. From a practical perspective a firm can compute its NFR gap in a manner of its choosing, and then set maximum limits per discrete time/duration horizon, along with a cumulative limit for a given block of time/duration. The most relevant time/duration horizons are likely to cover the over-night to one-month period – thereafter a firm might have enough ability to reshape elements of its cash flow profile to rely solely on monthly or quarterly limits.

Consider, for instance, a company with reasonable access to funding through its backup facilities and liquidity warehouse. It may feel com-fortable that it can quickly draw-down $200 million, and therefore sets its NFR gap from balance sheet and off-balance sheet items at $50 mil-lion on any given day and $150 million for a cumulative one-week period. Similarly, a financial institution that uses duration-based RSAs and RSLs to compute rate gaps and plan interest-rate risk and business origination strategies can set individual maximum net open gap limits by bucket, such as $50 million per day for the next month. By utiliz-ing these gap measures in conjunction with the other asset and fund-ing mechanisms mentioned above, a firm controls the joint interaction of cash inflows and outflows from its assets, liabilities, and off-balance sheet contingencies.

Naturally, other cash flow gap limits can be considered, such as maxi-mum overnight funding limits (to minimize the need to seek emergency funds through regulatory channels) and foreign currency gap limits (to minimize the risk of being unable to properly fund offshore operations without assuming significant foreign exchange exposure). 7 A firm should carefully evaluate the nature of its operations to determine whether other types of limits are necessary.

It is important to re-emphasize that cash flow limits are likely to be a reasonable, though not perfect, constraint on exposures; we have already noted that unexpected cash flows arising at a future time are one of the key causes of liquidity problems. However, by establishing gap limits with some buffer to allow for a certain amount of unexpected change, a firm can deal with a broad range of likely outcomes.

Balance sheet target limits

Joint asset and funding risks can also be controlled through balance sheet target limits, which cap the amount and speed of balance sheet growth and help ensure that business opportunities do not outpace a firm’s ability

212 Liquidity Risk

to properly fund them. Without such controls a firm that is expanding rapidly through organic growth or acquisition might find that it has not appropriately considered its funding needs, and the leverage it has used for expansion purposes may not be calibrated with the liquidity profile of the assets being funded. For instance, a company with $100 million in fixed assets and $100 million in liquid assets, funded with $150 million of long-term debt and $50 million of equity, might have an opportunity to buy a competitor or enter into a large investment project that will add $100 million in fixed assets. The firm may simply issue $100 million of CP to fund the expansion, leaving it with a significant increase in lever-age, a large funding mismatch, and a far less liquid asset portfolio; each of these could add to liquidity pressures. By establishing broad controls on total assets, total debt, and total liabilities, a firm restricts the amount of expansion that can occur without a thorough, ex ante evaluation of financing and liquidity alternatives.

Hybrid ratio limits

A firm can also consider using hybrid ratios to control aspects of liquid-ity risk. These limits include a mix of balance sheet, off-balance sheet, cash flow, and/or income statement accounts, and are a combination of stock and flow measures. For instance, a firm may wish to ensure that it has adequate coverage of short-term obligations coming due, and it can set a limit based on the following ratio: cash, haircut value of unencum-bered securities, and the unsecured portion of unused, committed lines, divided by unsecured debt due within 12 months. The ratio must remain above a minimum level at all times; if it does not, then its coverage of short-term liabilities is weakening and should prompt management to take corrective action.

Alternatively, a firm may wish to establish a minimum defensive interval of one month without tapping new sources of funding, and might establish the following limit: cash inflows from all sources during the month and haircut value of unencumbered securities, divided by cash outflows from all sources during the month. Again, the ratio must remain above a specified level, and if it weakens, management must be prepared to take corrective action. Similar types of hybrid ratios, including those tailored to specific industries, can be developed to limit exposures.

Off-balance sheet controls

Since off-balance sheet items can impact cash inflows and outflows, some-times dramatically, they must be properly constrained. In practice this


can be done through limits on forward commitments and contingencies. As already noted, off-balance sheet funding contingencies that generate cash through draw-down (such as advised or committed bank lines) are described in the funding section above.

Forward commitments and contingencies

Cash flows from derivatives, loan participations, revolving credit agree-ments, letters of credit, leases, recourse facilities, and guarantees supply and absorb cash, and must therefore be explicitly controlled. Though cash flows might be certain or uncertain (for instance, a true contingency that might or might not come to pass at some future time), the conservative approach caps, by future period, any net cash outflows that might require funding. Such limits control the amount and speed of off-balance sheet growth, and help ensure that contingencies do not outpace the firm’s ability to properly fund them. In fact, this is consistent with the balance sheet target limits described above, but applicable specifically to the gross amount of contracts with uncertain timing and value that might create cash outflows or require funding.

The same need not necessarily apply to net cash inflows, unless they are intended to fund another future obligation (that is, if the contingent cash inflow does not occur but the future obligation must still be funded, the firm will have to seek alternate sources of financing). Since this approach involves establishing limits on contingent cash inflows and outflows, it can be viewed as a stressed scenario limit framework that assumes the worst case will occur. In addition to limiting the absolute amount of con-tingent exposure over various future time horizons, the structure should control concentrations and credit quality, as in the discussion above. These may be denominated in value or percentage terms.

Figure 9.7 summarizes the limit structure for forward commitments and contingencies.

We have presented a matrix of limits that can be used to control dif-ferent aspects of liquidity risk in a manner that is consistent with the board-directed liquidity risk mandate and appetite. As we have indi-cated, these limits must be linked to the company’s desire and ability to absorb liquidity-induced losses of a given magnitude – that is, they need to be properly synchronized with the liquidity risk mandate and over-arching business strategies. In practice, however, they should be consid-ered limits rather than absolute ceilings. In the normal course of affairs a company will find opportunities to engage in incremental business that might add risk and breach previously agreed limits. A strict read-ing of policy and procedure might suggest this is unacceptable. In real-ity, exceptions can, and should, be accommodated to take advantage of

214 Liquidity Risk

worthwhile ventures, including those that are consistent with the firm’s business focus, and where the returns adequately compensate for any risks assumed. The LC should create sufficient flexibility within the limit process to handle temporary exceptions; exception procedures must, of course, be well understood and diligently applied. Naturally, exceptions must be temporary and infrequent. A limited number of exceptions should be granted for defined periods; a semi-permanent excess is a sign of flawed risk management that might eventually lead to serious prob-lems. In fact, exceptions can serve as important “early warning” indica-tors: if a company has established prudent and realistic limits that allow it to handle the liquidity risks of its business under normal conditions and then exceeds them with increasing frequency, it might be experienc-ing a subtle, though growing, liquidity problem. The LC should analyze the nature, reasons, and trends to determine whether protective action needs to be taken.

An associated point suggests that limits must be effective in constrain-ing a firm’s risk, regardless of the amount of financial resources available. If limits are too large, they will fail to constrain a firm’s exposures prop-erly; when they are smaller and exceeded from time to time (with prior approval), they increase awareness and elevate discussion.

Forward commitmentsand contingencies

Maximum of x$ per future time horizon

ConcentrationMaximum of x% or x$ of forwardcommitments and contingencies

Credit qualityMaximum of x% or x$ of forward

commitments and contingencies perrating category

Figure 9.7 Forward commitment and contingency limits


Other safeguards

In addition to the formal matrix of limits presented above, firms can use other tools to manage their liquidity exposures. Some of the most useful are the defensive interval (minimum survival period), reserves, mark and model verification, penalties, and external relationship management.

Defensive interval (minimum survival period)

We have noted earlier in the book the concept of the defensive inter-val (and the somewhat narrower liquid coverage ratio described in Chapter 8), which can be considered as a minimum survival period in a time of stress or duress. Though the interval can be defined in various ways, the most basic form is simply the difference between cash needs and cash sources, measured in terms of days. In other words, the interval is the portion of cash (or liquidity buffer) that covers cash outflows on day 1, day 2, day 3, and so forth, without any additional actions being taken. By expressing the interval in time, rather than monetary value, a company gets a good view of the amount of time it has before it runs into problems. The idea of taking no further actions is important in this measure as it is realistic to assume that in the midst of either an endog-enous or exogenous liquidity event, a firm will have less flexibility or manoeuvrability.

Comparing the liquidity buffer with expected net cash outflows pro-vides an easy read on the state and direction of the defensive interval. A sampling of these states is highlighted in Table 9.1. An examination reveals the obvious: increasing the liquidity buffer and/or decreasing net cash outflows improves a company’s defensive interval.

The defensive interval can be used as a control measure by ensur-ing that the firm maintains cash on hand sufficient to cover outflows over a defined period that might be agreed by the board and executive

Table 9.1 The liquidity buffer, net cash outflows and the defensive interval

Liquidity Buffer Net Cash Outflows Defensive Interval

↑ → ↑ ↑ ↓ ↑ → ↑ ↓ → ↓ ↑ ↓ → ↓ ↓ ↑ ↓

216 Liquidity Risk

management, such as 15 or 30 days. Indeed, depending on the structure of its stress scenario process, it may wish to calibrate the defensive inter-val limit with a specific scenario, e.g., minimum 180 days interval for a normal scenario, 120 days for a mild scenario, 90 days for a serious sce-nario, and 30 days for an extreme scenario.

Reserves

Firms often establish ex-ante reserves in order to cover possible sur-prises from financial and operating risks. This is considered prudent behavior, as no firm can be completely certain that it has accounted properly for all of the financial, operational, legal, and regulatory variables that impact business. Establishing reserves by reallocating a portion of current earnings allows a firm to build a buffer against unexpected cash flows. In most jurisdictions, additions to reserves must follow strict accounting rules that dictate when funds can be reallocated or released in support of a particular loss or cash outflow. By enforcing such rules, authorities attempt to minimize instances of financial “smoothing,” or earnings manipulation . Some jurisdictions follow a more liberal approach and permit the establishment of hidden reserves through undervaluation of assets; these are not necessarily identifiable on the balance sheet, so their existence and use may be uncertain to outsiders. Reserves can therefore be viewed as pre-loss financing to cover an unexpected cash flow, an expected future liabil-ity, or a shortfall arising from an asset disposal. Rather than having to secure specific funding for the eventuality, the reserves can be funded in advance of actual need as a form of self-insurance and drawn down as required. However, they must be considered a relatively small part of total funding or cash-generating requirements; accounting rules do not generally permit a company to reserve excessively for contingent events.

Mark and model verification

Ensuring that balance sheet and off-balance sheet items reflect correct economic value is another important aspect of the liquidity control process. There is little point in creating a limit framework based on the amount of cash that can be generated through assets or contingencies if the assigned values are not accurate. For instance, the firm that val-ues its portfolio of investment securities at $100 million when they are actually worth $90 million, or the unencumbered factory at $1 billion when it is actually worth $800 million, is creating a false picture of its access to liquidity. Accordingly, management, working through the LC, internal accountants, and external auditors, must enforce proper


valuation of all assets and contingencies, and thoroughly question any discrepancies. This exercise is particularly critical for any contract that lacks a transparent market (such as certain derivatives, structured notes, and securitizations). All models used to value complex risks or portfolios must be independently vetted and benchmarked before being employed in the valuation process; this can help minimize instances of error.

We re-emphasize a caveat presented in the last chapter: due care must be taken when using models to measure, value, and manage liquidity risks. Although good models are helpful tools, false comfort must not be derived from a process that is likely to be imperfect, and subject to instability and change in the face of stress. Care must also be taken regarding supervisory approval for models. While banking regulators often review and approve market and credit risk models – and, by exten-sion, the embedded liquidity risks – such approval cannot be taken as a sign that all is well. Flawed models – coupled with inexperience, posi-tive feedback trading cycles, and systemic risks – can exacerbate liquid-ity pressures, a lesson learned by many during the 2007–2008 financial crisis.

Penalties

Behaviors can be shaped through the use of incentives and penalties. Incentives are well established in the corporate world: businesses and managers that exceed their revenue targets and performance goals are rewarded through higher compensation and ancillary benefits. Penalties are not necessarily as common, but they can be extremely useful in help-ing a firm achieve a particular set of goals, such as the preservation of adequate liquidity. By creating well-designed and specifically targeted penalties, executives motivate managers to help the firm protect its liquidity.

For instance, we have noted that the amount of aged securities held for resale on a bank’s balance sheet must be minimized. Portfolios of securities that cannot be sold at, or near, carrying value for 60 or 90 days are clearly not valued correctly; those that are not being resold must be marked down to the clearing level and sold, or should attract aging penalties. A bank discovering that a portfolio of supposedly liq-uid securities remains on its books after 90 days can levy on the man-agement team responsible for the position a charge equal to a certain percentage of the outstanding balance; the charge detracts from that business unit’s revenues, and will result in lower year-end compensa-tion for those responsible for managing the unit. Once sold, any aging charges that have been accumulated can be credited back to the unit.

218 Liquidity Risk

Through this process, managers have incentives to find proper clearing levels for the assets (or create mechanisms, such as securitizations, to sell the assets).

Similar penalties can be applied to corporate trade receivables that are constantly lengthening and are not being actively collected, or off-balance sheet financial contracts that absorb too much “emergency” funding as a result of improper coordination between originators and the treasury/funding department. Naturally, if penalties are to be effec-tive, financial controllers responsible for tracking assets must be dili-gent about the process, and management must be strict in enforcing discipline.

External relationship management

While the management controls we have cited immediately above relate exclusively to the manner in which a firm handles its internal operations, external relationships are another important element of control. Since micro funding needs and the macro funding environ-ment change continuously, a firm must make certain that it regularly

Liquidity risk controls

Policies

Procedures

Asset liquidity controls

Funding liquidity controls

Joint liquidity controls

Off-balance sheetliquidity controls

Other safeguards

Reserves

Mark/model verification

Penalties

Relationship management

Figure 9.8 Liquidity risk controls


evaluates its funding program and makes relevant adjustments. It should develop new financing relationships in order to create future flexibility. Perhaps more importantly, it should remain constructive in its relationships with current lenders and investors. Funding rela-tionships are built atop strong confidence. A firm has to have strong communications with its key stakeholders, including debt investors, lenders, equity investors, and regulators. By ensuring that these rela-tionships are mutually beneficial and productive, a firm increases its ability to source funds on favorable terms when it needs them, and gains the confidence of the regulatory community. Lenders and debt investors, in particular, must feel that the firm is in command of its financial risks generally (and liquidity risks specifically). The firm that neglects these stakeholders might ultimately find that its funding access is curtailed during difficult times. 8 Managing these relation-ships closely in good times is thus a prudent form of ex-ante “qualita-tive” risk control. Ensuring that this group is also advised on a timely basis of potential problems or complications is equally important; investors and creditors that feel like they are in the information flow, learning first-hand about issues, may be more inclined to help solve a future problem.

Figure 9.8 summarizes the firm-wide liquidity risk controls we have described above.

Liquidity Risk Monitoring

Active management of liquidity through the framework of controls pre-sented above is only possible with proper monitoring capabilities. Indeed, there is little point in attempting to manage liquidity risk if no mecha-nism exists by which to monitor and report on the results. The moni-toring process, which depends heavily on proper technical capabilities, should focus on asset and funding portfolios, off-balance sheet contin-gencies, the forward balance sheet, stress scenarios, and general indica-tors; where relevant, information and data should be compared against any limits that have been established.

Note that the technical dimension of the exercise should not be under-estimated. In a complex, global organization, access to timely, high-quality data to support the categories below can be an expensive and time-consuming effort to implement. For some industries, such as the financial sector, this type of technological infrastructure is an absolute requirement, and access to real-time (or near real-time) data is increas-ingly important. Nevertheless, when we consider the consequences of not

220 Liquidity Risk

being able to properly monitor the liquidity position, it seems a relatively small price to pay.

Asset and funding portfolios

Monitoring liquidity risk in the asset portfolios requires detailed informa-tion on:

the maturity profile of assets, especially those coming due over the ●

critical 1 to 30 day period (in value amounts) large or concentrated positions (value and percentage of assets) ●

aged positions (value and percentage) ●

“problem” assets (such as uncollectible receivables, bad loans, other ●

non-performing assets) (value and percentage) unencumbered assets (value and percentage) ●

encumbered assets (value and percentage). ●

Monitoring in the funding portfolios centers on:

the maturity profile of liabilities, particularly those coming due over ●

the critical one-month period (value) committed, undrawn credit facilities (value and percentage of ●

funding) large and concentrated funding positions (by market, product, lender, ●

region) (value and percentage) status of trigger events (such as leverage, working capital, net tangible ●

asset covenants) that could lead to cancellation of facilities status of accounts payable terms ●

spreads on short-term funding instruments (such as CP, ECP, and ●

deposits).

The two broad portfolios should also be reviewed and monitored in a com-bined manner. Joint review of asset and funding portfolios (for instance via gaps or NFRs) can reveal the existence of mismatches (related either to cash inflows/outflows or maturity/duration variations). Other portfolio measures, such as VAR and LAVAR, should be reviewed when relevant. The asset and funding positions of the firm should be monitored on a regional, business unit, legal entity, and consolidated basis; this will pro-vide information on whether sufficient cash flows exist within regions and entities, or whether any concerns exist regarding blocked funds or upstreaming/downstreaming. Where relevant, the reported values should be compared against limits that have been established by the LC.


Off-balance sheet commitments and contingencies

Off-balance sheet items must be monitored carefully, particularly liabili-ties that might require future funding; since the contracts do not appear on the balance sheet, are unpredictable with regard to value and tim-ing, and can be difficult to interpret, there is a risk that future liquidity demands might be overlooked, leading to one of the cash flow surprises we referenced in Part I. Monitoring should be detailed enough to reveal cash inflows and cash outflows arising from:

option exercises and other derivative contract settlements ●

revolving credit draw-downs ●

lease payments/cancellations ●

guarantee and standby letter of credit receipts or payments ●

contingent receipts or payments (including recourse participations). ●

Forward balance sheet

Although monitoring the forward balance sheet is a mix of actual, prob-able, and unlikely, it can reveal important information about future cash inflows and outflows. The construction of the forward balance sheet is based on assumptions regarding events that might or might not occur, meaning different degrees of conservatism may be applied. For instance, reporting may include scenarios that depict cash flows and balance sheet items based on 100 percent, 75 percent, 50 percent, and 25 percent prob-ability of exercise, draw-down, or triggering of the contingent event. Alternatively, a firm may choose to segregate contracts that are certain to come into effect at some future point (that is, 100 percent probability), then weight all remaining contracts against an estimated market-driven likelihood of occurrence. In either case, the range of probability-driven scenarios provides a sense of the possible impact on firm-wide liquidity, and must be monitored.

Stress scenarios

Monitoring stress scenarios is the practical end-result of the measurement process described in the last chapter, and it helps a firm prepare for a cata-strophic event. A regular (i.e., monthly or quarterly) creation of prede-fined stress scenarios, such as those we have already described, can help reveal whether a firm’s liquidity profile grows more robust or fragile with the onset of improbable, though not impossible, events. Crystallizing such information through standard reporting allows the LC and manage-ment to take defensive action where necessary. As with forward balance

222 Liquidity Risk

sheet reporting, stress scenario reporting is based on a set of assumptions that might or might not occur. Despite this uncertainty, the nature of the firm’s liquidity profile under a stress event must be part of the monitor-ing process.

It is worth noting that construction of a forward balance sheet for monitoring purposes is different from creating one for stress scenario purposes. The former is a probability-weighted cash flow analysis, under normal market conditions, of transactions that are contractually in place (such as the draw-down of an existing credit facility, the consum-mation of the sale of certain assets, or the exercise of a purchased or sold option). The latter is a cash flow impact analysis of mild to extreme market scenarios. The two tools are complementary, but unique in the information that they convey. In particular, the stress scenario results are typically based on low-probability “disaster” events (such as a repeat of a 1998 or 2007–2008 market dislocation, placement of currency con-vertibility controls in an important local marketplace, freezing of capital within a country, destruction of a plant that is not adequately covered by insurance, severe credit downgrade by the rating agencies, or regula-tory changes prohibiting a legal entity from upstreaming cash to the parent); results must therefore be used and interpreted with caution.

General indicators

While many of the items we have discussed above form the core of a liquidity monitoring process, certain other financial and anecdotal mar-ket indicators can also reveal important liquidity information. A regular process of monitoring such indicators can be good corporate practice, and might even provide the additional reaction time that is essential in attempting to manage through a liquidity crunch.

● Growth in risk: a firm that is becoming riskier in its operations (whether from financial or operating risk) might be increasing its illiquidity should events move against it. For instance, the bank or company that assumes more market risk or credit risk might suffer greater losses in the event of volatility or default, and the losses might create additional cash flow pressures. ● Decline in asset quality: for financial institutions in particular, a marked decline in asset quality (measurable through past due loans, non-ac-crual loans, and other non-performing assets) might signal the need for greater credit reserves. The lack of income/cash flow from loan arrangements, together with any increase in reserves, can squeeze available liquidity. The same might be true, albeit to a lesser degree, with corporate receivables.


● Growth in assets: while most firms seek to expand their assets steadily in order to support increased production, a sharp spike in asset growth, particularly when it must be funded through short-term liabilities, can create liquidity pressures. ● Erosion of revenues/earnings: a firm that is consistently earning less than it projects, or that suffers outright losses, is no longer generating the cash flows it needs to fund operations. This can increase the demand on the funding program and decrease the amount of financing avail-able for future needs. ● Changes in financial terms/relationships: the financial terms and rela-tionships a firm maintains with its creditors, suppliers, and investors must always be monitored for signs of change. Any deterioration in financing terms can signal potential problems and must be addressed as a matter of priority. These can include changes in bank credit and/or trade/supplier terms (such as new security/collateral requirements, smaller facility/deal size, shorter maturities, and higher fees or rates), a decrease in correspondent bank relationships, a shrinking of the inves-tor base in short-term liabilities, and so forth. ● Increased withdrawals of short-term funds: any instance where a firm’s traditional short-term funding sources are withdrawn through explicit cancellation, early redemption, or lack of rollover must be treated very seriously. Although such withdrawals might be institution-specific or industry-wide, the ultimate impact is generally the same: increased short-term funding pressures. ● Increased market news/ rumors: in an age where information circulates freely and rapidly, a firm must monitor market-moving news and rumors continuously. Any information that reflects negatively on the company or its financial position must be addressed without hesita-tion (as we shall note in the next chapter); failure to do so can lead to a rapid escalation of problems, such as funding withdrawal or lack of rollovers. ● Changes in financial market measures: aspects of every public firm can be measured and monitored in the marketplace for change. This includes sensitive indicators such as credit rating watch status, credit spreads, and stock price. If a firm’s financial market measures are trending in a negative direction (for instance, falling stock price or widening credit spreads), the reasons must be ascertained as quickly as possible and defensive action should be considered. Steadily weak-ening financial market measures, whether or not they accurately reflect a firm’s operating state, can fuel negative press and generate market rumors; these, as we have already noted, can lead to the with-drawal of liquidity.

224 Liquidity Risk

Monitoring goals

Monitoring of assets, funding, joint cash flows, off-balance sheet commit-ments, forward balance sheet, and stress tests should reflect point-in-time snapshots to provide a current picture of liquidity status. These snapshots must be supplemented by trend information so that management can determine whether the firm is becoming more or less liquid over time. Information must also be specifically linked back to limits and the liquid-ity risk mandate, to ensure that the firm’s philosophy is being followed and resources are being allocated properly. This is an essential part of the “feedback loop” and informs directors and executives about the efficacy of the mandate.

The end result in any reporting endeavor should be the communi-cation of relevant and actionable information to directors, executives, and senior finance, risk management, and business management pro-fessionals with direct or indirect responsibility for generating or miti-gating liquidity risks. Information should reflect legal, business unit, and regional views to accommodate the needs of multiple users from a single source of data. The LC should take a leading role in designing information mechanisms and ensuring that the information generated becomes the basis for meaningful dialogue and action. The degree of reporting frequency and information granularity is likely to be institu-tion- and function-specific; in general, however, the LC should keep directors apprised of the firm’s liquidity profile, changes, and trends on a quarterly basis. Senior executives should be advised at least monthly, and more often as market circumstances warrant. Risk, finance, and business executives must review reports on a daily basis to ensure con-tinuous scrutiny of what will undoubtedly be a dynamically changing picture of cash flows.

Similar information must be provided to regulators and other key stakeholders (such as shareholders (via the annual and interim financial reports), lending banks, and rating agencies). 9 Information such as the overall liquidity governance framework, the general metrics used to meas-ure and control liquidity risks (including stress scenarios), the nature of the contingency funding plan, the status and availability of committed credit facilities, the approach taken to constructing the liquidity ware-house, and the state of key ratio measures (and associated compliance with any minimum requirements) can be of significant comfort and use to stakeholders and should be conveyed on a timely basis. Indeed, the firm that is willing to distribute more information instils confidence and builds stronger stakeholder relationships; the firm that opts for opac-ity and “black box” approaches may find it is cut off in times of crisis.


Assets Funding Off-balancesheet activities

Forward balance sheet

Stressscenarios

General indicators

Legal entity 1exposures, limits

Legal entity 2exposures, limits

Legal entity nexposures, limits

Region 1exposures, limits

Region 2exposures, limits

Region nexposures, limits

Business unit 1exposures, limits

Business unit 2exposures, limits

Business unit nexposures, limits

Consolidated viewexposures, limits

Summary information for stakeholders

Figure 9.9 Dimensions of liquidity monitoring

Figure 9.9 summarizes the spectrum of liquidity monitoring that a firm may consider in its operations.

Technical capabilities

As noted, monitoring and reporting of liquidity risks is only possible in the large organization with the proper technological infrastructure. Liquidity risks that can appear across business, product, legal, and/or geo-graphic divisions must be captured within a robust data management and technology environment. This demands a uniform mechanism for the collection and aggregation of data, along with the ability to use that information to measure risks and project stress scenarios. Specific modules are needed to report on ledger balances, fails, contract settlements, cash inflows and outflows, loans, placements, and other funding activity.

Technical capabilities must be sufficient to produce quality informa-tion in a timely manner. Executives using the information to manage the firm must have confidence in the integrity of the results and must be able to access the data quickly. This is particularly true in a crisis

226 Liquidity Risk

situation – a firm’s leadership cannot afford to discover that key informa-tion is missing from the reporting process, or that the aggregation of data is delayed. Indeed, high-quality, intraday data access is becoming increas-ingly important. Investment in the technology that permits effective reporting must be considered a worthwhile use of corporate resources, as it may help avoid more serious problems in the future; this is particularly true in instances involving crisis management, as we discuss in the next chapter.

227

10 Liquidity Crisis Management

A firm operating under normal market circumstances will be able to rely on its mandate, policies, and limits to control the liquidity expo-sures inherent in its business. If these mechanisms are structured prop-erly and followed diligently, the financial impact of the exposures should remain manageable. However, as noted in the last chapter, there may still be instances when endogenous or exogenous factors overwhelm the firm, giving rise to the possibility of greater financial problems and even instances of financial distress. In such extraordinary cases a firm must immediately commence its liquidity crisis management program. For instance, if during “good times” the company’s goal is to maximize earn-ings, we can see how the goal changes as the liquidity situation deterio-rates: in a mild crisis the focus turns to obtaining additional funding at a reasonable cost, in a serious crisis it might change to obtaining additional funding at any cost and implementing additional defensive measures, and in an extreme crisis the focus is to take any and all actions that can ensure survival – including the points we describe below. Any thought of maximizing earnings is temporarily abandoned during the crisis phase.

A successful crisis management program allows a company to deal with the dislocation and eventually normalize its operations at a minimum of cost; an unsuccessful program – or indeed the lack of any program at all – can lead to complications including, in the most dire circumstances, liquidity spirals and insolvency. In this chapter we consider the scope and focus of liquidity crisis management, ex ante market access, defensive measures, communications, trigger events, disaster recovery, and plan testing.

Scope and Focus

Although liquidity crisis management is institution-specific, crisis pro-grams typically have the same end goals: ensuring sufficiency of cash


228 Liquidity Risk

to continue operating, and limiting reputational and financial damage so that operations can be normalized as quickly as possible. A crisis pro-gram formalizes a firm’s objectives with regard to sourcing, managing, and maintaining liquid assets and funding during a stress period. In most cases this can be accomplished by focusing on three broad areas:

● Ex-ante market access Defensive measures ●

Communications. ●

We consider each of these, independently and in light of general dis-aster recovery and contingency plan testing, at greater length below. Before doing so, however, it is important to review overarching scope and focus.

A crisis management program should serve to protect a company dur-ing difficult times. The essential point is for the firm to accumulate and preserve enough cash to continue operations. Prioritizing actions and modifying behaviors can help accomplish this goal. Accordingly, a proper program must be developed in advance of any dislocation; history has demonstrated that simply reacting to a crisis on an ad hoc basis as events unfold is unlikely to be successful. That said, every crisis is unique in some way, so some degree of “reactive flexibility” must be built into the plan, allowing for adjustment or “fine tuning” of the existing plan as events unfold. If every aspect of a plan is followed in a perfectly strict and rigid manner, mistakes may be made or opportunities may be lost.

Although a crisis plan is generally driven from the top down and is a reflection of a firm’s consolidated liquidity needs, there are instances when separate plans have to be created for individual operating units in order to deal with specific needs, issues, and restrictions in the local envi-ronment. If this is necessary, plans must still be properly coordinated; we have already noted that the liquidity position of one unit might have a significant impact on that of another unit, so coordination is vital.

Executives must drive the crisis management process as a priority – both in the development stage and in actual implementation. Directors and executives must lead the way in creating a plan, and should be ready to activate it when advised by senior financial officers. Once in motion, it must become the focus of their efforts, as survival of the company might depend on whether matters are handled decisively. As we shall note later, the program should be thoroughly tested in advance of use. Indeed, such “dress rehearsals” should be a matter of regular review to ensure that all processes function as intended and all variables related to market access, defensive measures, and communications remain relevant. Testing should

Liquidity Crisis Management 229

be comprehensive and include drawing down on backup revolving credit facilities, selling a portion of the liquidity warehouse, entering the repur-chase agreement market (where possible and relevant), issuing a tranche of long-term notes from an MTN program, preparing draft communiques for stakeholders, and so forth.

Effective crisis management relies heavily on clear “command and con-trol.” In normal operating conditions many managers are likely to be part of the liquidity risk management process, each contributing experience and expertise and enjoying a certain amount of authority. This is espe-cially true for firms that opt for a decentralized risk management process. During the crisis management period much of this delegated authority needs to be redirected towards a very small team that can keep tight con-trol of the process and guide human and financial resources as needed. In practice, a firm may find it beneficial to concentrate authority in a liquid-ity crisis management team (LCMT) comprised, for example, of the:

CEO or COO ●

CFO ●

treasurer ●

heads of relevant business divisions ●

head of risk management ●

head of operations/settlements ●

head of legal/compliance ●

Liquidity Committee (LC, that is, the professionals responsible for the ●

ongoing management of the company’s liquidity profile, as noted in the last chapter).

In addition, each member should have a designated “backup.” This small team should be able to convene quickly and coordinate all of the neces-sary actions on behalf of the firm. Indeed, the LCMT must be prepared to put in motion a time-sensitive plan that addresses, in order of priority, the specific tasks that need to be performed: those that must be completed within 24 and 48 hours, those that must be in place within one and two weeks, and so forth. As part of the command and control chain, a policy of temporary recentralization, discussed below, should be enacted.

A key element of the plan must center on financing alternatives. In order to fulfil the primary goal of cash sufficiency, the LCMT, through the treasury and finance groups, must be aware of the firm’s short- and medium-term cash flows, and how these can be accommodated dur-ing the crisis period. Indeed, we indicated in Chapter 8 that cash flows should be stress tested to see how they change during a crisis period; this is especially critical when optionable or cancellable liabilities form part

230 Liquidity Risk

of the funding plan (while this involves assumptions about the behav-ior of trade credit suppliers, investors, depositors, or lenders, “worst case” behavioral changes are often a worthwhile starting point in the analysis exercise). We have also noted that stress testing should incorporate assess-ments of asset pledge or disposal value that might be obtained during difficult times.

With information on anticipated cash flows in hand, a prioritized action plan can be developed and put into motion; importantly, every aspect of the plan must be clear and actionable. Although the plan will be institution-specific and evolve over time (as the firm’s business, market access, and cash flows change), an example might be as follows:

Modifying liabilities (such as drawing down bank lines even if not cur- ●

rently needed; extending maturities by, e.g., issuing MTNs or bonds; and reducing CP and other short-term debt) Suspending discretionary or non-essential cash outflows ●

Pledging assets from the liquidity warehouse or other accounts ●

Neutralizing other financial risks through hedging ●

Selling marketable assets from the liquidity warehouse ●

Reducing/slowing growth in other assets (for example, slowing new ●

business and shrinking the balance sheet) Reducing cash outflows and net working capital (to the extent possible, ●

without damaging business relationships irreparably) 1 Delaying capital investments and other discretionary “cash outflow” ●

investments Crystallizing off-balance sheet opportunities (such as securitization ●

and option exercises) Selling hold-to-maturity investments and non-strategic fixed assets or ●

business units Communicating actively with all internal and external stakeholders. ●

We shall consider several of these issues in greater detail below. We stress at this point, however, that fundamental restructuring of the corporate balance sheet can take time. The best time to do such a “clean up” is before, rather than during, a crisis. Accordingly, management must always be on the lookout for potential areas of weakness as part of the daily operations described in the last chapter. To be sure, changes can be made at the margin as needed during a crisis, though the end result may be greater short-term losses or enterprise value destruction.

It is worth noting that the plan framework noted above should be enacted for the consolidated group company so that there is a degree of centrali-zation and uniformity. However, in order to avoid instances of trapped liquidity or other legal barriers, each substantive legal entity within a


group should have its own version of the plan in place and ready to use. Coordination with headquarters should then follow as a matter of course.

Ex-Ante Market Access

A company experiencing a severe liquidity squeeze must be prepared to take all actions that will help ensure its survival. This means it must be able to sell or pledge liquid assets, increase long-term liabilities (and pos-sibly short-term liabilities if this is the only viable option), decrease long-term assets, and defer non-essential cash flows. Each one of these actions demands proper access to markets.

From a liability perspective, a firm can develop appropriate ex-ante mar-ket access by making sure that its funding program is diversified, secure, and deep. Any program a firm creates should obviously be available for use during normal and crisis conditions. As noted in the last chapter, a firm must develop a portfolio of funding options that spans a variety of products, markets, and providers; this diversification helps ensure that the firm is not overly exposed to a single source of funds and can select from alternative products/conduits at any point in time. The funding pro-gram must also be secure; a company entering into a difficult financial period cannot afford to discover that facilities it believes are committed are actually subject to cancellation or modification. Finally, the funding program must be deep enough to give the firm access to the resources it requires under a variety of stress scenarios. Creating a diversified and secure funding program that accounts for only a fraction of what might be required in difficult times will do little to avert more significant prob-lems; the program must be large enough to accommodate all of the cash outflows that might become apparent during market stress.

From an asset perspective, a firm creates ex-ante market access by estab-lishing a liquidity warehouse that is specifically isolated from the rest of its corporate operations; this decreases the likelihood that a firm will have insufficient cash access during times of crisis. Indeed, and as we already know, a properly structured liquidity warehouse reduces a firm’s reli-ance on the actions of short-term investors, depositors, or creditors – thus reinstating some amount of control within the firm itself. The liquidity warehouse is, of course, a partial drain on resources and will not contrib-ute in the short run to enterprise value maximization. Nevertheless, the warehouse can be viewed as a valuable liquidity option, exercisable in the event of a true financial dislocation. As we have indicated, the portfolio must be comprised of high quality, saleable instruments that retain their market value (particularly during flight-to-quality cycles), and should be appropriately diversified across obligors and markets. The liquidity ware-house should not be used as a “dumping ground” for unwanted assets, or

232 Liquidity Risk

“raided” and put to use in other endeavors (e.g., selling marketable securi-ties to invest in fixed assets). By following these simple rules, a firm ensures that the pool is available to generate cash through disposal or pledging precisely when needed, in an amount dictated by a true carrying value.

Defensive Measures

Recentralization

When a firm moves into a crisis management mode, the actions taken by the LCMT are defensive, meaning that recentralizing authority is advis-able. Any delegated authorities granted to those responsible for managing a business, product, or region (including the financial dimensions that gen-erate or absorb liquidity) should be temporarily revoked so that actions can be properly coordinated from the center. This does not mean that those managing businesses or regions cannot form part of the crisis management process; indeed, they must, as they are likely to be intimately familiar with important information that can impact the firm’s liquidity. And, as noted above, there may be instances where a legal entity within a group must take matters directly into its own hands in order to comply with local law/regulation. But, apart from such exceptional circumstances, their role must temporarily be limited to one of communication and guidance rather than action or decision making. The LCMT responsible for the process must use business and regional managers in any way necessary to see the firm through difficult times, but it must retain decision-making authority.

Funding management

In most instances the LCMT should expect to turn to the funding pro-gram as a priority; this is logical since the liability portfolio always provides the first line of defence in generating cash (apart from flows generated by core operations). Crisis-based funding management centers on prioritizing draw-downs, extending funding maturities, and suspend-ing non-essential cash flows.

Prioritizing funding draw-downs

A firm in a crisis mode must make every attempt to accumulate a suffi-cient cash buffer in order to carry on with its operations. Accordingly, it should be prepared to quickly draw down on its credit and funding facili-ties. The process begins by prioritizing funding access: a firm must deter-mine which facilities to access, when, and in what amount, in order to secure the cash it needs. This brings us back to a point we introduced in Chapter 3 regarding the differences between theoretical and actual amal-gamated sources of liquidity. Although the full complement of theoretical


sources of liquidity might be available and accessible to a firm during normal market conditions, only the actual sources of liquidity that are still available matter when a crisis strikes. From a liability perspective, the firm’s contingency program should discount, heavily or completely, any theoretical funding sources that are likely to disappear during stressed market conditions; funding prioritization should exclude liquidity sources that are not absolutely undoubted.

In most crisis situations a firm is unlikely to call on all of its pre-ar-ranged financing facilities simultaneously, meaning it must prioritize draw-down. Prioritization might be a function of a firm’s relationship with lenders/investors, its desire for a particular type/class of funding (such as floating versus fixed rate, senior versus subordinated, onshore versus onshore, domestic versus foreign currency), its access to intrac-ompany or group funds, and its need for specific maturities (as noted immediately below). It might also relate to the relative cost of access, the total amount of funds available in a market or product, and the speed at which funds can be accessed. (In fact, a firm must be extremely sensitive to the notification period required for draw-down, as certain facilities/products incorporate multi-day delays; crucial time might therefore be lost.) Regardless of the specific criteria used, the important point is for the LCMT to implement a clear road map regarding funding draw-downs. Box 10.1 provides a simplified illustration of such a road map. (In prac-tice the road map is likely to be much more extensive and detailed and include amount, rate, and currency draw-down options based on remain-ing availability, investor appetite, market levels, the shape of the yield curve, and so forth.) Once prioritized, funding should occur automati-cally via the treasury or finance department, so that no time is wasted.

Extending liability maturities

When a firm enters a crisis mode, it must attempt to reshape its funding profile. This generally means trying to replace short-term, credit/market-sensitive liabilities with longer-term funding. From a practical perspective this may involve drawing down 6- or 12-month bank revolvers, and issu-ing two- or three-year MTNs or EMTNs, while allowing 7-, 14-, or 30-day CP and payables to roll off. In a normal positive yield curve environ-ment, this will lead to an immediate rise in funding costs, and a resulting decrease in enterprise value. Nevertheless, it is an important defensive measure that relieves short-term funding pressures that are so often the source of major liquidity problems. Of course, it is not always possible for a firm in a crisis mode to term out its funding; medium-term capital (via the loan or capital markets) might be relatively scarce unless stable, ex-ante arrangements are in place. Where possible, however, a firm should attempt to extend maturities.

234 Liquidity Risk

Box 10.1 Summary funding draw-down road map

Company ABC: contingency funding priorities

Bank XYZ facility ■ $100 million, three-year, fixed rate ■ $100 million, five-year, fixed rate

Bank ABC facility ■ $100 million, five-year, floating rate, swapped into fixed rate

MTN program ■ $200 million, two-year, fixed rate

EMTN program

■ €300 million, three-year, fixed rate, 50 percent remaining in €, 50 percent swapped into $

Bank TUV facility ■ $300 million, seven-year, fixed rate

Private placement ■ ¥10 billion, three-year, private placement, floating rate

Suspending cash flows

When preserving cash is an overriding corporate goal, non-essential cash outflows must be suspended. Discretionary payments that can safely be eliminated, postponed, or reduced without damaging enterprise value or reputation should be curtailed as a matter of priority. During the pre-crisis planning stage, the LCMT should obtain information on the firm’s near and medium-term cash flow commitments, segregated into discretionary and non-discretionary components. Non-discretionary cash flows typi-cally give a firm little flexibility; in most instances these are contractual cash flows associated with planned investments, capital expenditures, raw material/resource acquisition, debt and lease servicing, and so forth, and cannot be suspended. Discretionary flows, in contrast, allow a firm to manage cash in relation to the current financial position. If a firm can curtail a previously planned investment or capital expenditure, or if it can quickly close down a business unit with negative cash flows, it must consider doing so. Cash that can be preserved while in the crisis mode strengthens the overall financial position during a critical time period.

That said, a firm should minimize or avoid any actions that might permanently impair enterprise value or reputation. For instance, even if


a contract allows a firm to cancel a long-standing project with another partner, due consideration must be given to whether this is the best course of action; cancellation might damage the relationship and jeop-ardize future business opportunities. Equally, the suspension of divi-dends on common stock or non-cumulative preferred stock, although a cash saving measure, is generally a drastic action that sends a negative signal to the investment community. While cash is preserved, dividend suspension can cause the value of the firm’s stock to drop and remain depressed for an extended period of time. The costs and benefits must therefore be thoroughly analyzed before any decision is taken by execu-tive leadership (including board directors, who are typically responsible for dividend policy).

Asset management

A firm in a crisis mode must still fund its assets in order to remain a viable operation. That said, the program must focus on opportunities to decrease the amount of assets requiring funding: that is, reducing, or deleveraging, the balance sheet. While shrinking the balance sheet dur-ing a crisis is not necessarily the easiest course of action (as at least some companies have discovered in the past), there are instances where it can be done successfully, at a minimum of cost. The strategy must therefore at least be explored.

While liquid assets that are coming due can be allowed to roll off, sold at carrying value, or pledged against new funding, and are thus unlikely to present a problem, less liquid assets that are only marginally produc-tive might represent an unnecessary funding burden. A company should identify, on an ex-ante basis, assets that can be sold during a crisis phase in order to relieve associated financing pressure. The same applies to new business: if a firm actively generates receivables or inventories as an ele-ment of its operations, it may wish to reduce business, and the assets that are generated, in order to temporarily decrease its funding require-ments. Business levels can be rebuilt once the crisis has passed and the firm is in a better position to finance its portfolio of less liquid, or illiquid, assets (including those with less attractive returns). Naturally, decreasing earning assets, even temporarily, must be handled with care, as these are the very investments, receivables, inventories, and plant and equipment that generate a firm’s enterprise value. If the process is handled improp-erly, it might be difficult and expensive for a firm to recover value once the liquidity crisis has passed. Note that the same consideration must be given to off-balance sheet contracts; where these have the potential to result in cash outflows, they should be reduced.

236 Liquidity Risk

Risk hedging

In Part I we noted the close relationship that exists between on- and off-balance sheet credit, market, and liquidity risks. It is generally true that a firm that is heavily exposed to market and credit risks directly or indirectly generates a significant amount of liquidity risk. Accordingly, one of the most important defensive moves of any crisis management program centers on neutralizing, or minimizing, the credit and mar-ket risks impacting the business. By doing so, a firm reduces the chance that its liquidity profile will be further pressured in the event of new or incremental risk challenges. This is especially true when we consider sys-temic dislocations, which can produce a larger amount of credit failures/defaults and asset flight-to-quality. A firm’s crisis management program must therefore focus on the nature of market and credit risks at the time the crisis plan is invoked, and determine which can be hedged through offsetting transactions or derivatives in order to ease cash flow pressures.

Communications

Information voids can be extremely damaging and actually exacerbate a negative situation, meaning external and internal communications are vital. From an external perspective, stakeholders that have a vested inter-est in a company, its financial condition, and future prospects, need to be kept apprised of developing events. This is particularly true with credit-sensitive relationships when the spectre of default might be increasing. Accordingly, the contingency program must include robust and effective external communication mechanisms. Management must take steps to ensure a regular flow of information to debt and equity investors, lenders, regulators, credit rating agencies, and the financial media at large, and to accept and respond to inquiries as soon as they are received. Particular attention must be paid to regulatory queries. Stakeholders who receive timely and detailed information directly from a company on its financial status and plans are less likely to create, or fall victim to, rumors and sen-sationalized accounts of problems – which, as we have noted, can inten-sify liquidity pressures and even fuel liquidity spirals.

Communicating internally is equally important. Employees and man-agers that drive a firm’s business do not want to learn about potential problems through rumors or gossip; they have a vested interest in the firm by virtue of their status as employees (and often shareholders) and must be given relevant information about the state of affairs during the crisis period. But communication must flow towards management as well. Managers operating business units or regional offices often have valuable and unique information regarding the firm’s condition that may affect


its ability to manage the situation; mechanisms such as daily conference calls or message repositories must be established to ensure that the infor-mation is delivered to the LCMT on a timely basis.

Invoking and Terminating the Program

A crisis management program should be invoked through a process built around objective triggers from external measures and subjective input from executives and managers. A firm must identify early warning meas-ures that reflect changing liquidity circumstances; these should be supple-mented by anecdotal evidence from the marketplace and management’s interpretation of such facts (such as difficulties with rollovers, widen-ing spreads, reluctance by lenders to renew long-term facilities, increased reliance on brokers to source funds). Early warning measures should be agreed in advance by executives and the financial controllers responsible for compiling statistics, and should form part of the regular monitoring process detailed in the last chapter. When the objective measures are trig-gered, or reach pre-defined warning thresholds, the LCMT must quickly obtain supplemental qualitative information from the marketplace on the nature of the liquidity disruption or pressure. The combination of objective and subjective inputs should be sufficient for authorized parties to determine the need to invoke the program. It is important that the process be sufficiently automated that response can be quick, but not so automated, or bereft of human judgment and experience, that it becomes a rote exercise that is subject to misinterpretation or misuse.

Terminating a crisis program should also be a defined event. The LCMT should use the same ex-ante early warning measures noted above to determine whether the firm is poised to return to a normal operating environment – one where it can safely devolve duties back to the line/region, rebuild business, replenish the liquidity warehouse, reshape fund-ing maturities, strengthen the balance sheet, and so forth. The process can again consist of objective metrics, such as a return to the liquidity risk measures that existed prior to the crisis, along with subjective input and analysis from market sources, investors, and lenders. In practice this might take one or two quarters to achieve; lender and investor confi-dence – as reflected through credit spread movements, ease of rollovers, and access to fresh funds – is unlikely to occur in a matter of days or weeks, particularly if the firm has been through a wrenching event. Once the crisis program is terminated, the LC and internal/external auditors should examine it in detail to determine whether there are any points of weakness or areas for improvement. Adjustments should be made to the program in advance of any future re-enactment.

238 Liquidity Risk

We note from the discussion above that a company that is attempting to defend, and ultimately rebuild, its liquidity position whilst in crisis management mode has at its disposal a number of tools. Let us combine all of this material in a simple example. Assume, for instance, that a mid-size industrial company is trying to defend its cash position after posting several years of losses and being presented with some unex-pected legal payments. The company’s market indicators begin to reflect a weakening (e.g., lower stock price, wider credit spreads), and at least two large institutional investors in the company’s debt have indicated that they may be reluctant to roll over their obligations when they come due. With management aware of the serious nature of the situation and the growing liquidity squeeze, it gathers its crisis team to enact a con-tingency plan developed some years earlier. Since its immediate interest is in preserving cash so that it can continue to fund its core business operations, the crisis team issues the following directives to its respon-sible line managers:

Sell unused raw material back to suppliers to both minimize financing ●

costs and to raise immediate cash Review accounts receivable and take aggressive collection actions with ●

regard to any delayed or delinquent accounts Analyze accounts payable and deal with suppliers to obtain better ●

financing terms Pool cash from its various divisions into a central hub where move- ●

ment can be more effectively tracked Postpone discretionary, non-essential investments/projects that absorb ●

cash Reduce expenses through quick, aggressive and disciplined cost ●

cutting Sell non-essential capital assets ●

Rationalize business/product lines that are cash-flow negative ●

Engage in sale-and-leaseback deal on corporate headquarters ●

Draw-down on committed bank facilities ●

Extend maturities on short-term liabilities out to the medium-term as ●

the markets allow Communicate details of the liquidity plan to key lenders and select ●

institutional investors, as well as its suppliers, key customers and the credit rating agencies.

Each of these actions can help put the company in a stronger liquid-ity position. To be sure, some can be enacted within days, while others may take several weeks (or even months) to complete. However, all have


the end goal of shoring up liquidity. Once this occurs, the company can “stand down” from crisis mode and will be able to resume its normal core operations – hopefully expanding business in a prudent, focused, and profitable manner.

Disaster Recovery

In an era where institutions rely heavily on technology to manage their businesses, it is important to ensure that appropriate disaster recovery plans are in place. Such plans typically center on establishment of remote business locations, computer, network, and data redundancy, and com-munications backup. In order not to jeopardize business opportunities, franchise value, financial commitments, or reputation, a firm must be able to resume its business without pause in the event it becomes the sub-ject of a catastrophic disaster that interrupts normal operations. Indeed, the topic is so important that the entire discipline of disaster recovery is taking hold in the corporate world, and more firms are engaged in seri-ous consideration, design, and implementation of disaster recovery plans. While these plans are typically broad-based and intended to cover the widest possible scope of corporate operations, the very liquidity contin-gency plan that a firm develops must form a leading part of the exercise. While cash access is always vital, it becomes even more vital during a disaster: cash availability in the midst of general or specific disruptions must be undoubted. If a firm can arrange its liquidity program so that it has simple, efficient, and secure access to funds as it attempts to cope with other operating interruptions caused by a catastrophic event, then it mitigates a risk that might otherwise create financial distress. This is especially true when a disaster is broad, impacting an entire sector, coun-try, or system.

Testing the Plan

The time to determine whether a crisis management plan is working as anticipated is not in the midst of a company-specific or sector-wide crisis, but before it is required. Accordingly, a firm’s contingency plan must be tested during normal market conditions to ensure that all aspects func-tion as intended. Testing should be comprehensive, covering all parts of the plan outlined above, including market access, funding, hedging, and other defensive measures, as well as internal/external communications. Simulated events should be conducted in order to determine whether responsible parties are effective in managing their portions of the contin-gency plan, communicating with others, and directing resources. Such

240 Liquidity Risk

“dress rehearsals” can demonstrate vulnerabilities and reveal areas for improvement – in advance of an actual crisis.

Part of plan testing should also focus on real-life exercises, such as drawing down bank facilities, issuing new CP, selling a portion of the investment portfolio, and so forth. Indeed, actually drawing down bank facilities that serve primarily as a backup is a sensitive topic. Some firms are loath to do so, even in a “trial mode,” as they are reluctant to send the wrong signal or have use of the facilities misinterpreted. However, since backup lines are such an essential component of the contingency plan, they must be tested periodically. No stigma should be attached to draw-downs of backup or emergency revolvers – firms must be able to test their facilities without sending a negative signal. Similar testing should

Liquiditymanagement

Liquidity commitee

Disasterrecovery

Plan testing

Development ofcrisis management plan

Invokingcrisis management plan

Terminatingcrisis management plan

Post-crisisaudit and improvements

Defensive measures Communications

Establishingpriorities

Designatingcrisis team

Liquiditymanagement

Liquidity commitee

External

Internal

Objectivemetrics

Subjective input

Recentralization

Funding management

Assetmanagement

Risk hedging

Ensuring exante access

Figure 10.1 A liquidity crisis management program


occur via the issuance of short and medium-term notes, the sale of small portions of the liquidity warehouse to test asset prices, and so forth.

While standard liquidity policies and procedures are likely to be used in the normal course of a firm’s business, it should be clear that advance preparation of a crisis program is an important part of prudent risk man-agement. A firm can manage through a crisis situation with greater ease if it has a robust contingency plan in place.

Figure 10.1 summarizes aspects of the process discussed above.

242

11 New Regulatory Initiatives

We have mentioned throughout the book various issues related to the financial crisis of 2007–2008, including deep and widespread losses, weak risk management and regulatory practices, and institutional and systemic liquidity dislocations. In fact, the financial crisis was so destructive, on so many levels, that it has caused many to consider what went wrong and how such financial destruction might be avoided in the future. To be sure, detailed discussion of “lessons learned” is beyond the scope of our theme; the brief summary at the beginning of this book touches on the issues related to liquidity risk, but the crisis was far deeper and broader.

Any objective review of the crisis reveals the fact that whilst financial institutions were the primary cause of, and transmission mechanism for, the crisis, regulations in existence at the time were inadequate to properly control institutional or systemic risks, including those associated with liquidity. Most regulations were either non-existent or too “high level” to be effective. It is not surprising, therefore, that a number of regulatory initiatives have been proposed, reviewed and promulgated since the end of the crisis; some of these have been central to the risk management topic generally, and to liquidity risk management specifically. A number of these initiatives are worth exploring in greater detail, as they build on material from previous chapters and chart a future course for liquidity risk management. Though our intent in the book has been to keep the topic of liquidity risk management general so that it is applicable across a mul-titude of industries and sectors, we must, for obvious reasons, narrow our focus slightly in this chapter to concentrate on the regulatory initiatives that are being applied to financial institutions. In particular, we consider liquidity-focused measures put in place under Basel III (global banks), the Dodd-Frank Act (US financial institutions), BIPRU 12 (UK financial institutions) and Solvency II (EU insurers); we also consider some addi-tional “best practices” put forth by the European banking supervisors. Note that in the interest of space we include only summary discussion of


New Regulatory Initiatives 243

the relevant points of each on these initiatives. Very detailed rulebooks should be consulted by those seeking precise formulae, descriptive list-ings and so forth; these sources are listed in the reference section of the book.

Basel III

Some of the most important new liquidity rules are embedded in Basel III, the supervisory rules developed by the Basel Committee on Banking Supervision (BCBS) which are devolved to, and enforced by, national banking authorities in participating nations . Previous iterations of the Basel framework have focused on prudent bank capital levels related to credit risk (via Basel I, 1988, now largely replaced by its successors), mar-ket risk (via the 1996 Amendment), and credit risk methodologies; capital levels for operational risk; and demonstration of robust risk management, capital allocation, disclosure and control processes embedded in bank-ing organizations (via Basel II, 2004) . While each successive iteration has been designed to increase the strength and stability of both banks and the banking sector, each new crisis appears to highlight additional flaws. In fact, the financial crisis of 2007–2008 did just that, revealing gaps in the proper treatment of risk and allowing for regulatory arbitrage by mov-ing business off-balance sheet and into SPEs. The crisis also revealed the shortcomings of credit and market risk models that had previously been approved by national regulators.

In an effort to improve on these shortcomings, BCBS proposed a series of post-crisis amendments to Basel II (so-called Basel II.5) whilst working towards the broader set of rules ultimately contained in Basel III. The amendments, offered between 2008 and 2009, focused on such topics as incremental capital charges to trading operations and enhancements to market risk computations, amongst other items. Basel III has become the new version of the framework, with a focus on minimum require-ments for stress testing, new standards for bank capital adequacy based on both higher quality capital instruments and additional capital buffers (e.g., a mandatory capital conservation buffer and a discretionary coun-ter-cyclical buffer), a limit to maximum leverage through a prescriptive definition, and, of interest to our discussion, prudent treatment of market liquidity risk. It comes as no surprise that the major themes of Basel III are all related to weaknesses uncovered during the last financial crisis.

New liquidity measures

Though a full review of all aspects of Basel III is beyond the scope of our discussion, a focus on the liquidity elements is both manageable

244 Liquidity Risk

and relevant. In this section we consider the introduction of two new liquidity measures that must be instituted by all regulated banking insti-tutions, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR); the two ratios (along with the accompanying practices embodied in BCBS’s 2008 Principles for Sound Liquidity Risk Management ) are designed to ensure that banks maintain a sufficient amount of stable liquidity, so that individual institutions, and the marketplace at large, will not be as vulnerable during the next financial crisis. In fact, the cri-sis demonstrated that while most banks had enough capital, more than a few were at considerable risk because of rapidly forming liquidity pres-sures; the speed at which traditional funding sources disappeared was nothing short of remarkable.

Liquidity coverage ratio ( LCR)

We begin with a brief description of the LCR. This ratio is designed to promote a more robust handling of liquidity by requiring banks to pre-serve enough unencumbered high-quality liquidity assets (HQLAs, as described below) to meet a 30-day liquidity stress scenario. Naturally, the LCR on its own is only a minimum measure and is not enough, by itself, to guarantee prudent liquidity management. Other sound liquidity risk management measures we have described in earlier chapters (e.g., proper governance, monitoring, stress testing, limits, and so forth) must be part of the process. In order to allow for reasonable implementation, banks are allowed to phase in the LCR between January 2015 (60% compliance) and January 2019 (100%).

The basic LCR formula is given in formula (11.1):

LCRHQLA

Net CashOutflow= ≥ 100%

Where HQLA is the stock of high-quality liquid assets Net Cash Outflow is the total net cash outflow over 30 days; total net

cash outflow is computed as total cash outflows – min [total expected cash inflows; 75 percent of total cash outflows ] over the next 30 calendar days.

The formula thus indicates that HLQAs must more than cover net out-flows over a 30 day horizon. We describe HQLAs in more detail below and in the endnotes, but for the moment we define them as unencum-bered, low-risk assets that can be easily (and precisely) valued, which have low/no correlation with other risky assets, which are listed on a recognized exchange and that trade in an active/sizeable market. While this sounds like a rather formidable list of desirable characteristics (for


obvious reasons), perhaps the most practical test is that qualifying assets must be saleable or repoable in times of market stress without a haircut. In fact, the BCBS recommends banks monetize a portion of their HQLAs periodically to verify the pricing (which is consistent with the point we raised earlier in the book). Assets taken in on reverse repo or derivatives collateral can also be included in the HQLA, to the extent no rehypothe-cation has occurred; assets which are encumbered must, of course, be excluded.

Basel III distinguishes between assets in the HQLA, grouping them into 2 broad classes: Level 1 and Level 2. Level 1 assets – high quality and liq-uid, such as cash, bank reserves and government securities – can account for 100 percent of the pool and are not subject to a haircut under the LCR, though national supervisors preserve discretion on haircuts based on, among other things, their duration, credit and liquidity risk, and standard repo haircuts. 1 Level 2 assets – including lower-rated govern-ment securities, corporate bonds and covered bonds – can comprise up to 40 percent of the HQLA pool (after having received a 15% mandatory haircut). The second Level 2 group, Level 2B, can be included based on national discretion, up to a maximum of 15 percent of the HQLA pool; this sub-portfolio includes riskier instruments, such as mid-rated corpo-rate bonds and common shares. It is expected that regulators and partici-pating banks will approach this topic with care and that the decision to allow additional assets will be made only after confirmation that partici-pants have adequate systems and controls in place. Table 11.1 provides a

Table 11.1 LCR HQLA factors

HQLA Type Factor (%)

Level 1 assets Coins and bank notes Qualifying marketable securities from sovereigns, central banks,

public sector entities, multilateral development banks Qualifying central bank reserves Domestic sovereign, central bank debt for non 0% risk weighted

sovereigns

100

Level 2A assets Qualifying marketable securities from sovereigns, central banks,

public sector entities, multilateral development banks with 20% risk weighting

Qualifying corporate debt securities AA- or above Qualifying covered bonds AA- or above

85

Level 2B assets Qualifying RMBS Qualifying corporate debt securities A+ and BBB- Qualifying common equity

75 50 50

246 Liquidity Risk

summary of the LCR HQLA factors. Those with a factor closer to 100 per-cent are more liquid, and require less coverage, than those with a factor closer to 50 percent. The caps on maximum Level 2 and 2B assets help ensure a given bank overweights its HQLA portfolio with the best and most liquid assets.

Let us now consider the net cash outflow component of the calculation in more detail. Per formula (11.1) above, the total expected cash outflows are calculated by multiplying outstanding balances of liabilities and off-balance sheet commitments by the specified “run down rates”; the same occurs for inflows, albeit to a maximum of 75 percent (i.e., the cap put in place to ensure some modicum of conservatism). Although the run down rates are generally harmonized, some national discretion is still possible. For instance, the run down rate on stable retail deposits (e.g., those which are fully insured by a strong and prudent deposit insurance scheme) is assumed to be 3 percent, while the rate on those which are less stable increases to 10 percent. Foreign currency deposits are also assumed to be less stable than domestic deposits. Run downs on unsecured wholesale funding again vary based on the nature of the depositor: those from small business customers, which act similar to retail deposits, are set at 5 per-cent, while those from the far less stable clearing and custody business are as high as 25 percent.

Tables 11.2 and 11.3 provide a summary of the LCR cash outflow and inflow run down rates.

Placing this information in the context of formula (11.1), the total from Table 11.2 minus the minimum of either the total from Table 11.3 or 75 percent of gross outflows combine to form the denominator, while HQLA stock is the numerator.

The LCR needs to be reported to supervisors at least monthly, and more frequently as the need arises. The measure applies to all banks on a con-solidated basis, with home jurisdiction rules applying for cross-border entities. Indeed, cross entity liquidity pools cannot be counted in the HQLA computation if there is any reason to suppose that the free transfer of assets may be jeopardized or otherwise delayed.

Net stable funding ratio ( NSFR)

NSFR, the second of the Basel III liquidity ratios, is intended to ensure stability over the medium- and long-term by encouraging more funding through stable financing sources (i.e., less “hot money” and more term financing). Through its very construction NSFR ensures that long-term assets (e.g., loans) are funded with some minimum amount of stable lia-bilities – effectively discouraging too much reliance on short-term funds (and particularly those that are volatile). The relevant formula is given in (11.2):


Table 11.2 LCR cash outflow factors

Cash outflows Run down

rate (%)

Retail deposits Stable deposits (less than 30 days maturity) Less stable deposits (less than 30 days maturity) Term deposits

3–5 10 0

Unsecured wholesale funding Stable deposits by small business (less than 30 days maturity) Less stable deposits (less than 30 days maturity) Operational deposits from clearing, custody, cash management Cooperative network qualifying deposits Non-financial corporates, sovereigns, central banks, multilateral

banks, PSEs Non-financial corporates, sovereigns, central banks, multilateral

banks, PSEs covered by deposit insurance Other customers

5 10 25 25 40

20

100 Secured funding Secured funding transactions with a central bank or secured by

Level 1 assets Secured funding transactions backed by Level 2A assets Secured funding transactions with domestic sovereigns,

multilateral development banks or domestic public sector enterprises

Secured funding transactions backed by Level 2B RMBS Secured funding transactions backed by other Level 2B assets All other transactions

0

15 25

25 50

100 Other requirements Valuation changes on non-Level 1 assets posted as collateral on

derivatives Excess collateral held by a bank on a derivative that can be called

by the counterparty Liquidity needs related to collateral contractually due from the

bank on derivatives Increased liquidity needs related to derivatives that permit non-

HQLA collateral substitution Liabilities from maturing ABCP, SIVs, SPV s Asset backed securities applied to maturity amounts Undrawn committed facilities to retail/small business clients Undrawn committed facilities to non-financial corporates,

sovereigns, central banks, multilateral development banks, public sector enterprises

Undrawn committed facilities to regulated banks Undrawn committed facilities to other financial institutions and

other legal entity customers Other contingent funding liabilities for trade finance Other contingent funding liabilities for customer short positions Additional contractual outflows Net derivative cash outflows

20

100

100

100

100 100

5 10–30

40 40–100

0–5 50

100 100

248 Liquidity Risk

Table 11.3 LCR cash inflow factors

Cash inflows Run down rate (%)

Maturing secured lending Maturing secured lending transactions backed by

Level 1A assets Maturing secured lending transactions backed by

Level 2A assets Maturing secured lending transactions backed by

Level 2B RMBS Maturing secured lending transactions backed by

other Level 2B assets

0 15 25 50

Other maturing/credit transactions Margin lending backed by all other collateral All other assets Credit or liquidity facilities provided to bank Operational deposits held at other financial

institutions

50 100

0 0

Other inflows Receivables from retail counterparties Receivables from non-financial wholesale counter-

parties Receivables from financial institutions and central

banks Net derivative cash inflows

50

50

100

100

NSFRAvailable stable funding

equired stable funding= >

R100

Where Stable funding is defined as the amount of equity and liabilities expected

to be reliably available over a 1-year time horizon, under stressed condi-tions (where the stress centers on an increase in solvency risk coming from losses, a downgrading event or some other material event affecting operations).

From a technical perspective, the financing categories shown in Table 11.4 qualify as available stable funding sources by percentage weighting (i.e., the higher the percentage factor, the more stable the funding).

The amount of required stable funding is computed by examining the liquidity characteristics of a bank’s individual assets and contingencies. Not surprisingly, special focus is given to illiquid assets (regardless of how they are treated from an accounting perspective) and to the rel-evant portion of off-balance sheet commitments. Thus, the amount of


Table 11.4 Available stable funding factors

Funding Type Factor (%)

Equity capital (Tier 1 and Tier 2) 100Preferred stock with maturity in excess of 1 year 100Borrowings and liabilities with maturity in excess of 1 year 100“Stable” demand deposits or terms deposits with maturities under 1 year provided by retail or small business customers

90

“Less stable” demand deposits or terms deposits with maturities under 1 year provided by retail or small business customers

80

Wholesale demand deposits or term deposits with maturities under 1 year

50

All other liabilities 0

Table 11.5 Required stable funding factors

RSF Category Factor (%)

Cash Unencumbered short-term instruments with maturities of less than

1 year Unencumbered securities with remaining maturities of less than

1 year Unencumbered securities with an offsetting reverse repurchase

transaction Unencumbered loans to financial entities with remaining maturi-

ties of less than 1 year, with an irrevocable right to all

0

Unencumbered marketable securities with maturities of more than 1 year that are claims on sovereigns, central banks and multilateral banks and public sector enterprises in 0% risk weight countries

5

Unencumbered corporate bonds or covered bonds rated AA- or higher with maturities of more than 1 year

Unencumbered marketable securities with maturities of more than 1 year that are claims on sovereigns, central banks and multilateral banks and public sector enterprises in 20% risk weight countries

20

Unencumbered gold Unencumbered listed common equity securities, not issued by

financial institutions Unencumbered corporate bonds or covered bonds that are central

bank-eligible for liquidity, not issued by financial institutions, are rated A+ to A– and trade in a deep market

50

Unencumbered residential mortgages that quality for a 35% risk weight

Unencumbered loans with a maturity of more than 1 year, that qualify for a 35% risk weight

65

Unencumbered loans to retail customers or small business customers with a maturity of less than 1 year

85

All other assets not previously mentioned 100

250 Liquidity Risk

required stable funding is obtained by multiplying the value of an asset (or contingency) by a so-called required stable funding (RSF) factor, and then summing up across each individual RSF-adjusted asset (and con-tingency). Not surprisingly, the more liquid the asset, the lower the RSF factor; encumbered assets, by extension, have an RSF factor of 100 per-cent. We might say, therefore, that the RSF factors provide an estimate of the amount of an asset that can be monetized during a stress event lasting a year or more. The focus of NSFR is obviously on longer-term liquidity issues (whereas short-term liquidity issues are governed by the LCR described above); accordingly, assets and liabilities maturing in less than one year are excluded from the exercise (and are simply matched by bucket to reveal possible mismatches). The required stable funding attached to off-balance sheet contingencies can be thought of as some-thing of a “reserve,” to be used if ever needed. Table 11.5 highlights the RSF factors for various accounts. As noted, assets accounts with an RSF factor closer to 0 percent are more liquid than those that are closer to 100 percent.

Monitoring liquidity risks

Regular reporting of LCR and NSFR must begin prior to the “go live” date of 2015 and will become a regular feature of bank transparency there-after. To be sure, the challenge is significant, particularly in large, com-plex institutions. Many firms already face significant data quality and technology issues, and adding another set of very specific and involved reporting instructions will do little to alleviate existing infrastructure pressures.

In addition to the specifics of LCR and NSFR, the new regulatory framework calls for a more precise and consistent view of liquidity monitoring metrics and reporting. This is undoubtedly in response to the poor job that most banks (and national regulators) did in the run up to the financial crisis of 2007. While certain guidelines and best practices existed, they were wholly insufficient to warn against, or pre-vent, any of the major liquidity-induced problems that appeared during the crisis.

Among the key areas of monitoring focus are contractual maturity mismatches, funding concentrations, available unencumbered assets, counterbalancing capacity, and LCR by currency. Per Basel III, banks must have in place a robust framework that lets them project cash flows coming from assets, liabilities, and off-balance sheet contingen-cies, across a relevant time horizon. Let us first consider the maturity mismatches. Under the new regulatory framework, banks are required


to map all on- and off-balance sheet cash flows by time bucket (e.g., overnight; next day; 7, 14, 30, 60, 90, 180 days; or 1, 3, 5, 5+ years), determining the mismatches in each bucket by assuming no rollover of existing liabilities. This information would presumably alert a bank to any instances where gaps look unfavorable and need some correc-tive action. From the perspective of concentrations, banks are required to present the funding liabilities from significant counterparties as a percentage of products/instruments – once again, to alert a bank to any overweight positions that might be in jeopardy in the event of counter-party downgrade, default or withdrawal. Unencumbered asset monitor-ing is centered on available assets that are marketable as collateral in the secondary markets and those that are eligible for inclusion in central bank repo facilities. The reporting includes amount, type and location by currency, and must also include an estimated haircut for each asset. Counterbalancing capacity (CBC) is another important metric produced by banks and can be used with the liquidity gap to determine the net liquidity position. In essence, it conveys the amount of liquidity an institution is able to access over a given period to cover any gap, e.g., cash from HQLAs along with cash generated from specific pre-emptive actions (e.g., delaying cash out and accelerating cash in). 2 Figure 11.1 illustrates how cash flows, gaps, and the CBC combine to reveal the net liquidity position.

Any bank operating in multiple jurisdictions must also monitor LCR by significant currency. In this instance, a bank uses the stand-ard LCR formula described above in each relevant currency – thus, HQLAs would reflect all the assets held in a given non-domestic cur-rency, while net cash outflows would reflect all the 30-day cash flows

Contractual cash flows(loans, deposits)

Future cash flows (loan renewals, deposit

renewals)

Potential cash flows(granted credit lines, callable

liabilities)

Liquidity Gap (positive/negative)

Counterbalancing capacity

Net liquidity position (positive/negative)

+

Figure 11.1 Cash flows, CBC and the net liquidity position

252 Liquidity Risk

in that non-domestic currency, net of any currency hedges. In addition to these specific monitoring mechanisms, BCBS urges banks to make use of other market and financial metrics, as well as those relevant to each individual institution, in order to form the most complete liquid-ity picture possible.

While LCR and NSFR and the new liquidity monitoring tools can be regarded as positive enhancements, they must still be seen as limited in scope; they are just additional “tools in the toolkit” rather than com-prehensive solutions. There is also some degree of uncertainty regarding the potential “unintended consequences” that could arise through imple-mentation of LCR and NSFR. For instance, demand for certain types of HQLAs may outstrip supply, leading to increasingly expensive liquidity protection. In addition, institutions that cannot meet the requirement or who feel that resources can be allocated in more productive ways may choose to deleverage their balance sheets; this, in turn, may constrain the flow of credit to economic sectors, causing a slowdown in growth. The true effects of the new Basel liquidity requirements will take several years to unfold.

Dodd-Frank Act

The US Dodd-Frank Act (or, more formally, the Dodd-Frank Wall Street Reform and Consumer Protection Act ) is a broad-based US legislative framework signed into law in July 2010 in response to the problems and abuses brought to light during the financial crisis. The Act is comprehen-sive in its scope, covering topics related to consumer protection; proprie-tary trading; leverage, liquidity and risk concentrations; payment systems and clearinghouses; governance; mortgage reforms; and so forth; in fact, the regulatory reach of the bill is so extensive that, even several years after being signed into law, major portions of the detailed implementa-tion were still being resolved.

While the bill is broad and contains many provisions, we are particu-larly interested in the portion related to liquidity risks, which is included under Section 165. Specifically, the new liquidity-related regulations (to be overseen by the Federal Reserve for US bank holding companies with over $50 billion in assets and systemically important “non-bank financial institutions”) are centered on the following:

Creating proper risk management governance processes, which ●

explicitly deal with liquidity risks (as well as all other financial risks) Establishing relevant liquidity limits based on key liquidity metrics ●


Keeping a liquidity buffer of HQLAs in an amount that is sufficient to ●

meet projected net cash outflows and projected loss of funding sources for 30 days under a stressed liquidity condition Performing liquidity stress tests every month to determine any asset ●

deterioration under defined stressed market conditions; relevant time horizons are overnight, 30 days, 90 days and 1 year Creating in advance a contingency funding plan for managing stress ●

events; this should include a quantitative assessment of liquidity needs and alternative funding sources (under the assumption that normal sources will be unavailable) and an actual process for managing the institution through a defined liquidity event Adhering to the LCR and NSFR measures promulgated under Basel III ●

(which will be done via separate US rulemaking).

As we can see, these measures are either precisely or approximately equal to those we have discussed earlier in the chapter and earlier in the book: e.g., keeping enough HQLAs on hand, performing stress tests, developing and using a contingency plan, and measuring LCR and NSFR. Though they break no “new ground” as such, they codify what institutions should have been doing all along and in that sense create new higher standards for liquidity risk management.

Committee Of European Banking Supervisors Liquidity Consultation

While Basel III is a formalized reflection of the framework developed by the BCBS and is intended as the blueprint for national compliance, the Committee of European Banking Supervisors (CEBS) has put forth its own recommendations. While these may not be binding in all cases, they form an important contribution to the post-crisis discussion on liquidity.

CEBS, in its mid-2009 “Consultation paper on liquidity buffers and sur-vival periods,” put forth a series of guidelines after input from, and dis-course with, various regulatory and industry partners. Not surprisingly, many of these reinforce themes found in Basel III and Dodd-Frank, and are grounded in prudence and common sense. The CEBS guidelines include:

Maintaining an adequate liquidity buffer, defined as available liquidity ●

resources that can be used to cover additional liquidity needs over a short time period under stressed market conditions. Establishing the correct size of liquidity buffer by using a survival ●

period (e.g., defensive interval) of at least 30 days under stressed mar-ket conditions.

254 Liquidity Risk

Ensuring the liquidity buffer is comprised of cash and assets that are ●

highly liquid and central bank eligible (e.g., repoable with the central bank). Where needed, banks must be able to demonstrate their ability to generate liquidity from specified assets. Performing three stress scenarios, including one which is institution- ●

specific (i.e., no rollover of unsecured wholesale funding together with outflows of a certain percentage of retail deposits), a second which is market-based (i.e., reduction in liquidity value of certain assets and worsening conditions in various funding sources/markets), and a third which is hybrid (i.e., representing the specific and general cases). Managing inventories of liquid assets actively enough to ensure they ●

will be available as needed; this means limiting concentrations and ensuring that no legal entity or operational restrictions block the movement of asset sales or pledging when needed. Ensuring that the legal structure of the bank and its access to liquid- ●

ity are synchronized, so that there is no possibility of liquidity being trapped in a subsidiary or other part of the banking group.

Financial Services Authority BIPRU 12

The UK’s FSA has put forth its own regimen of liquidity enhancements through its consultative and finalized publications in 2008 through 2009; the final work, which is contained in bank prudential regulation 12 (BIPRU 12), was put into effect in stages in 2009 and 2010, and is now mandatory for banks, building societies, and investment companies oper-ating in the UK. s Once again, the main themes navigate relatively familiar territory, focusing on several key areas:

Ensuring adequate liquidity and self-sufficiency. In the first instance, a ●

qualifying institution must be able to demonstrate that it has enough liquid resources, of sufficiently high quality, to be able to operate effectively, even under stressed conditions. (Note that the prudential rulebook does not prescribe which specific assets qualify as “liquid,” noting only that a firm must hold sufficient assets which are market-able or realizable, that it can generate funds from those assets in a timely manner (e.g., repo), and that the assets have maturities appro-priate to the funding profile.) In the second instance, the institution must ensure that individual entities within the group have enough of their own liquidity that they need not rely on group transfers of cash; this is obviously intended to remove the risk of trapped cash or hoarding by, for instance, the parent company. In this sense, every


significant subsidiary or legal entity within a consolidated group must have enough standalone liquidity to continue with its operations. While this is certainly prudent from a regulatory perspective, it may not result in optimal allocation of resources. Note that it is permissible for a subsidiary to have access to a parent company’s liquidity sources – however, this access must have a legal basis and not simply exist as a potential or theoretical right. Implementing enhanced systems and controls. The FSA requires ●

qualifying institutions to adopt infrastructure and control processes that allow for proper monitoring and management of liquidity risks; such minimum standards are based on those developed by BCBS and CEBS. Examples of this type of governance and process include detailed requirements about the responsibilities of individual groups within a firm with regard to liquidity risk; development of strategies, policies, systems, limits, contingency funding plans and stress tests; pricing of liquidity risk; and management of collateral, among other items. Importantly, firms should demonstrate a linkage between busi-ness strategies and the liquidity risks generated so that there is proper proportionality. In addition, the control framework should build logi-cally upon the one developed under Basel II Pillar 2 Internal Capital Adequacy Assessment Process (ICAAP) requirements, so that there is adequate synchronicity. Developing a quantitative framework for liquidity management that ●

allows a firm to survive through market stress scenarios of varying severity and duration (e.g., an idiosyncratic stress lasting 2 weeks, a market-wide stress lasting 3 months, and a joint scenario incorporating both). This framework must be reviewed through the FSA’s independ-ent liquidity adequacy assessment, which evaluates the firm’s adher-ence to systems, controls, stress tests, liquid asset sufficiency, and so forth. Creating proper group-wide and cross-border management of liquid- ●

ity. In instances where it is deemed appropriate, a qualifying institu-tion can apply through waivers and modifications for an exemption to the self-sufficiency requirement. This can only be done, of course, if no additional risks are created for a range of stakeholders. In order to qualify for a modification, a firm must submit an application that addresses its need to modify the overall liquidity adequacy rule by relying on other group companies. It must also adhere to statutory tests under the Financial Services and Markets Act of 2000. The point of the modifications/exemptions is to make it relatively challenging, though not impossible, for an individual firm to avoid the principle of self-sufficiency. Naturally, an entity receiving an exemption from

256 Liquidity Risk

self-sufficiency must still comply with the control, quantitative, and reporting requirements. Developing granular standardized reporting of liquidity risks which the ●

FSA can then use for surveillance purposes across institutions, markets and risk exposures. The reporting requirements (which vary in terms of frequency, from weekly to quarterly to annually) include the following:

FSA047: Daily flows. This includes daily flows out to 3 months so that the survival periods can be computed and so that any potential liquidity squeezes are discovered sooner rather than later. Frequency is weekly (or daily if there is liquidity stress).

FSA048: Enhanced Mismatch Report (EMR). This includes the ILAS risk drivers and contractual flows across the full maturity spectrum. Frequency as above.

FSA050: Liquidity Buffer. This provides a more detailed analysis of a firm’s marketable assets. Frequency is monthly.

FSA051: Funding concentration. This captures a firm’s borrowings from unsecured wholesale funders, by counterparty. Frequency is monthly.

FSA052: Wholesale liabilities. This includes daily transaction prices and transacted volumes for wholesale unsecured liabilities. Frequency is weekly.

FSA053: Retail, Small and Medium Enterprises, Large Enterprises, and Corporate funding. This includes a firm’s retail and corporate funding profiles and the stickiness of various retail deposits. Frequency is quarterly.

FSA054: Currency analysis. This includes an analysis of a firm’s FX exposures on the balance sheets. Frequency is quarterly.

FSA055: Systems and Controls Questionnaire. This permits FSA to monitor a non-ILAS BIPRU firm’s compliance with the new require-ments. Frequency is annual.

Through these collective requirements, FSA expects participating insti-tutions to strengthen their understanding and management of liquidity risk, employ stress testing and contingency funding plans more actively, improve the funding profile by reducing reliance on short-term funding and other forms of “hot money” in favor of “sticky” retail funds, and hold a more liquid asset buffer. Whilst it is understood that these actions will not prevent any future liquidity crises, the expectation is that firms operating in the UK marketplace will be better prepared to deal with the effects of any such crisis.


Solvency II and Other Insurance Regulations

Solvency II exists as the insurance industry’s “Basel II equivalent,” using the “3 pillar approach” to establish minimum requirements for risk strat-egy and appetite (including capital allocation), valuation/measurement, monitoring, management and controls, and disclosure and market infor-mation. The ultimate goal of the framework (which replaces the original Solvency I) is to create over time a convergence path between banking and insurance regulation, recognizing that there are (and will continue to be) differences between the two sectors. For instance, we can draw an important distinction between bank and insurer liabilities: while banks often borrow short-term to lend long-term (thus creating a potential trou-blesome gap), insurers carry significant long-term liabilities from their historical books of business; short-term funding is considerably smaller, meaning different dynamics are at work, particularly with regard to liquidity.

Solvency II classes risks into five categories – insurance, market, liquid-ity, credit, and operational risks – and requires demonstration of effective risk management of each one. The intent is to ensure insurance compa-nies feature a better reflection of the risk profile, align economic and regulatory capital, and synchronize the risk profile with capital (where that risk profile explicitly also addresses liquidity risks). Article 44 of the EU Solvency II Directive, for instance, establishes relevant standards for liquidity management, requiring risk management processes to address asset liability management activities and liquidity and concentration management activities, topics we have touched on earlier in the book. While Solvency II is a Eurozone initiative, with rollout from 2013 and beyond, it also applies to EU subsidiaries of US insurance groups and, from a consolidation perspective, US subsidiaries of EU insurance groups.

Some insurance companies need not adhere to Solvency II – namely, the large Swiss insurers, which are governed by their own domestic regula-tions. In fact, the Swiss Financial Markets Supervisory Authority (FINMA) has historically required insurers to practice “prudent liquidity manage-ment,” demonstrating an organizational structure that allows for effec-tive monitoring and management of liquidity. However, in 2012 FINMA launched a new effort to deepen and formalize liquidity management regulation, focused on the following:

Identify liquidity risk in annual capital planning, with clarity on ●

sources and demands, and with detailed explanations on assumptions Determine the cumulative cash inflows and outflows under normal ●

market conditions and “tightened market conditions”

258 Liquidity Risk

Report annually to FINMA in detail the true liquidity position of the ●

group.

It should be relatively clear from the brief overview given in this chapter that, post-crisis, the financial sector is required to focus more intently and formally on liquidity risk management, which is a welcome effort. The main caveat to stress is that while many of the steps summarized above should help individual institutions cope with liquidity risk in a more prudent and proactive fashion, they will not eliminate the spectre of idiosyncratic or systemic liquidity problems. These issues will continue to exist since liquidity risk can never be eliminated entirely – though it will hopefully never be as damaging as during the 2007–2008 crisis.

259

12 Summary: The Future of Active Liquidity Risk Management

As we conclude our review and analysis of liquidity risk, we consider the prospects for active liquidity risk management over the medium term. It is clear, in the aftermath of the financial crisis of 2007–2008, that com-panies (and sovereigns) have become more attuned to risks and risk man-agement over the past few decades. Volatile markets, asset and funding dislocations, systemic stresses, and resulting losses have played an impor-tant part in heightening risk awareness, though wrenching events like the last crisis highlight that more needs to be done. With little to indicate that the economic and financial operating environment will become more benign in coming years, rigorous risk management will remain essential. But there can be little doubt that liquidity risk has entered thought and practice in the financial mainstream. Identification and management of liquidity risk is now the norm rather than the exception, which must be considered a significant step forward.

In order to cope with business uncertainties, many institutions now fea-ture formalized risk management processes, including those focused on liquidity exposures. Indeed, with each new micro or macro crisis, firms appear more willing to consider changes that will allow them to manage their risks more effectively (in some cases, of course, regulators step in and demand that changes be made). Some firms have made conscious efforts to reduce their reliance on a small group of funding markets, lenders, or investors; others have created policies allowing them to decrease assets in times of financial strain, and still others have created robust liquidity warehouses with an appropriate mix of high-quality, saleable assets. Such processes must be extended even further, to the point where all firms have some type of liquidity risk management mechanism in place – ide-ally, one that is linked to other aspects of financial risk management. As we summarize our work in this book, we consider the nature of essential firm-specific best practices and discuss the role and responsibility of regu-latory authorities in helping promote a system of sound liquidity.


260 Liquidity Risk

The Micro Role: Best Practices

We know from our discussion in this book that there is no single “correct solution” to the effective management of liquidity risk: processes that are effective for one company or industry might be of limited use to another, those that are best suited for normal market conditions might be inap-propriate during a crisis, and so forth. That said, the conceptual basis for managing liquidity risk is sufficiently universal that it is possible to develop a micro-level summary of best practices, applicable in general across firms and market conditions. This summary is a crystallization of ideas we have presented in previous chapters.

Creating a sound governance framework

Preserving stakeholder confidence is an essential element of liquidity ●

management; companies must be perceived as being stable and in con-trol of their liquidity position at all times, and they should communi-cate this message to stakeholders. The board of directors must play a leading role in defining and commu- ●

nicating the firm’s ability and desire to assume liquidity risk. It must authorize the creation of the mechanisms needed to create a proper liquidity risk management process (including a liquidity committee, risk expertise, policies, procedures, and technical infrastructure). The board of directors should define the firm’s liquidity philosophy ●

through a liquidity risk mandate, ensuring that it is consistent with the firm’s strategy, business focus, risk appetite, and resources. There can be no inconsistency in these fundamental issues: if business strategy and liquidity risk appetite are not synchronized, it will only be a ques-tion of time before a firm runs into trouble. The liquidity risk mandate must be conveyed to all interested stake- ●

holders, including investors, creditors, regulators, employees, and rat-ing agencies; subsequent changes (approved under the direction of directors and executives) should also be broadcast. Overarching liquidity risk policies and procedures must be crafted by ●

the liquidity committee and disseminated throughout the firm; poli-cies should be reviewed annually to ensure they remain relevant. A proper internal liquidity risk pricing mechanism must be put in ●

place to price risk fairly and to sensitize business managers to the cost of assuming incremental risk. The degree of decentralization and nature of delegated responsibilities ●

related to management of liquidity risks must be clearly defined by directors and executives.

Summary: The Future of Active Liquidity Risk Management 261

Liquidity practices must be properly incorporated into all of the firm’s ●

financial activities; the linkage between market, credit, and liquidity risks means that they must be considered and managed jointly, par-ticularly if a firm is attempting to operate efficiently and maximize enterprise value. The liquidity risk/return trade-off is always present; the firm must con- ●

sider the right balance between revenue maximization and liquidity preservation, particularly when it comes to determining a proper fund-ing program and an optimal liquidity warehouse. A comprehensive liquidity risk management program that makes ●

appropriate use of assets, liabilities, and off-balance sheet transactions to generate liquidity, as and when needed, should form the centerpiece of any process. The liquidity risk process must be based on realistic assessments of cur- ●

rent and future business and cash flow needs under a variety of operat-ing and growth scenarios; these should then form the foundation for more extensive stress testing. Banking and investor funding relationships must be reviewed fre- ●

quently to determine whether they are stable and diversified and can adequately meet the company’s changing needs. The liquidity risk management process should be surrounded by ●

independent controllers capable of regularly analyzing and auditing aspects of measurement, monitoring, and management. The process should be examined by directors and executives at least annually to make sure that it remains consistent with the firm’s mandate, struc-ture, and growth plans, and is relevant in the market and regulatory environment.

Implementing proper measures and reporting

The firm should develop and use robust liquidity risk measures that ●

are applicable to its business. While balance sheet data can provide useful point-in-time stock measures, these should be supplemented by dynamic flow measures that take account of gaps, durations, probabilities of draw-down, disposal discounts, and loss of market access. Measures must be conservative in their treatment of pricing and liquida- ●

tion parameters, particularly during stress periods. Conservative evalu-ation of asset discounts and funding access (including quantity and speed) is the safest way of managing general liquidity risks; although a conservative approach can dampen overall enterprise returns, it can help minimize the chance of financial distress.

262 Liquidity Risk

The inherent flaws of quantitative models must be understood, particu- ●

larly during times of market stress when model assumptions may prove unrealistic. Models should be supplementary tools, and they cannot replace other liquidity measures, stress tests, or experiential analysis. Independent experts must always value assets, liabilities, and off-bal- ●

ance sheet contracts, and model valuations should be routinely tested for reasonableness. Assets, liabilities, and off-balance sheet activities must be regularly ●

stress-tested to reveal areas of vulnerability. Stress tests should range from mild to extreme, and the results must be used to help shape busi-ness strategy and contingency planning. Stress test results must be viewed as useful approximations, not precise computations. Continuous monitoring of profiles and trends is essential; qualitative ●

and anecdotal measures must also be followed closely (such as the sta-tus of credit renewals, widening of spreads, and changing terms in loan agreements). Detailed information related to critical daily, weekly, and monthly ●

flows must be given to business and control managers. Summary infor-mation must be given regularly to directors and executives for discus-sion and action. The firm’s infrastructure should be able to provide managers with fre- ●

quent, granular detail on liquidity risks.

Using tactical controls

Limits should be established to control all relevant aspects of liquidity ●

exposure and should relate directly to the firm’s liquidity risk mandate. Concentrations within the asset, funding, and off-balance sheet port- ●

folios can intensify a liquidity problem; diversification across invest-ments, obligors, lenders, maturities, credit ratings, markets, and products is an essential component of prudent risk management. Even when no specific regulatory requirements exist, a liquidity ware- ●

house must be established and maintained to help absorb unexpected payments. Additional protection via reserves is advisable. A firm must maintain constructive relationships and communications ●

with its key lenders and investors, and should continuously develop new sources of funding. Off-balance sheet activities should be monitored and controlled closely; ●

since they can expand future contingencies and liabilities in an uncer-tain, and sometimes opaque, manner, they must be explicitly limited. The firm should regularly test its ability to sell a portion of its liquid- ●

ity warehouse, including both conventional, high-quality government bonds and complex, difficult to value, or thinly traded financial assets, as a way of verifying asset valuations, model accuracy, and haircuts.


Developing and implementing a crisis management process

A centralized crisis management program that is regularly tested and ●

updated must be developed in advance of a crisis, not during a crisis. Knowing when to invoke the program is absolutely essential, as any unnecessary delay can prove costly. The program should be based on well-defined asset, liability, and ●

hedging priorities, and feature a very rigorous and dynamic commu-nications process (geared particularly toward external stakeholders, including regulators, investors, creditors and clients). Objective measures should be the primary method of invoking a pro- ●

gram, but subjective review and judgment should form part of the proc-ess. Indicators that can serve as possible “early warning signs” should be reviewed regularly. Committed backup bank lines should be tested on a regular basis, ●

regardless of the negative message it might send the marketplace. Advised bank lines should be completely discounted in a crisis man- ●

agement scenario.

Performing ongoing reviews

A firm’s liquidity risk process should be thoroughly vetted by internal ●

and external auditors to ensure that it meets necessary governance and regulatory standards. Auditors should verify proper independence and segregation of duties between those generating and controlling liquid-ity risks. When liquidity problems arise and are ultimately resolved, a firm must ●

examine the causes, reactions, and solutions to determine whether enhancements to the overall process are necessary. Policies and procedures should be analyzed to determine their efficacy ●

and consistency in supporting the liquidity risk mandate. Procedures related to violations and penalties should be reviewed, and ●

actual application of proper disciplinary action should be confirmed. Valuation models (such as VAR, LAVAR, derivative and credit risk pric- ●

ing, and stress testing algorithms) must be independently reviewed and benchmarked, and the assumptions driving the results must be thoroughly understood. The integrity of the data used for liquidity measurement and monitor- ●

ing should be verified by internal auditors.

The Macro Role

While much of what we consider in this book is directed towards institu-tional-level management of liquidity, we know that macro bodies have a

264 Liquidity Risk

role to play as well. Any regime or rule that promotes system-wide liquid-ity helps individual institutions cope with their own liquidity. The issue becomes increasingly important as global asset and funding markets become more intricately related and co-dependent: effective funding, trading, financing, investing, hedging, and speculating require systemic stability. In fact, there exists a very strong relationship between financial institutions and financial markets: banks in particular require markets in order to access funding and risk management/transfer opportunities, while markets require banks for liquidity and maturity transformation and credit provision. Systemic stability is thus essential.

Unfortunately, in a drive to achieve certain levels of market share or profitability, entire sectors may misprice or ignore their risks, which can add to systemic instability. As we have seen, ripples that flow through the system can be especially damaging, and have the potential to cre-ate significant financial losses for individual firms and entire sectors. Accordingly, it is incumbent on industry regulators, representatives, and self-regulatory organizations to consider mechanisms that can help pro-mote and expand stability. While some national authorities already play an active role in this area, others do not, or need to improve their proc-esses and techniques.

The role of regulators in fostering conditions that protect and encour-age liquidity is important. Although this relates primarily to the financial sector in its role as liquidity provider to all other industries, it need not be limited to financial institutions; where relevant, industry represent-atives and trade groups should promulgate best practices for other sec-tors as well. Within the financial services industry, a number of national banking regulators, insurance commissioners, securities regulators, and supranational organizations have put forth varying rules and recommen-dations regarding the protection of liquidity, including those applicable in a post-crisis world. We have summarized some of these points in the book, and note further that their recommendations are often quite exten-sive and, in the main, constructive. But they are not exhaustive: while financial regulators have been quite direct and precise in the manage-ment of credit and market risks, they have tended to be more oblique in their approach to liquidity risks, in some cases addressing the issue only indirectly – if at all. 1 While this lack of direct treatment has changed since the financial crisis of 2007–2008, it is still a nascent and unproven effort. In addition, we have noted that there are instances where regulations can actually exacerbate liquidity problems (such as the use of standard risk models, and the creation of countercyclical capital and capital controls). Fortunately these are still the exception rather than the norm. Although new regulatory initiatives have been developed in recent years, regulators


can help foster an even more robust environment by conducting regular inspections, promoting competition, avoiding fragmentation, minimiz-ing costs, harmonizing accounting treatment, ensuring proper capital allocations, and providing selective lender of last resort access. We con-sider each one of these in more detail.

Conducting regular inspections

Regulatory and industry bodies should regularly examine the liquidity practices of institutions operating in their jurisdictions. The review should focus on many of the topics we discussed in previous chapters, includ-ing measurement, monitoring, and management, as well as the nature of governance and independent controls that surround the process, mecha-nisms used to manage legal entity requirements, and the particulars of any contingency/crisis management program. In fact, authorities should insist on the creation and use of contingency programs, as these can help minimize instances of systemic dislocation. While much of the focus of external regulatory inspections is, rightly, on the financial institutions sector, trade groups and self-regulatory organizations should review the activities of non-financial institutions based on minimum best-practice standards. We have already noted instances where large non-financial institutions, lacking the proper approach to liquidity risk management or the scrutiny of a regulator, have encountered significant difficulties. Future problems can be minimized through a formal review process.

Promoting competition

It is clear that market makers, dealers, and exchanges have a central role to play in the provision of financial asset liquidity. They must be allowed to operate in a competitive and efficient manner, and regulators should promote any prudent deregulation measures that allow for greater com-petition. We have indicated that as more participants are attracted to a market, bid–offer spreads tighten, volumes increase, additional partici-pants are drawn in, and so forth, in a self-perpetuating cycle. Regulators should encourage measures that support heterogeneity in order to help build two-way flows; for instance, allowing certain parties to participate in areas that have previously been restricted or prohibited can create opposing views and generate more trading interest. But promoting com-petition does not mean allowing risks to be mispriced; it is important to stress that undercutting margins to gain market share and inject liquidity is not a viable or sustainable process, either for individual institutions or marketplaces at large. Firms and supervisors need to be vigilant on this point.

266 Liquidity Risk

Avoiding fragmentation

Regulators must avoid actions that lead to market fragmentation. This represents a balancing act, as it is generally beneficial to promote alterna-tives in order to keep competition strong. But too much fragmentation has been shown through empirical studies to damage trading volumes and divide liquidity pools; this applies across asset classes and funding sources, and also includes off-balance sheet contracts. Wherever sub-stitutes can be introduced, care must be taken to ensure that they are value-added and complementary, and not destructive. For instance, local government bonds (and the government yield curves they generate) play multiple roles: providing “risk free” safe haven investments (certainly for industrialized economies with solid investment-grade ratings); supplying price references for private sector financing issues and bank borrowings; providing a supply of securities for repurchase/reverse repurchase activi-ties; and creating references and deliverables for listed and OTC deriva-tives. Each one of these functions promotes liquidity in other asset and funding classes. Accordingly, it is vital for activity in government bonds to be as strong as possible. This means issuance cannot be spread too widely across issues, coupons, and maturities. Such an approach will almost cer-tainly fragment the market and leave associated asset and liability mecha-nisms in an uncertain state. In fact, it is preferable for national issuance to be concentrated on a handful of benchmark issues (with authorities “reopening” them as needed rather than issuing new tranches and creat-ing greater market atomization).

Minimizing costs

It is well established, theoretically and empirically, that measures that reduce the cost burden of participating in a trading, investment, or fund-ing market lead to an increase in activity – and, hence, liquidity. There is considerable evidence to demonstrate the positive effects of lower costs (for example transactions costs, stamp duties, and taxes) on activity levels (not just trading volumes, but also borrowing levels, investment activi-ties, and so forth). Where regulators have the ability to eliminate unnec-essary costs, they should be prepared to do so.

Harmonizing accounting treatment

Firms are periodically precluded from participating in a market or trans-action (for example an investment, a funding or new issue transaction, or a derivatives trade) as a result of accounting rules. While there are often good reasons for particular accounting treatments, there are also


instances where rules are a vestige of past practice and may no longer be applicable to the current state of industry or markets. Whenever possible, rules should be harmonized or synchronized with the realities of the cor-porate world of the 21st century. The removal of artificial barriers based on accounting, rather than economic, rules is almost certain to generate additional activity in specific market segments.

Reinforcing proper capital allocations

Global financial regulators have generally done an acceptable job in ensur-ing that financial institutions preserve sufficient capital for core market and credit risks; the discipline is by now well established and appears to have served the financial community, and by extension all other indus-trial and service sectors relying on the community, well. But, as the finan-cial crisis demonstrated, the process is not yet complete: formal capital allocation must occur in support of other risks, most notably liquidity risk and operational risk. The lessons from financial dislocations of the past few years demonstrate that some types of financial institutions may not be providing adequate capital in support of their non-credit/market risks. Enactment of rules regarding the process (e.g., Basel III, Solvency II, Dodd-Frank, and similar efforts) must be considered as a matter of priority.

Providing selective lender of last resort support

Preserving our focus on the financial sector, we note that there is a defen-sible argument to be made in ensuring that certain financial institu-tions be granted undoubted access to a lender of last resort. The systemic stability that can be gained from making sure that the most significant liquidity conduits have a “backstop” is of considerable importance – as we collectively learned during the last financial crisis.

The main criticism of lender of last resort access is rightly one of moral hazard: financial institutions, knowing that they have support through a central bank or monetary authority, may behave recklessly in an attempt to maximize returns (including holding insufficient liquidity in order to boost profits). Equally, depositors who believe they are placing their funds in an institution with an implicit government guarantee may be less vigilant regarding the bank and its activities. This is a valid argument, meaning lender of last resort access should only be granted selectively, to those institutions that are “too big to fail” 2 and that do not appear to be deliberately managing their operations in a reckless manner. The gains that can be derived from a stable environment must surely outweigh the

268 Liquidity Risk

potential costs of moral hazard problems and, in the event of a problem, the actual costs of interceding.

When ex post regulatory intervention must occur, it should take the form of open market operations and liquidity injections into the finan-cial system, as well as direct collateralized repos and loans to the troubled institution(s). 3 Where direct access is not possible or convenient (because it involves an institution that is “out of scope”), regulatory authorities should take any actions that can lead to private sector support or bailout. This is particularly true for securities firms that lack formal backstops, and may also be useful for certain private investment funds (as in the LTCM case).

The key point in relation to the topic above is not to insert regulators into the process to actively promote liquidity, but to have them consider structural reforms and measures that can further liberalize financial and physical asset and funding markets. Success will ultimately benefit the liquidity access of all companies.

Figure 12.1 summarizes our consideration of overarching micro and macro practices that can promote effective liquidity risk management.

In conclusion, we wish to reiterate that in the aftermath of the financial crisis, the singular importance of liquidity has become widely accepted. In an era of financial uncertainty, a firm must manage its liquidity dil-igently, through a combination of internal best practices and external

Conducting regularinspections

Promotingcompetition

Avoidingfragmentation

Minimizing costs

Harmonizing accountingtreatment

Reinforcing capitalallocations

Providing selectivelender of last resort

support

Creating a soundgovernanceframework

Implementingproper measures and

reporting

Using tacticalcontrols

Developing a crisismanagement process

Performing ongoingreviews

Micro/internal Macro/external

Effectiveliquidity

risk management

Figure 12.1 Towards effective liquidity risk management


support. The end goal should be to minimize, or avoid, the likelihood of disrupting access to cash resources. A firm must ultimately seek to pre-serve its business franchise through the most severe financial stresses, emerging intact to continue prospering. Prudent, and active, liquidity risk management makes this goal achievable.

270

Appendix : A Primer on Gap Management

Earlier in the book we described the importance of cash flow bucketing and analysis in the computation of the net cash balance of a firm. This practice is important for all companies that have an interest in success-fully managing their liquidity, but it is of course vitally important for those in the business of maturity transformation and liquidity provision, i.e., banks and other financial institutions.

As we have also noted, the management of interest rate risk is inti-mately related to the management of funding risk, which is a central part of liquidity management. Gap management, which is a key tool in the analysis and balancing of rate risk, represents an important part of both rate risk management and liquidity analysis. In this brief primer we shall highlight some of the key points associated with gap management, pro-viding several simple examples to help illustrate how it is used in practice. Many of these principles are, of course, applicable in the liquidity analy-sis process, with the caveat that bucketing moves from contractual (or behavioral) maturities to expected cash inflows/outflows.

Interest rate activities

Banks are fundamentally focused on the impact of interest rates on their activities. Indeed, their business strategies are typically centered on their current and expected views of interest rates. The reasons for this are obvious: core banking activities, including investing, lending and fund-ing, are all interest rate sensitive. Current and future net interest income (NII), which is simply interest income less interest expense, is impacted by interest rate changes. And the market value or net worth of a bank is ultimately impacted by NII.

Since interest rates are so fundamental to banking, a brief review of dura-tion is helpful to set the stage for subsequent review of some elemental asset liability management (ALM) measures, including gap analysis, duration gaps and earnings sensitivity. Figure A1.1 summarizes aspects of this framework.

Duration

Duration, a fundamental concept of the interest rate markets that has been in use for many decades, is a standard measure of the linear

Appendix : A Primer on Gap Management 271

price sensitivity of an asset or liability (or off-balance sheet contract) to changes in rates. In fact, we may regard duration as the cash flow weighted maturity of an asset, liability or contract – which, except for zero-coupon structures, is shorter than the final maturity. Although there are various formulae for computing duration (e.g., modified, Macaulay’s, and so on), the basic duration formula is given in (A1.1) as the sum of the time-weighted (t), discounted cash flows (CF), divided by the price (P), or

tDur t cf r p* / (1 ) // (1t * / (1∑∑

We shall illustrate the computation in an example below. Ultimately, duration indicates how much the price of a rate sensitive

asset (RSA) or rate sensitive liability (RSL) will increase (decrease) for a small decrease (increase) in rates (e.g., up to several basis points). Since duration only captures the linear relationship over a relatively small rate movement, we need to adjust the overall computation if we want to measure the sensitivity of an RSA or RSL to an instanta-neous large movement in rates (e.g., 25, 50 or more bps); this is done through a convexity adjustment. However, for basic purposes of sim-ple rate change estimates in our discussion, duration is an adequate approximation.

Consider the following example: assume a bank is holding a four-year bond with a 6% annual coupon, that redeems at par. We can compute the bond’s duration using the data summarized in Table A1.1.

In this example the bond has a duration of 3.67 (versus a maturity of 4). Any estimate of price sensitivity will thus be a more accurate estimate than a pure examination of maturity. In practical terms the

Interest Rates

FundingInvestingLending

Net Interest Income

Market Value Impact

Gap analysis

Duration gaps

Earnings sens

Duration

MeasuresRate Sensitive Banking Activities

Figure A1.1 Interest rates, rate measures, and banking activities

272 Appendix : A Primer on Gap Management

duration indicates that if rates change by 1 basis point (bp), the price of the bond will change by 0.0367 points. If rates change by 10 bps, the price of the bond will change by 0.367 points. We now have a basic tool by which to estimate rate sensitive asset/liability price changes given rate movements.

Common measures

Let us now consider several common ALM measures, commencing first with gap analysis. Gap analysis, as noted earlier in the book, is a measure of the total rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs) that reprice in a given time period, used to determine whether they are mismatched (recalling the subtle difference between rate gaps and liquidity gaps, where the former is based on repricing and the latter on expected net cash flows). The most granular approach examines mismatches at specific time intervals (“gaps” or “maturity buckets”). An extension of this process centers on so-called duration gaps, which is a measure of RSAs and RSLs based on their duration rather than their contractual maturity. A cumula-tive effect based on the duration of the balance sheet and a forecast of rates can be computed to derive the change in market value or net worth of the bank. We can also consider earnings sensitivity, which is an enhanced gap analysis that takes account of embedded options and interest rate forecasts/shocks to reveal sensitivity of bank NII to changing rates.

In basic gap analysis, a bank must first identify its RSAs and RSLs, i.e., all instruments whose price can be impacted by rate changes. An asset or liability is considered rate sensitive if during the selected gap interval:

it matures ●

it represents an interim or partial principal payment ●

it can be repriced ●

For instance, a 0–30 day gap might feature the following RSAs and RSLs:

Table A1.1 Sample duration calculation

Year 1 Year 2 Year 3 Year 4 Total

CF 6 6 6 106PV 5.66 5.34 5.04 83.96 100PV/P 0.0566 0.0534 0.0504 0.8396 1.00T * (PV/P) 0.0566 0.1068 0.1511 3.3585Dur 3.673


Maturing instruments or principal payments: ●

If an asset or liability matures within 30 days, the principal amount ●

will be repriced. Any full or partial principal payments within 30 days will be ●

repriced. Floating rate instruments: ●

If the index contractually changes within 30 days (e.g., 1 week or ●

1 month EURIBOR), the asset or liability is rate sensitive.

The actual computation of a gap for any particular period t is straightfor-ward and can be given by (A1.2):

t t tGap RSA RSLt ttRSARSA

It should be clear that assets/liabilities that fall outside the gap period are not included in the gap calculation.

Not surprisingly, RSAs and RSLs have a direct impact on NII, since these are the very contracts or instruments that generate interest income or expense. By extension, a bank can also compute a net interest margin (NIM), given simply as NII divided by earning assets.

Naturally, NII (and NIM) are affected by a series of factors, including:

changes in the level of interest rates ●

changes in the composition of assets and liabilities ●

changes in the volume of earning assets and interest-bearing liabilities ●

(and hence the gap) changes in the relationship between the yields on earning assets and ●

rates paid on interest-bearing liabilities

In practice, a bank follows a series of steps in order to understand its sensitivity to rate risk, and how its NII and NIM are likely to fare as rates change. It does so by:

developing an interest rate forecast. ●

selecting a series of “maturity buckets” or intervals for determining ●

when assets and liabilities will reprice. grouping assets and liabilities into these “buckets” ●

calculating the gap for each “bucket” ●

forecasting the change in net interest income given an assumed change ●

in interest rates

Let us consider a simple example to illustrate.


A European bank has the simplified balance sheet shown in Table A1.2:

Under this construct, we can easily determine that

NII = ● €78.5mm – €37.2mm = €41.3mm NIM = ● €41.3mm / €850mm = 4.86% Gap = ● €500mm – €600mm = –€100mm

Let us next assume that short-term rates increase by 100 bps, affecting all RSAs and RSLs as noted in Table A1.3:

Under this scenario,

NII = ● €83.5mm – €43.2mm = €40.3mm NIM = ● €40.3mm / €850mm = 4.86% Gap = ● €500mm – €600mm = –€100mm

Since the bank has been running a negative gap, more liabilities than assets reprice in the higher rate environment, meaning NIM and NII both decline. Not surprisingly, the reverse would occur if short-term rates fell 100 bps.

Finally, let us assume that the mix of assets and liabilities changes so that the gap is smaller, as noted in Table A1.4:

Under this scenario,

Table A1.2 Sample European bank balance sheet

Avg rate €mm Avg rate € mm

RSAs repricing in 1 year

8% 500 RSLs repricing in 1 year

4% 60

Assets not repricing in 1 year

11% 350 Liabs not repricing in 1 year

6% 220

Non-earning assets 150 Equity 80Total assets 1000 Total Liabs+Equity 1000

Table A1.3 Sample European bank balance sheet 2

Avg rate € mm Avg rate € mm



5% 600



6% 220



NII = ● €77.3mm – €38mm = €39.3mm NIM = ● €39.3mm / €850mm = 4.62% Gap = ● €540mm – €560mm = –€20mm

Although the gap is smaller – meaning rate risk is smaller – the bank’s earning power has declined.

An extension of the gap formula lets a bank quickly determine how interest rate changes affect NII (and NIM); in fact, changes in NII are directly proportional to the size of the gap. This is given in (A1.3):

( )NII r RSA RSL Gap* ( ) *ΔNII rNII * ( ))

Assume, for example, that a bank has RSAs of €500mm and RSLs of €520mm in the gap period. If rates rise by 100bps, the change in NII will be – €200,000 (e.g., –€20mm * 1%); conversely if rates fall by 100 bps, the change will be €200,000. Naturally, this approach includes simplifying assumptions, including:

parallel rate change to all RSAs and RSLs, ●

instantaneous change at the beginning of each gap period. ●

These assumptions are not very realistic, but the formula provides for a “quick and dirty” estimate. Based on this discussion, some “rules of thumb” can be drawn:

When RSAs and RSLs are equal, we may say that RSA/RSL is 1.0, mean- ●

ing the bank is perfectly matched. This indicates that for a given increase in rates it will lose on its liabilities and gain on its assets. When RSA < RSL (RSA/RSL is < 1.0), the bank is running a negative gap ●

or is liability sensitive. This also means that the bank has an asset duration that is shorter than its liability dura- ●

tion, or it has more rate sensitive liabilities than assets. ●

the NII will generally fall (rise) when interest rates rise (fall). ●

Table A1.4 Sample European bank balance sheet 3

Avg rate € mm Avg rate € mm



4% 560



6% 260



When RSA > RSL (RSA/RSL is > 1.0) the bank is running a positive gap ●

or is asset sensitive, indicating that the bank has an asset duration that is longer than its liability ●

duration, or the bank has more rate sensitive assets than liabilities. ●

the NII will generally rise (fall) when interest rate rises (fall). ●

The decision to hold a positive or negative gap will depend on the bank’s expectation of interest rates and its overall business mix and strategy. When rates are expected to rise, a bank should reduce its negative gap or increase its positive gap. When rates are expected to fall, a bank should increase its negative gap or decrease its positive gap. In general, the sum-mary relationships in Table A1.5 may be said to hold true:

In order to reduce rate risk, a bank must narrow its gap – meaning it must become “less negative” or “less positive”, depending on its current positioning. For instance, if a bank is liability sensitive (e.g., negative gap or RSA/RSL < 1.0), it should attempt to increase RSAs and decrease RSLs and vice-versa. Naturally, to increase rate risk it must widen its gap.

The range of available solutions can be summarized as per Table A1.6:

Table A1.5 Relationships between gap, rates and net interest income

Gap Position

Changes in Interest Rates

Changes in Interest Income

Changes in Interest Expense Change in NII

Positive Increase Increase Increase IncreasePositive Decrease Decrease Decrease DecreaseNegative Increase Increase Increase IncreaseNegative Decrease Decrease Decrease DecreaseZero Increase Increase Increase NoneZero Decrease Decrease Decrease None

Table A1.6 Solution to increase/decrease asset/liability sensitivity

Objective Solutions

Reduce asset sensitivity Buy longer-term securities. Lengthen the maturities of loans. Move from floating-rate loans to term loans.

Increase asset sensitivity Buy short-term securities. Shorten loan maturities. Make more loans on a floating-rate basis.

Reduce liability sensitivity Pay premiums to attract longer-term deposits. Issue long-term subordinated debt.

Increase liability sensitivity Pay premiums to attract short-term deposits. Borrow more via non-core purchased liabilities.


It comes as no surprise that some of these actions will also have an impact on a bank’s liquidity strategy and position. Essentially, any action that affects the maturity (duration) profile of assets or liabilities will affect the liquidity of the bank. So, if a bank wants to increase its long-term loan growth by funding strictly with short-term deposits, it will be incurring additional liquidity risk. The issue to be considered is whether the explicit spread between the long-term loans and short-term deposits (in a normal positive yield curve environment) compensates sufficiently for the incremental liquidity risk taken. Extending the discussion, we may say that increasing liability sensitivity by boosting short-term depos-its also increases the bank’s exposure to short-term liability withdrawals (i.e., intensifies potential liquidity risk) in an unstable market; reducing asset sensitivity by making longer term loans may reduce liquidity risk if these loans are term funded, and so on. The main point to stress is that development of a bank’s strategy for generating NII based on an increase or decrease in its gapping should not be done in isolation – it must logi-cally also include a discussion of its strategy for dealing with liquidity issues.

Continuing our discussion, a duration gap can be computed by exam-ining the durations of the RSAs and RSLs (recalling that duration is addi-tive, and it is possible to sum across time and maturity). This is given in (A1.4):

gap RSADur Durgap R⎛ ⎞RSLRSL Dur* R−RSADurR⎛ ⎞⎛ ⎞RSLRSL DurR

⎝ ⎠RSA⎜ ⎟⎜ ⎟RSA⎛ ⎞⎛ ⎞⎛ ⎞⎛ ⎞

This formula indicates that the duration gap is equal to the duration of the RSAs, less the duration of the RSLs, adjusted by the weighting of the RSAs and RSLs (or total assets (TA) and total liabilities (TL)). A simple and powerful extension of this formula, shown in (A1.5), allows us to calculate the change in the bank’s net worth (as a percentage of assets) for a given change in rates.

Δ = − ΔNWAssets

Durr

gar pa *( )+ r

For instance, if a bank estimates its duration gap at 1.7, it would expect its net worth (as a percentage of assets) to decline by 0.17% for every 10bps increase in rates. Naturally, this is to be regarded as a general esti-mate only.


Earnings sensitivity is another tool in understanding ALM and earn-ings. Under this framework a bank can increase the sophistication of its analysis by:

including embedded options that can potentially alter the bank’s cash ●

flows – a process which is ignored by the basic gap analysis described earlier. incorporating interest rates change by different amounts at different ●

times by running multiple “what-if” scenarios.

Earnings sensitivity generates the potential variation in NII across dif-ferent interest rate environments, based on different assumptions about balance sheet composition, when embedded options will be exercised, the timing of repricings, and so forth. It essentially demonstrates the potential volatility in earnings across each environment; ultimately, the greater the potential variation in earnings (earnings at risk), the greater the amount of risk being assumed by a bank.

The process of creating an earnings sensitivity matrix is based on the following steps:

Step 1: Develop multiple interest rate forecasts and select one as the ●

future evolution of rates; this may span 1, 2, 3, etc., years. Step 2: Compute the “enhanced” periodic and cumulative gap by mak- ●

ing detailed assumptions about when any embedded options might be exercised and how they may change cash flows, assets, liabilities, e.g.,

Option to refinance a loan ●

Call option on a bond in the investment portfolio ●

Depositors option to withdraw funds prior to maturity ●

Cap (maximum) rate on a floating-rate loan ●

Note: The more detailed the analysis on optionality, the more relevant the results.

Step 3: Apply the rate changes to the enhanced gap measure for each ●

relevant time period to determine the NII. Step 4: Determine the bank’s NII earnings sensitivity by computing ●

the change in NII for different shocks (e.g., +/– 100, 200 bps, etc.).

These shock scenarios can be applied against any relevant risk limits. Consider the following simple example based on the periodic and cumu-lative option-adjusted gap and a sample interest rate path (most likely versus market implied), as shown in Table A1.7 and Figure A1.2.


The NII results for the next year based on the most likely (ML) inter-est rate scenario can be determined for the stated gap and can then be shocked to extremes of +/– 300 bps to provide an earnings sensitivity range in terms of NII. The process can be repeated for year 2 scenarios and so forth. Any ALCO or Board limits can be included to determine whether warnings or breaches occur. Decisions about the proper periodic or cumulative gap should take account of the construction of the bank’s balance sheet, paying close attention to liquidity features and the ability to realize cash quickly and cost-effectively.

It is important to remember that measures such as duration, gap analy-sis, duration gaps, earnings sensitivity and the like are simply tools that banks can use to help them gauge rate risk and, by extension, aspects of liquidity risk. These are tools with assumptions, and so must be used care-fully. Naturally, there is no single optimal solution to what a bank’s gap should be – every bank is different. The ultimate answer will be based on a bank’s interest rate forecast, business strategy and revenue diversifica-tion, funding sources and risk appetite (including both market risk and liquidity risk).

Table A1.7 Sample option-adjusted gap

Total3 Months or less

>3–6 Months

>6–12 Months

>1–3 Years

>3–5 Years

>5–10 Years

>10–20 Years >20 Years

GAP –20,252 –6,249 11,053 43,582 49,200 71,748 51,918 –201,000Cumulative –20,252 –26,501 –15,448 28,134 77,334 149,082 201,00

4.5

4

3.5

3

2.5

21 2 3 4 5

Most Likely Mkt Implied6 7 8 9 10 11 12

Interest rate scenario 1 over next 12 months

Figure A1.2 Sample interest rate scenario

280

Notes

1 Liquidity Risk Defined

1. The specific term “liquidation risk” is sometimes used to denote the risk of selling an asset at a loss.

2. Although the value of derivative transactions must now be reported on a firm’s balance sheet and income statement under some accounting systems, the nature of future commitments and obligations under such contracts is still generally oblique.

3. Financial operating risks, such as securities and foreign exchange settlements, delivery of cash against securities, and so forth, comprise a separate category of operational risk that can also impact liquidity risk. For instance, failure by a bank to receive payments on securities that have already been delivered can result in a cash deficit that needs to be funded on a short-term basis.

4. Note that at least one major study has suggested that the interbank funding spread featured two different risk components: at the beginning of the first phase of the crisis (October–December 2007) credit risk was the dominant factor, while after the Lehman collapse in September 2008 the liquidity risk component moved to the forefront.

5. Unfortunately, the track of record of the public rating agencies in properly evaluat-ing structured credit has been shown to be poor at best. Bad modelling, conflicts of interest and slow reaction times meant that many of the AAA-rated securities backed by mortgages should never have carried such ratings. Furthermore, the record of the agencies in identifying companies with liquidity pressures (leading ultimately to financial distress and either bankruptcy or acquisition) has also been weak, to wit major “misses” on Penn Central, Drexel, WorldCom, First Executive, Enron, Bear Stearns, Lehman Brothers, among others.

2 Liquidity and Financial Operations

1. Interestingly, half of all US bank failures between 1984 and 1989 occurred within institutions that would have been considered “adequately capitalized” under the BIS 1988 Capital Accord definitions; capital alone is thus not enough to prevent a firm from failing.

2. We note that sovereign organizations, though not necessarily concerned with value maximization, are often equally interested in minimizing financial problems.

3. Indeed, in an effort to manage greater funding liquidity risks, some securities firms arrange for committed bank line facilities from the banking sector; this gives them some measure of safety in the event the short-term markets prove challenging.

3 Sources of Liquidity

1. It is true, of course, that banks active in the repo and reverse repo market often run “matched books” so that they do not face an excess of interest rate risk or curve risk. Thus, if a bank allows its reverses to roll off in order to generate additional cash, it must either rebalance its own repurchase agreement position by construct-

Notes 281

ing appropriate interest rate risk hedges or allowing the repos to roll off as well; if it selects the latter it will, of course, face a liquidity constraint of its own as it will have lost a source of funding. However, the securities it receives back from the repo close-outs can then be sold in the marketplace to generate additional cash. Such a process is common when a bank is shrinking its matched book, which often occurs prior to quarter-end financial reporting periods.

2. For instance, in 1996 the Bank of England introduced the Sterling Stock Liquidity Regime (SSLR), which broadened the liquidity requirements for commercial banks with a large retail presence. Under the SSLR banks must supplement the traditional cash inflow/outflow gap/ladder approach (which we discuss in Chapter 8) with a portfolio of liquid sterling assets that can be used to cover any potential loss of wholesale funding. (Note that a separate process, the Mismatch Liquidity Regime, which permits committed funds and a broader array of assets to be used in comput-ing the net liquidity position for each ladder maturity, was introduced in 1999 for non-SSLR banks,. )

3. In fact, certain empirical research (see Schlingemann, Stulz, and Waking, 2001, for example) suggests that a firm is most likely to sell portions of its business that are liquid, or those that are unrelated/immaterial to core operations or poor perform-ers, and far less likely to sell portions that are illiquid.

4. Note that similar local CP markets exist in other countries as well: Canada, for instance, features a relatively active marketplace for unsecured C$-denominated CP.

5. Investor demand for A-2/P-2 and A-3/P-3 issues is very small (less than 5 percent of total outstanding during normal market conditions) and can disappear very quickly, particularly during times of market stress or general credit deterioration, when investors are less eager to speculate on short-term credit spread movements. When this occurs, lower rated issuers with outstanding notes in the market may work with their dealing banks to “manage out” of the CP market (without causing any disruption in their operations or creating any negative publicity) by tapping alternative facilities, such as bank borrowings. Since the crisis of 2007–2008, the market for lower-rated CP has essentially become dormant .

6. A small number of CP programs are supported by bank letters of credit or are struc-tured as asset-backed programs, and would thus be considered “secured.”

7. Even deposits with longer maturities can indirectly affect a bank’s funding. For example, institutional investors that sell medium-term bank deposits in the sec-ondary market at a discount in order to retrieve their capital can send a negative signal to other low-risk institutional investors, making rollovers of other funds more difficult.

8. It is worth emphasizing that short-term liabilities (regardless of source) have an important role to play in the management of liquidity. In a general sense, we may say that when short-term liabilities (STLs) > short term assets (STAs) a company will be under some degree of liquidity pressure. It must therefore either increase its long-term liabilities (LTLs) to redeem the STLs, or it must convert long-term assets (LTAs) to STAs in order to meet STLs as they come due. Naturally, if STLs < STAs, there is no particular pressure, as enough STAs remain on hand to cover STL obliga-tions. The issue at hand, then, is the dynamism of a company’s STLs – a company must understand how they behave and whether they can change rapidly in the face of changing markets.

9. Euronote facilities generally permit issuance in the one to ten-year sector (com-plementing the shorter term issuance provided by ECP) and are often backed by bank tender panels, which absorb unsold notes and so provide contingent funding. Tender panel facilities are generally committed or transferable to other banks upon agreement by all parties.

282 Notes

10. Some firms have opted to follow the concept of cash capital as a way of financing long-term assets, particularly those that are illiquid in nature, as well as certain “critical” accounts, such as haircuts. Though the definition of cash capital can vary, it can include equity, long-term debt, synthetic structures which provide the equivalent of greater than 1 year funding, and so forth.

11. Some securitizations are liability, rather than asset, based and are intended to remove particular types of risks from the liability side of the balance sheet. The concepts are similar, although we shall not consider them in further detail.

4 Funding Liquidity Risk

1. It is worth noting that such reserves may have to be held in low/no-yield assets, which reverts to the issue of risk/return trade-off and enterprise value maximiza-tion.

2. Financial mismanagement has been at the heart of significant corporate problems over the past few decades, including those associated with Enron, Tyco, WorldCom, Swissair, and many others. Many problems ultimately manifested themselves in the form of severe liquidity pressure.

3. Bankers Trust serves as an interesting example of a firm that was plagued by rep-utational problems. It was ultimately subsumed by Deutsche Bank when it was unable to overcome the crisis of confidence. Although not strictly a liquidity prob-lem, the bank’s well-publicized client derivative lawsuits and settlements (such as Procter & Gamble, Gibson Greetings, and Sandoz) in the early 1990s, coupled with nearly $500 million in losses in Russia in 1998, eroded depositor and investor confidence in the bank and its management. The firm was downgraded on various occasions and was unable to generate a competitive cost of funds as a result of its problems. Deutsche Bank ultimately stepped in to acquire the bank when it was clear that further growth was becoming virtually impossible.

4. For instance, Gatev and Straham (2001) have found that bank assets (securities and bank lines of credit) increase more rapidly when short-term credit spreads (that is, commercial paper less Treasury bills) widen, and that the quantity of assets funded with deposits increases during a crisis period. The study has also found that banks have a comparative advantage over other financiers in extending loans during a crisis, as the yields they pay on flight-to-quality deposits decrease as credit spreads widen. Credit extensions, however, are not granted uniformly; that is, they are not granted to idiosyncratic borrowers who might wish to draw down based on their own credit circumstances, but to systematic borrowers, who draw down based primarily on the availability of market liquidity. Banks can thus lend to highly rated systematic borrowers during times of market stress, suggesting some “win-ners” exist when exogenous forces are otherwise proving disruptive. The reverse is also shown to be true: when markets regain their balance and depositors withdraw funds to reinvest in higher yield alternatives, banks are no longer flush with cash and thus scale back on the highly rated systematic lending they once engaged in.

5 Asset Liquidity Risk

1. For instance, there is empirical evidence that in some markets futures and the underlying cash assets they reference complement each other, promoting strong liquidity in both sectors – Eurodollar futures and Eurodollar deposits are one example of this. In other cases, futures and cash are independent and fraction-alized because they act as true substitutes. In such instances one of the instru-ments might exhibit a great deal more liquidity. In Japan, for example, the 10-year

Notes 283

Japanese Government Bond (JGB) futures contract is far more liquid than the underlying benchmark bond. The same can occur with corporate or sovereign bond issues. If the issuer offers too many different maturities as part of its debt management program, it might fractionalize the market so much that insufficient liquidity builds in any single issue. Alternatively, if it issues only a few maturities, it might fail to generate enough interest among investors and be unable to construct a meaningful yield curve. Balancing these two “fungibility forces” is not an easy task.

2. Most institutional OTC markets are quote-driven, while many public equity mar-kets are order-driven (or hybrid).

3. Similar spread differentials between on- and off-the-run securities have been observed in other asset classes during a variety of market conditions. For instance, off-the-run asset-backed securities might trade at a spread of +4–5 bps to the on-the-run asset-backed benchmark during normal market conditions, but as much as +40 bps in poor conditions; the same has been observed for investment grade bonds. Off-the-run high-yield bonds, in turn, might normally trade at +10–20 bps to the high yield on-the-run benchmark, and in excess of +50–75 bps in poor conditions.

4. A company will only lose ownership of the asset if it defaults on the terms of the collateralized financing transaction: that is, it fails to pay timely principal and interest or breaches a covenant.

6 Liquidity Spirals and Financial Distress

1. There are various academic theories about the underlying causes of bank runs. For instance, Diamond and Dybvig (1983) posit a model where banks are provid-ers of liquidity insurance to depositors who may decide to flee based on random events; Chari and Jagannathan (1988) focus on a model where systemic risks may be derived from idiosyncratic risks that lead to bank runs; Gorton (1988) assumes that bank runs are recession-related and tied directly to corporate and business fail-ures. Despite different models and views, empirical and anecdotal evidence sug-gest that bank runs tend to be driven by institutional, rather than retail, depositors because institutions have better access to information and less insurance coverage. The growing level of interbank and off-balance sheet activity, and the ease by which contagion can spread to other banks in the system, might exacerbate the runs.

2. Although some facilities contain material adverse change clauses giving funding banks the option to opt out if the credit environment has deteriorated enough to pose a financial risk, such clauses are rarely invoked; private “restructuring” may be a preferred alternative.

3. Credit extensions by banks can accelerate during stressed times as companies draw down facilities (such as during the 1998 Russia/hedge fund crisis, when credit expanded by 30 percent). The main issues center on whether deposits flee or are attracted, and whether banks are willing to assume the additional credit risk. Large banking institutions can often attract deposits, but the same is not necessarily true for small or mid-sized banks.

4. In some national systems regulators limit or prohibit the amount of credit that can be extended to rapidly deteriorating firms, which would exacerbate the problem.

5. It is important to note that liquidity problems are not the only reason a company might enter into a state of financial distress. Difficulties related to earnings, asset quality, overall leverage, or strategy, for example, can be equally damaging and might also induce a state of distress. While these are all important, they are outside the scope of this text.

284 Notes

7 Case Studies in Liquidity Mismanagement

1. In 1984 Continental Illinois, which was heavily reliant on wholesale and interna-tional markets for its funding, was unable to halt interbank deposit withdrawals fuelled by news of problems within the bank’s emerging market and energy loan portfolios. As liquidity drained away, a consortium of 29 banks and the Federal Deposit Insurance Corporation interceded with a $7.5 billion rescue package that reinjected cash into the bank; this was supplemented by a further $4.5 billion of borrowings from the Federal Reserve’s discount window. The bailout was consid-ered necessary as the possible disruptions from a large bank failure were deemed to be too great.

2. The reasons for the liquidity problems varied, but the end result was always the same: extreme difficulty accessing funds, resulting in very high funding costs. The Bank of New York suffered a large liquidity deficit in 1985 through operational errors, Salomon Brothers through the Treasury bond auction scan-dal in 1991, and Citibank through massive commercial real estate write-downs in 1991.

3. Although the October 1987 stock market crash was caused by a number of different factors, including excess leverage and speculation, and weakening economic condi-tions, the fall was exacerbated by the use of portfolio insurance, which involved selling assets (such as individual stocks or index futures contracts) into a falling market. The estimated $100 billion-plus of portfolio insurance programs created greater market instability on the downside and converted two-way flows into large one-way flows; the dynamic replication of portfolios via portfolio insurance called for selling more stock or index futures contracts as prices fell, injecting more selling pressure into the market and creating a self-fulfilling downward spiral. During the immediate pre-crash period, some $12 billion of index rebalancing was required, but only $4 billion was executed. By the time the crash was in full motion, the pent-up selling forces were unleashed: when the cash market faced delayed open-ings, the rebalancing programs were shifted to index futures, which exacerbated the fall. Liquidity eventually became so impaired that rebalancing could no longer be undertaken; portfolio insurance techniques were widely criticized in the after-math. Circuit breakers, designed to avoid market free-falls, were eventually insti-tuted and remain in place in various markets to the present time.

4. Following Mexican bank privatizations in 1991 and 1992, the sector entered a phase of rapid asset growth; indiscriminate lending led ultimately to deteriorating asset quality, which strained bank revenues. This was compounded by a very heavy reli-ance on domestic and offshore interbank deposits (63 percent of all funding) rather than more stable retail deposits. When the Mexican government devalued the peso by 56 percent in late 1994, most major banks suffered a rapid, and significant, loss of funds as interbank depositors exited. The ensuing losses left many banks in a weakened state; many smaller institutions were forced to close down or merge, and the government bailed out several larger banks (through the deposit insurance company and central bank).

5. Caprio and Klingebiel (1999) record 112 systemic banking crises in 93 countries between the 1970s and late 1990s, many of them the result of significant liquidity risk difficulties. Importantly, the authors indicate that such crises have impacted developed, as well as developing, nations; countries such as the US, UK, Spain, Finland, and Sweden appear to have been just as susceptible to systemic problems as emerging market systems.

6. Kidder Peabody, Donaldson Lufkin Jenrette, Lehman, Nomura, JP Morgan, Morgan Stanley, Merrill Lynch, Salomon, UBS, Bear Stearns, and Prudential were all lenders to Askin Capital.

Notes 285

7. In January 1995 Orange County sued Merrill for $2.4 billion, claiming it “wan-tonly and callously” sold the county risky securities in violation of state and fed-eral laws. Orange County claimed ultra vires , saying that it was acting out of its legal scope and that the transactions were unsuitable. County bondholders also sued Merrill and Citron for false disclosure in the July 1994 bond prospectus, and suits were filed against Morgan Stanley, Nomura, and CSFB for their role in grant-ing excessive amounts of leverage. All of the banks initially denied any wrongdo-ing, but eventually settled out of court: Merrill paid $437 million, Morgan Stanley $70 million, CSFB $52 million, and Nomura $48 million. Separately, the courts determined that Citron was to blame for the flawed strategy; Citron pleaded guilty to six felony counts related to making misleading statements in selling securities, falsifying accounting records and redirecting investment funds (not for losing the $1.7 billion).

8. To be sure, many banks were acting in self-interest; this was not a public bailout, obviously, but a reorganization with creditors risking $3.6 billion of their share-holders’ funds to avoid a catastrophe. The Street’s risk exposures were so large that it is likely that many players would have been severely damaged without the bailout.

9. Many major banks gave LTCM the leverage – repos, derivatives, and credit facili-ties – on very liberal terms, essentially mispricing their risk in order to secure a portion of the fund’s commission-based business. They also lent without good disclosure (contrary to standard credit operating procedures), opted not to require upfront collateral, and relied too heavily on their own flawed models. In some instances they attempted to replicate LTCM’s own positions, injecting the same illiquidity into their own books.

10. For instance, exposure to LTCM caused UBS to lose $690 million, the Bank of Italy $100 million, Credit Suisse $100 million, Dresdner $145 million, Sumitomo Bank $100 million, and so on. Broader market dislocations arising from vola-tility, illiquidity, and forced selling in other asset classes generated additional losses: CSFB reported losses of $1.3 billion in Russia, including nearly $640 mil-lion in rouble forwards purchased via the Moscow Interbank Currency Exchange to hedge rouble exposure; Citibank lost $60 million on Russia and $300 million on its arbitrage positions; Merrill lost $1.5 billion, mostly on spread widening affecting very large, and often illiquid, portfolios of corporate bonds and pre-ferred stock; Goldman reported proprietary trading losses of $650 million across various markets; and so on.

11. SAG featured 72,000 workers, including 21,000 in Switzerland, far more than any other carrier operating similar fleet size and routes, and its employees were among the highest paid in the entire industry. It also incurred additional expenses from its inconvenient dual hub system (Swissair/Zurich, CrossAir/Basel).

12. Readers interested in a broader review of the details of the case from a corporate governance perspective may wish to consult the discussion in Banks (2004a).

13. Including LJM1, LJM2, JEDI 1, JEDI 2, Chewco, and Raptors I-IV. 14. Andersen, Enron’s external auditor and architect of the partnerships (for which it

earned many millions of dollars in fees), indicated that it had not accounted for the SPEs correctly; as a result of errors early in the process, the SPEs were not con-solidated on Enron’s balance sheet as they should have been, forcing the restate-ments. Many of the SPE transactions between Enron and the LJM1, LJM2, and Chewco partnerships were arranged because the company could not, or would not, do them with third parties; the end-game in all cases appears to have been financial window dressing rather than genuine risk transfer.

15. There was fallout in other sectors as well: external auditor Andersen eventually failed under the weight of criminal obstruction of justice charges, and various

286 Notes

banks and law firms that assisted in the creation of a number of special, and ulti-mately illegal, transactions were fined and sanctioned.

16. http://companyinfo.northernrockassetmanagement.co.uk/downloads/results/ res2006PR_AnnualReportAndAccounts.pdf, p.2.

17. At least some blame for the Northern Rock crisis must also be attributed to the weak regulatory structure in the UK at the time, which spilt duties between the Bank of England and the Financial Services Authority (FSA). Ex-post analysis suggests that the FSA knew about Northern Rock’s liquidity problems at an earlier stage but did not act. There is also evidence of lack of coordination and mismanagement of decision-making. Furthermore, the deposit protection scheme was antiquated and at least somewhat flawed, and the regulatory framework lacked any mechanism to deal with the unwinding of troubled banks; much of the regulatory response was ad-hoc in nature. As a result, other troubled banks, including RBS, Bradford and Bingley, and Lloyds TSB, had to be wholly or partly nationalized when they ran into trouble.

18. “Banking Reform – Protecting Depositors,” Discussion Paper, HM Treasury, October 11, 2007.

19. Rather curiously, the Lehman Treasury “roadshow” material, presented in July 2008 by the bank as it attempted to broaden and strengthen its funding, con-tained an appendix referencing “lessons learned from the Bear Stearns liquidity event.” Apparently, sufficient lessons were not learned.

20. http://oversight.house.gov/images/stories/Hearings/110th_Congress/ Fuld_Statement.pdf

8 Measuring Liquidity Risk

1. Liquidity ratios are an important aspect of overall financial analysis and bank-ruptcy prediction; empirical research on bankruptcies suggests that the most important financial variables with predictive capabilities include leverage, liquid-ity, profitability, earnings volatility, and company size.

2. “Hot money” is characterized by a perfectly elastic supply curve, meaning it is extremely sensitive to interest rate levels and changes.

3. Duration can be measured in a number of different forms, including Macaulay’s duration and modified duration. For a standard fixed income instrument, these are given as:

2 1

1*

(1 )

*)

( )n)

Dury)

nCy y y2 (1

Dur (P

⎡ ⎤1 2c nC nM2= * ⎢ ⎥1 2(1 ) (1 ) (1 )1 2 n n(1 )⎡ ⎤⎡ ⎤1c c nC nM2+ + + +1 2)) ⎣ ⎦)y y y y(1 ) (1 ) (1 ) (1) (1 ) (1 ) (1 ⎥⎥(1 ) (1 ) (1 ) (1 )1 2 n(1 )(1 ) (1 ) (1 ) (1) (1 ) (1) (1 ) (1 ) (1(1 ) (1 ) (1 )) (1 ) (11 2 (1(1 ) (1 ) (1 ) (1) (1 ) (1) (1 ) (1 ) (11 2 (1

⎛ ⎞100

C⎜ ⎟100⎛ ⎞⎛ ⎞100 −

⎡ ⎤11

⎝ ⎠y⎜ ⎟⎜ ⎟100y

+⎥1⎤⎤1

1 −(1(1⎣ ⎦yy(1 )(1 ))

=

where C is semi-annual coupon interest, y is the semi-annual yield, n is the number of semi-annual periods, and M is the maturity value of the bond (generally par). These can be supplemented by measures of convexity, or the change in duration for a change in yield, which is important in determining the sensitivity of cash flows to large changes in rates:

http://companyinfo.northernrockassetmanagement.co.uk/downloads/results/res2006PR_AnnualReportAndAccounts.pdf, p.2.

http://oversight.house.gov/images/stories/Hearings/110th_Congress/Statement.pdf

http://oversight.house.gov/images/stories/Hearings/110th_Congress/

http://companyinfo.northernrockassetmanagement.co.uk/downloads/results/

Notes 287

21

( 1) ( 1)(1 ) (1 )

n

n)t 2t

t t C n n M( 1) ( 1)1) (Cvx

y y) (1) (122=

1) ((1) (+2

( )t 2=

)) (1(12 (12∑

4. Interestingly, a survey by IOSCO (2002) found that many firms at the turn of the millennium still did not regularly measure commitments or other off-balance sheet contingencies.

5. Note that, while there is no precise definition of the “correct” maturity buckets to use, and this definition remains at the discretion of individual institutions, many appear to focus on the following buckets as being most relevant: overnight, next day, 7 days, 14 days, 1 month, 2, months, 3 months, 6 months, 1 year, 3 years, 5 years, and 5+ years.

6. The essential maturity transformation function played by banks and other finan-cial institutions necessarily means that contractual short-term cash flows will be large, but may not necessarily be quite as large when considered on a behavioural basis, as those holding the liability cash flows may be quite happy to continue holding them through extensions, rollovers, and so forth.

7. Not surprisingly, banks must be able to adequately model the behaviour of these types of liabilities, so that they can understand how much funding they have under different scenarios. As we might expect, during stressed market situations, the “stickiness” of liabilities may change, with withdrawals or lack of rollovers accelerating versus some “historical norm.”

8. See Kyle (1995), for instance. 9. Note that spreads can also be measured in other forms, including the realized

spread, or the differential between the weighted average bid–offer for executed trades over time, and the effective spread, or the actual transaction price incorpo-rating the direction of price movements.

10. It is worth noting that dealing can occur within the full bid–offer spread (such as limit orders and guarantees) so friction may be overstated; in order to avoid this overstatement, a half spread (bid–offer/2, or quoted mid-market point prior to a trade) can be used as a proxy.

11. There is a large body of practical, empirical, and theoretical literature on VAR, which the interested reader may wish to consult; Jorion (1996) serves as an excel-lent primer. In general terms we note that “standard” parametric VAR (or variance/covariance VAR) relies on use of a multivariate distribution of asset returns and a variance/covariance matrix that is specified by time series returns. Volatilities and correlations may be estimated through historical processes (and may be expo-nentially weighted to give more recent observations greater weight in the sample), or they may be approximated through volatility estimation techniques (such as GARCH). The resulting parametric VAR, which is a multiple of the standard devia-tion of the distribution of portfolio returns, is simple to implement but cannot accommodate non-linear instruments (or can only do so crudely, through the use of delta approximation techniques.)

A second approach, the historical simulation VAR, is useful when the observed distribution of returns cannot be accommodated by a parametric approach. Under this framework, historical returns for assets in the portfolio are sampled, a time series of portfolio returns is simulated, and the appropriate confidence level VAR is determined. This process does not rely on assumptions about the shape of the distribution or estimates of volatility and correlation for individual assets; how-ever, it requires a long history of data (and might be questionable for any data

288 Notes

regime shifts). From a regulatory perspective, the BIS requires banks to perform a VAR computation based on the method of its choosing, adjusted to the 99 percent confidence level and a ten-day liquidation horizon, and scaled by a multiplier of 3 (which represents a safety cushion). The process also requires a regimen of stress testing, backtesting of results, input parameter updates, and appropriate qualita-tive standards and controls. While the aim is constructive and well-intended, it has shortcomings, including some mentioned in this chapter. Sophisticated finan-cial institutions rarely rely on standard VAR as their only means of measuring and managing market risk (and, by extension, aspects of liquidity risk).

12. Readers interested in an excellent overview of alternative LAVAR approaches (e.g., Almgren-Chriss, Jarrow-Subramanian, Bangia, Diebold, Schuermann and Stroughair) may wish to consult Erzegovesi (2002).

13. Note that it is common to define stress testing as an integrated, multivariable test, while scenario analysis is a future state based on the movement of a single vari-able; each scenario analysis calls for holding constant all variables except one.

14. While standard VAR data sets and computational frameworks based on historical data may lack the relevant “fat tail” characteristics, extreme value theory (EVT), which focuses on the tail of the distribution, tends to provide additional and valu-able information about the low probability/high severity events.

15. It is interesting to consider just how the “dominoes toppled” during the crisis. Whilst the genesis of the crisis had appeared much earlier, e.g., during the first half of the decade, as loose monetary policy had caused a very significant real estate bubble to develop, the first signs of trouble came in early- to mid-2007. In April 2007, New Century and American Home Mortgage, two large US mortgage originators, reported large losses and eventual closures. In May 2007, UBS’s pro-prietary trading “internal hedge fund,” Dillon Read, shut down after large credit and market losses. In June 2007, two Bear Stearns hedge funds had to be bailed out by the investment bank (consuming precious resources, as would be made clear in early 2008). In August 2007, BNP froze three investment funds, and German bank IKB had to be bailed out by the German banking sector after posting massive losses on its illiquid securities portfolio; another state bank, Sachsen Landesbank, suffered similar losses and required support. By the end of the month, a key fund-ing source, the asset backed commercial paper market, effectively shut down as investors refused to rollover paper any more. This instantly put pressure on all banks active in the securitization market and the structured investment vehicle sector, as they had to bring these assets (many of them illiquid subprime-backed securities) on–balance sheet, funding them through any means possible. Just a month later, the Bank of England supplied Northern Rock with a temporary liquidity facility and, together with HM Treasury, would soon issue a blanket guar-antee on deposits in order to stop the growing deposit withdrawals (as we have discussed earlier in the book). Throughout this period many US and international banks were posting increasing losses as they marked their illiquid asset portfolios to market; some were forced into a deleveraging situation. In November 2007, HSBC was forced to absorb $45 billion in SIV assets. Unfortunately, 2008 was even worse, as illiquidity and market losses intensified. In March 2008, Bear Stearns ran out of cash and was rescued by JP Morgan (with some backing from the US Treasury). Turmoil continued throughout the summer, and in September 2008 events came to a climax: Wachovia and Merrill Lynch, both suffering from con-tinued funds outflows, were forced into shotgun marriages with Wells Fargo and Bank of America, respectively. Shortly thereafter, Lehman Brothers, like Bear, ran out of cash, but was not rescued – it was forced into bankruptcy. That triggered panic throughout the markets, causing governments to assemble rescue packages for Fannie Mae and Freddie Mac, AIG and many other US and international banks

Notes 289

(as well as the entire nation of Iceland). The government intervention, through massive liquidity injection and partial nationalizations, calmed the markets and put things on a more stable footing. However, most of 2009 was fragile, with mar-ket conditions far from normal and liquidity in many assets still thin. Not until 2010 did some semblance of normalcy begin to return. So the toppling of the dominoes was extensive, and although credit and market risks featured as initial drivers, liquidity risks came into full force at various occasions during the period. Any successful stress testing exercise demands some “blue sky thinking” about unimaginable events and connections – just as the last crisis demonstrated.

16. Consider, for example, that changing interest rate levels will not have a significant impact on the cash flow portion of the exercise (as the critical time period falls within weeks or months, rather than years) but it will have a rather large effect on the value of assets in the liquidity buffer (particularly those securities that have long durations and are thus very price/rate sensitive).

17. One area of study that attempts to provide better estimates of the tails of statisti-cal distributions is extreme value theory (EVT). EVT estimates probabilities by fitting a model to the tail of a probability function using only extreme event data; a tail index is derived and the thickness of the distribution in extreme regions can be analyzed. EVT is used in catastrophic risk analysis by insurers and reinsurers to capture the low frequency/high severity events to which they are potentially exposed. We might argue that a systemic liquidity crisis, or perhaps a multi-insti-tution liquidity crisis, falls into that category, suggesting that EVT may be useful.

18. One further note bears mentioning for institutions that are forced to dispose of securities held in investment, rather than trading, accounts. Under International Accounting Standards, 35 so-called “hold to maturity” assets need not be marked to market. However, if these “hold to maturity” investments are liquidated in support of current liquidity requirements, additional penalties may accrue to the firm, diminishing the cash value that can be extracted from the portfolio.

19. The haircuts applied to fixed assets can be more challenging to determine because they are based on assets that are unique and often lack a ready market of buyers. An industrial company with an unencumbered factory valued at $500 million (after depreciation) may not receive the full value in a disposal or pledging sce-nario; how much it receives will depend on both the perceived worth of the fac-tory to a lender or buyer and the time horizon during which transaction execution must occur. Engineers and auditors must perform due diligence on the estimated sales value of the factory, and investment bankers might then approach commer-cial banks and/or competitors to determine whether they would be willing to lend or buy at the independently assessed value. The process is time-consuming and far from transparent, meaning an ex-ante haircut value can be difficult to ascertain. The time dimension again features in the equation, with rapid disposal or pledg-ing creating a larger discount. As with any illiquid asset, it is reasonable to assume that in most instances the haircut will be considerable, 25–75 percent of book value, and possibly even more.

9 Controlling Liquidity Risk

1. These are often driven by expectations regarding key financial indicators such as economic growth, interest rates, term structure movements, foreign exchange rates, consumer confidence, and inflation.

2. In the banking sector, for example, the BIS has specifically noted in its Liquidity Risk discussion paper from 2008 (Principle 4) that “a bank should incorporate liquidity costs, benefits and risks in product pricing, performance measurement and new product approvals.”

290 Notes

3. Consider, for instance, that in the United States a bank holding company (BHC) cannot accept deposits or make use of the Federal Reserve discount window, and must therefore rely very heavily on the interbank market for liquidity. In addi-tion, a BHC faces considerable constraints regarding upstreaming of funds and divi-dends from main bank units, putting even greater pressures on funding (e.g., credit from a main bank unit to a BHC must be collateralized, a main bank unit cannot repay a BHC’s obligations, dividends can only be moved upstream as long as the main bank’s capital ratios remain sound). Similar restrictions exist in the insur-ance industry and in other regulated/unregulated industrial sectors. All of these relationships must be well understood before liquidity can be properly controlled, hence the importance of a legal entity and consolidated focus.

4. To give just one example, the US Office of the Comptroller of the Currency (OCC) believes that a funding concentration exists when a single decision or single market factor could lead to a large withdrawal of funds. The OCC has also indicated that US banks must be very cautious about over-reliance on the interbank funding market, even if activity is spread out among a large number of banking institutions.

5. In some cases, institutions can create products that allow better control of what might otherwise be an uncertain maturity; for instance, a liability may include an early exercise penalty that effectively dissuades presentation prior to the original contract maturity.

6. Even in instances when a MAC is not publicly triggered, there is the possibility that bankers will press the borrowing company to take certain actions or enact certain reforms that will add pressure to its financial position.

7. It is interesting to note that at least one banking regulator has proposed the estab-lishment of one week and one month cash flow gap limits built atop multi-week dynamic “stress factors” that are applied to actual and contingent inflows and out-flows. Larger stress factors are used when currency mismatches exist. This approach can be viewed as a matrix of hybrid multi-currency cash flow gap limits that have been recalibrated for the effects of stress testing.

8. Consider the case of US bank Wachovia, which suffered greatly during the financial crisis. Specifically, in the aftermath of the Lehman collapse, the bank lost approxi-mately $6.8 billion in deposits and commercial paper. Though the bank still held a liquidity buffer of more than $100 billion, it had done a poor job of communi-cating effectively with its financing providers; concerns about the bank’s mort-gage portfolio and lack of clear answers led to growing nervousness. Shortly after the silent run on the deposits, counterparties demanded repayment of a further $50 billion of credit. Over the following weekend, US regulators determined that Wachovia stood to lose a further $115 billion of funding from retail and corporate deposits (versus $100 billion in coverage). Given this liquidity squeeze, regulators approved an 11 th hour acquisition of Wachovia by beleaguered Citibank; the bid was trumped at the last minute by the much stronger Wells Fargo, which essen-tially saved Wachovia from collapse. While we may never know what might have happened had Wachovia been more forthright and constructive in its dialogue and relationships with funders, it is an important lesson to bear in mind. Loss of confi-dence can occur quickly and can be damaging.

9. In some instances regulations or accounting conventions require firms to comply with specific liquidity-related disclosures. For instance, in the regulatory commu-nity, the US Securities and Exchange Commission, commenting on Management Discussion and Analysis of Financial Condition and Results, has indicated:

In determining required or appropriate disclosure, companies should evalu-ate separately their ability to meet upcoming cash requirements over both the short-term and long-term. Merely stating that a company has adequate resources is insufficient unless no additional more detailed or nuanced information is

Notes 291

material.… One starting point for a company’s discussion and analysis of cash requirements is a tabular disclosure of contractual obligations, supplemented with additional information that is material to an understanding of a company’s cash requirement. Companies should address, where material, the difficulties involved in assessing the effect of amount and timing of uncertain events, such as loss contingencies, on cash requirements and liquidity. Any such discussion should be specific to the circumstances and informative.

(SEC, 2003) Within the accounting sector, the International Account Standards Board, ref-

erencing disclosures related to financial instruments, has noted that “an entity shall disclose (a) a maturity analysis that shows for financial liabilities the remain-ing contract maturities; and (b) a description of how it manages the liquidity risk inherent in (a).” Other accounting systems have requirements of their own.

10 Liquidity Crisis Management

1. Reductions in net working capital are very industry dependent. In some instances working capital is relatively high, e.g., construction (20–25% of assets) while in others it is comparatively low, e.g., oil and gas, mining (10%). Those with higher working capital certainly have greater flexibility in reducing as needed; common methods include collecting receivables, reducing inventories, and managing paya-bles more conservatively.

11 New Regulatory Initiatives

1. Level 1 assets are limited to: Coins and banknotes ●

Central bank reserves (including required reserves) to the extent that the cen- ●

tral bank policies allow them to be drawn down in times of stress Marketable securities representing claims on or guaranteed by sovereigns, ●

central banks, PSEs, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and European Community, or mul-tilateral development banks, as long as they have a 0% risk weight under Basel II, traded in a deep market with a proven track record of liquidity under all conditions, and not issued by a financial institution Domestic (local currency) sovereign or central bank debt for non-0% risk ●

weighted sovereigns. Level 2A assets include:

Marketable securities representing claims on or guaranteed by sovereigns, central ●

banks, PSEs or multilateral development banks that satisfy all of the following conditions: assigned a 20% risk weight under the Basel II Standardized Approach for credit risk; traded in large, deep and active repo or cash markets character-ized by a low level of concentration; have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions (i.e., maximum decline of price not exceeding 10% or increase in haircut not exceeding 10 percentage points over a 30-day period during a relevant period of significant liquidity stress); and not an obligation of a financial institution or any of its affiliated entities. Corporate debt securities (including commercial paper) and covered bonds that ●

satisfy all of the following conditions: in the case of corporate debt securities: not issued by a financial institution or any of its affiliated entities; in the case

292 Notes

of covered bonds: not issued by the bank itself or any of its affiliated entities; and are “plain vanilla” in nature, with no complex features or subordination. Additionally, they must

have a long-term credit rating from a recognized external credit assessment institution (ECAI) of at least AA-21 or in the absence of a long-term rating, a short-term rating equivalent in quality to the long-term rating; or (ii) do not have a credit assessment by a recognized ECAI but are internally rated as having a probability of default (PD) corresponding to a credit rating of at least AA-;

be traded in large, deep and active repo or cash markets characterized by a low level of concentration; and

have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions: i.e., maximum decline of price or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10%.

Level 2B assets include:

Residential mortgage backed securities (RMBS) that satisfy all of the following ●

conditions may be included in Level 2B, subject to a 25% haircut: not issued by, and the underlying assets have not been originated by, the bank

itself or any of its affiliated entities; have a long-term credit rating from a recognized ECAI of AA or higher, or in

the absence of a long-term rating, a short-term rating equivalent in quality to the long-term rating;

traded in large, deep and active repo or cash markets characterized by a low level of concentration; have a proven record as a reliable source of liquidity in the markets (repo or

sale) even during stressed market conditions, i.e., a maximum decline of price not exceeding 20%;

the underlying asset pool is restricted to residential mortgages and cannot contain structured products;

the underlying mortgages are “full recourse’’ loans (i.e., in the case of fore-closure the mortgage owner remains liable for any shortfall in sales pro-ceeds from the property) and have a maximum loan-to-value ratio (LTV) of 80% on average at issuance; and

the securitizations are subject to “risk retention” regulations which require issuers to retain an interest in the assets they securities.

Corporate debt securities (including commercial paper) that satisfy all of the ●

following conditions may be included in Level 2B, subject to a 50% haircut: not issued by a financial institution or any of its affiliated entities; either (i) have a long-term credit rating from a recognized ECAI between

A+ and BBB- or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; or (ii) do not have a credit assessment by a recognized ECAI and are internally rated as having a PD corresponding to a credit rating of between A+ and BBB-;

traded in large, deep and active repo or cash markets characterized by a low level of concentration; and

have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, i.e., a maximum decline of price not exceeding 20% or increase in haircut over a 30-day period not exceeding 20 percentage points during a relevant period of significant liquidity stress.

Notes 293

Common equity shares that satisfy all of the following conditions may be ●

included in Level 2B, subject to a 50% haircut: not issued by a financial institution or any of its affiliated entities; exchange traded and centrally cleared; a constituent of the major stock index in the home jurisdiction or where

the liquidity risk is taken, as decided by the supervisor in the jurisdiction where the index is located;

denominated in the domestic currency of a bank’s home jurisdiction or in the currency of the jurisdiction where a bank’s liquidity risk is taken;

traded in large, deep and active repo or cash markets characterized by a low level of concentration; and

have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, i.e., a maximum decline of share price not exceeding 40% or increase in haircut not exceeding 40 percentage points over a 30-day period during a relevant period of sig-nificant liquidity.

2. Another definition of counterbalancing capacity is given as the liquid asset portfolio plus new short-term debt plus new long-term debt.

3. The rules distinguish between Individual Liquidity Assessment Standards (ILAS) and non-ILAS entities. ILAS include banks, building societies and investment companies, while non-ILAS include small banks, limited license operations and limited activity operations.

12 Summary: Toward Active Liquidity Risk Management

1. Consider, for example, that UK securities firms were historically not directly sub-ject to the liquidity rules imposed by the Bank of England on other domestic bank-ing institutions, even though they may have had considerable liquidity exposures. That has changed with FSA’s BIPRU 12.

2. Elimination of “too big to fail” has been a priority for a number of national regula-tors, who seek to avoid a repetition of the bailouts they were party to in 2008–2009. While various initiatives have been put forth, including shrinking bank activities and granting regulators defined authorities in a “wind down” or resolution phase, there does not seem to be any widespread belief that the “too big to fail” concept, with its attendant call on taxpayers, has actually been resolved.

3. The process should also involve ancillary and indirect forms of support, such as temporarily relaxing collateral, reserve, and solvency requirements for other insti-tutions in the system, and sterilizing any system-wide liquidity injections in order to avoid inflationary pressures and currency weakness. In general, more “extreme” government actions, such as interest rate cuts, capital controls, or deposit freezing should be avoided, as these can send a potentially damaging signal to the market-place at large, and actually affect liquidity.

294

Selected References

American Academy of Actuaries (AAA) (2000) “Report of the American Academy of Actuaries Life Liquidity Working Group,” Washington, DC: AAA.

American Bankers Association (ABA) (2011) “Dodd Frank Act Implementation: Executive Overview,” Washington DC: ABA.

Bangia, A., Diebold, F., Schuermann, T., and Stroughair, J. (1999) “Modeling Liquidity Risk with Implications for Trading Market Risk Management,” Working Paper, University of Pennsylvania.

Banks, E. (2004a) Corporate Governance , Basingstoke, UK: Palgrave Macmillan. Banks, E. (2004b) The Credit Risk of Complex Derivatives , 3rd edn, Basingstoke, UK:

Palgrave Macmillan. Banks, E. (2006) The Failure of Wall Street , NY: Palgrave Macmillan. Banks, E. (2010) Risk and Financial Catastrophe , UK: Palgrave Macmillan. Banks, E. (2011) See No Evil , Basingstoke, UK: Palgrave Macmillan. Banks, E. and Dunn, R. (2003) Practical Risk Management , London: John Wiley. Barrett, A. (2003) “Cash: Burn, Baby, Burn,” Business Week , April 28. Basel Committee on Banking Supervision (BIS) (1992) A Framework for Measuring

and Managing Liquidity , Basel: BIS. Basel Committee on Banking Supervision (BIS) (2008) Principles for Sound Liquidity

Risk Management , Basel: BIS. Basel Committee on Banking Supervision (BIS) (2010) Basel III: International

Framework for Liquidity Risk Management Standards and Monitoring , Basel: BIS. Basel Committee on Banking Supervision (BIS) (2013) Basel III: The LCR and

Liquidity Risk Monitoring Tools , Basel: BIS. BIS (1999) Market Liquidity: Research Findings and Selected Policy Implications, Basel:

BIS. BIS (2000) Sound Practices for Managing Liquidity in Banking Organizations , Basel:

BIS. Berkowitz, J. (2000) “Incorporating Liquidity Risk into VAR models,” Working

Paper, University of California at Irvine. Bernstein, P. (1987) “Liquidity, Stock Markets, and Market-Makers,” Financial

Management , Summer, pp. 54–62. Borio, C., (2009) “Ten Propositions about Liquidity Crises,” BIS Working Paper

293, Basel: BIS. Brockman, P. and Chung, D. (2001) “Managerial Timing and Corporate Liquidity:

Evidence from Actual Share Repurchases,” Journal of Financial Economics , Vol. 61, No. 3 (September).

Brown, K., Fiedler, R., and Moloney, J. (2001) “Liquidity In a Dry Climate,” E-Risk Portal , New York: E-Risk.

Buraschi, A. (2002) “Liquidity Risk and Specialness,” Journal of Financial Economics , Vol. 64, No. 2 (May).

Canadian Institute of Actuaries (CIA) (1996) “Liquidity Risk Measurement,” Subcommittee on Liquidity Risk Measurement, Ottawa, Canada.

Caprio, G. and Klingebiel, D. (1999) “Episodes of Systemic and Borderline Financial Crises,” World Bank Monograph, Washington, DC: World Bank.

Selected References 295

Chari, V. and Jagannathan, R. (1988) “Banking Panics, Information, and Rational Expectations Equilibrium,” Journal of Finance , Vol. 43.

Committee of European Bank Supervisors (CEBS) (2009) “Consultation Paper on Liquidity Buffers and Survival Periods,” Brussels: CEBS.

Committee of European Bank Supervisors (CEBS) (2010) “EU Banks’ Liquidity Stress Testing and Contingency Funding Plans,” Brussels: CEBS.

Covitz, D. and Downing, C. (2002) “Insolvency Or Liquidity Squeeze?” Federal Reserve Bank Bulletin, Washington, DC: Federal Reserve Bank (FRB).

Coyle, B. (2000) Cash Flow Forecasting and Liquidity , Chicago: Glenbrook. Davis, E. (1999) “a Reappraisal of Market Liquidity Risk in the Light of the

Russia/LTCM Global Securities Market Crisis,” Presentation at Basel Banking Supervisors Conference.

Decker, P. (2000) “The Changing Character of Liquidity and Liquidity Risk Management,” Chicago: Federal Reserve Bank of Chicago.

Desocio, A. (2011) “The Interbank Market after the Financial Turmoil,” Bank of Italy Working Paper 819, Rome: Bank of Italy.

Diamond, D. and Dybvig, P. (1983) “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Econom y, Vol. 91 (June).

Diamond, D. and Rajan, R. (1999) “Liquidity Risk, Liquidity Creation and Financial Fragility: a Theory of Banking,” Working Paper, National Bureau of Economic Research.

Drehmann, M. and Nikolaou, K. (2010) “Funding Liquidity Risk: Definitions and Measurement,” BIS Working Paper 3164, Basel: BIS.

Dudley, W. (2009) “More Lessons from the Crisis,” Federal Reserve Bank of New York speech, New York: FRB.

Ernst and Young (2012) Bank Risk Management Survey: Liquidity Management , New York: E&Y.

Erzegovesi, L. (2002) “VaR and Liquidity Risk,” Working Paper, University of Trento, Italy.

European Commission (2009) “Directive 2009/138 of the European Parliament on Insurance and Reinsurance (Solvency II),” Brussels: EC.

Federal Deposit Insurance Corporation (FDIC) (1998) DOS Manual of Examination Policies: Liquidity and Funds Management, Washington, DC: FDIC.

Federal Reserve Bank of San Francisco (2008), “What Is Liquidity Risk,” Economic Letter 2008–33, San Francisco: FRBSF.

Fernandez, F. (1999) “Liquidity Risk: New Approaches to Measurement and Monitoring,” Working Paper, Securities Industry Association.

Financial Services Authority (FSA) (2003) Liquidity Risk in the Integrated Prudential Sourcebook: A Quantitative Framework , London: FSA.

Financial Services Authority (FSA) (2008) Strengthening Liquidity Standards, London: FSA.

Financial Services Authority (FSA) (2010) Liquidity Regime and Non-ILAS BIPRU Firms , London: FSA.

Gatev, E. and Straham, P. (2001) “Banks’ Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market,” Working Paper, University of Pennsylvania.

Gorton, G. (1988) “Banking Panics, and Business Cycles,” Oxford Economic Papers , Vol. 40.

Gorton, G. and Huang, K. (2002) “Liquidity, Efficiency, and Bank Bailouts,” Working Paper, University of Pennsylvania.

296 Selected References

HM Treasury (1999) UK Economic Glossary , London: HM Treasury. International Association of Insurance Supervisors (IAIS) (2000) “Solvency

Subcommittee Issues Paper,” Basel: IAIS. International Institute of Finance (2009) “Reform in the Financial Services

Industry,” Washington DC: IIF. International Organization of Securities Commissioners (IOSCO) (2002) Sound

Practices for the Management of Liquidity Risk at Securities Firms , Geneva: IOSCO. Jameson, R. (2001) “Who’s Afraid of Liquidity Risk?” E-Risk Portal , New York:

E-Risk. Jarrow, R. and Subramanian, A. (1997) “Mopping Up Liquidity,” Risk , December

10. Jorion, P. (1996) Value at Risk , Burr Ridge, IL: Irwin. Kyle, A. (1995) “Continuous Auctions and Insider Trading,” Econometrica , Vol. 53,

No. 6. Locke, P. and Sarkar, A. (1996) “Volatility and Liquidity in Futures Markets,”

Federal Reserve Bank of New York Paper, New York: FRB. Lott, F. and Marcucci, J. (2003) “Corporate Liquidity Demand in the US,” Working

Paper, Bank of Italy and University of California San Diego. Lucas, R. and Stokey, N. (2011) “Liquidity Crisis: Understanding Sources and

Limiting Consequences,” Federal Reserve Bank of Minneapolis Economic Policy Paper 11–3, Minneapolis: FRBM.

Lucas, Y. (2009) “The Impact of Financial Crises on Transfer Systems,” Paris: Banque de France.

Matz, L. (2011) Liquidity Risk Measurement and Management: Basel III and Beyond , New York: Xlibris Corp.

Matz, L. and Neu, P. (2006) Liquidity Risk: Measurement and Management, Singapore: John Wiley.

Muranaga, J. and Ohsawa, M. (1999) “Measurement of Liquidity Risk in the Context of Market Risk Calculation,” Bank of Japan Bulletin , Tokyo: Bank of Japan.

Nikolaou, K. (2009) “Liquidity Risk Concepts,” ECB Working Paper 1008, Brussels: ECB.

Northern Rock (2006) Annual Report, and Accounts, Newcastle upon Tyne. Office of the Comptroller of the Currency (OCC) (2001) Liquidity: Comptroller’s

Handbook , Washington, DC: OCC. Office of the Superintendent of Financial Institutions Canada (OSFI) (1995)

Liquidity Guideline , Ottawa, Canada: OSFI. Schlingemann, F., Stulz, R., and Waking, R. (2001) “Divestitures and the Liquidity

of the Market for Corporate Assets,” Working Paper, National Bureau of Economic Research.

Securities and Exchange Commission (SEC) (2003) “Management Discussion and Analysis of Financial Condition and Results: Interpretative Guidance,” Washington, DC: SEC.

Sender, H. and Singer, J. (2003) “a Betting Man and His Fund’s Hard Fall,” Wall Street Journal , April 9.

Sprinzen, S. and Petit, M. (2002) “Framework for Analyzing Corporate Liquidity Under Stress,” Standard and Poor’s CreditWeek , New York: Standard and Poor’s.

Taleb, N. (1996) Dynamic Hedging, New York: John Wiley.

297

active liquidity risk management, future of 259–69

macro role 263–9avoiding fragmentation 266conducting regular inspections 265harmonizing accounting

treatment 266–7minimizing costs 266providing selective lender of last

resort support 267–8reinforcing proper capital

allocation 267micro role: best practices 260–3

creating a sound governance framework 260–1

developing and implementing a crisis management process 263

implementing proper measures and reporting 261–2

performing ongoing reviews 265using tactical controls 262

asset liquidity risk 5, 93–107effects of 106–7exogenous considerations 96–8nature of asset liquidity risk

problems 101–6excessive concentrations 102–3insufficient collateral 105–6lack of asset marketability 99–101lack of unencumbered assets 101–2misvalued assets 103–5

sources of 96asset liquidity, sources of 49–55

Bank for International Settlements (BIS) 16

Basel III 243–52BIS, see Bank for International

Settlements

case studies 122–52Askin Capital 126–9Drexel Burnham Lambert 123–6Enron 140–4General American 135–6Lehman Brothers 148–52Long Term Capital Management 131–4

Northern Rock 144–8Orange County 129–31Swissair 136–40

cash flow gaps 162–7Committee of European Banking

Supervisors Liquidity Consultation 253–4

conduit 16contagion 120–1controlling liquidity risk 188–226

governance structure 188–90liquidity risk controls 196–218

asset liquidity controls 197–204collateral/pledging limits 202–4liquidity and fixed asset

limits 198–202funding liquidity controls 204–10

committed facility limits 207–10diversified funding limits 205–7

joint liquidity controls 210–12balance sheet target limits

211–12cash flow gap limits 210–11hybrid ratio limits 212

off balance sheet controls 212–14forward commitments and

contingencies 213–14other safeguards 215–19

defensive interval 215–16external relationship

management 218–19mark and model

verification 216–17penalties 217–18reserves 216

liquidity risk management 191–4financial and human

resources 192–4risk plan 191–2

liquidity risk monitoring 219–26asset and funding portfolios 220forward balance sheet 221general indicators 222–3management goals 224–5off balance sheet commitments and

contingencies 221stress scenarios 221–2

Index

298 Index

controlling liquidity risk – continuedtechnical capabilities 225–6

management duties 194–9corporate liquidity ratios 160counterbalancing capacity 251credit risk 4, 13

defensive interval 215–16defensive measures 232–7definition of liquidity risk 3–7depth 168Dodd Frank Act 252–3duration 270–2

endogenous liquidity 5, 9–10, 43exogenous liquidity 5, 9–10, 47, 96–8

financial distress 119–1201financial institution liquidity ratios 161financial instrument liquidity

measures 168–73financial risk 3Financial Services Authority BIPRU 12,

254–6funding liquidity risk 4, 77–92

effects of 91–2exogenous considerations 85–7nature of funding problems 87–91

commitment withdrawals 89–90excessive concentrations 90–1lack of market access 88–9rollover problems 87–8

sources of 78–85mismanagement 84negative perceptions/market

actions 84–5unfavorable legal/regular

actions 83–4unpredictable cash flows 78–83

funding liquidity, sources of 55–64

gap analysis 271–2gap management 270–9

common measures 272–9duration 270–2interest rate activities 270

haircut 50–1high quality liquid assets (HQLA) 50,

244–6HQLA, see High quality liquid assets

joint asset/funding liquidity risk 5, 108–13

liquid assets 49–53liquidity adjusted value at risk 170–3liquidity committee 188–90liquidity contingency risk 5liquidity coverage ratio 161, 244–6liquidity crisis management 227–41

defensive measures 232–7communication 236–7recentralization 232–6

asset management 235funding management 232–5risk hedging 236

disaster recovery 239ex-ante market access 231–2invoking and terminating the

program 237–9scope and focus 227–31testing the plan 239–41

liquidity mismatch risk 5liquidity ratios 157–62liquidity risk

controlling 188–226measuring 155–87monitoring 219–26policies 196pricing 193–4

liquidity risk and financial operations 24–47

endogenous versus exogenous liquidity 43–7

external requirements 29–31financial imperatives 28–9general approaches to liquidity

management 27–8liquidity operating requirements

24–7liquidity profiles by industry 33–42

capital intensive companies 41–2financial institutions 34–40municipalities and sovereigns 42non-financial service

companies 40–1liquidity risk/return tradeoff

31–3liquidity risk controls 196–218liquidity risk defined 3–23

definition of 3–7liquidity risk and financial

crises 14–22liquidity, risk and the

corporation 7–13market risk, credit risk and liquidity

risk 13–14

Index 299

liquidity risk management, active 259–69

liquidity, sources of 48–73liquidity spirals and financial

distress 108–21contagion 120–1financial distress 119–1201joint asset and funding risks 108–13

causes 112–13problems 109–11

liquidity spirals 113–19causes 115–19

debt investors and banks 116–18management reaction 119rating agencies 118–19s

problems 113–15liquidity warehouse 53, 199

market risk 4, 13, 93measuring liquidity risk 155–87

common liquidity measures 155–86cash flow gaps 162–7financial instrument liquidity

measures 168–73liquidity ratios 157–62stress tests 173–87

asset disposals, secured funding and haircuts 179–82

cash flows 178–9collateral 184–5covenants and

terminations 183–4currency exposures 185event risks and joint

scenarios 185–6liquidation horizon 178market parameters 176–7stress test framework 175–6unsecured funding 182–3

net funding requirement 163–5, 211net interest income 273net interest margin 273net stable funding ratio 161, 246–50new regulatory initiatives 242–58

Basel III 243–52monitoring 250–2new liquidity measures 243–50

liquidity coverage ratio 244–6net stable funding ratio 246–50

Committee of European Banking Supervisors Liquidity Consultation 253–4

Dodd Frank Act 252–3Financial Services Authority BIPRU 12,

254–6solvency II and other insurance

regulations 256–8

off balance sheet liquidity, sources of 64–71

operating risk 3–4

rate sensitive assets 166–7, 271rate sensitive liabilities 166–7, 271rating agencies 30–1repurchase agreement 16resiliency 168–9risk appetite 192–3

securitization 17, 65–6shadow banking 16silent bank run 17, 146SIV, see Structured investment vehiclesolvency 25solvency II and other insurance

regulations 256–8sources of liquidity 48–73

amalgamating sources of liquidity 71–3

sources of asset liquidity 49–55fixed assets and intangibles 54–5

fixed assets 54–5intangibles 55

liquid assets 49–53cash and marketable

securities 49–52inventories 52–3receivables 52

sources of funding liquidity 55–64equity capital 63–4medium/long-term funding

marketsfunding agreements and

guaranteed investment contracts 60–3

loans 62–3long-term bonds 61–2medium term notes and

Euronotes 60short-term funding markets 57–60

commercial paper and euro commercial paper 57

deposits and repurchase agreements 58–9

payables 58

300 Index

sources of liquidity – continuedshort-term bank facilities 57

sources of off balance sheet liquidity 64–71

contingent financings 66–7derivatives 68leases 67–8securitization 65–6

stress tests 173–87structured investment vehicle (SIV) 16,

17, 20

tightness 168

value at risk (VAR) 134, 170–3VAR, see value at risk

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