Introduction: different types of liquidity The concept of liquidity is used in two quite different...

Introduction different types of liquidity The concept of liquidity is used in two quite different ways It is used in one way to describe financial

instruments and their markets A liquid market is one made up of liquid assets normal transactions can be easily executed ndash the US treasury market for on-the-run bonds is an especially good example Liquidity is also used in the sense of the solvency of a company A business is liquid if it can make payments from its income stream either from the return on its assets or by borrowing thefunds from the financial markets

The liquidity risk we consider here is about this second kind of liquidity Financial institutions are particularly at risk from a liquidity shortfall potentially ending in insolvency

Liquidity of financial markets and instrumentsIt would seem straightforward to define the concept of market liquidity and the liquidity of financial instruments

A financial market is liquid if the instruments in this market are liquid a financial instrument is liquid if it can be traded at the

lsquomarket pricersquo at all times in normal or near-normal market amounts

The firm while in good financial health can readjust its maturity structure more quickly in response to changes in its asset value Ideally the firm would secure long-term financing just prior to when its financial health may worsen Through this strategy the firm can secure financing for the longest continuous period possible without rollover failure avoiding inefficient restructuring costs Put differently the objective of the firm with long-term assets is to maximize the effective maturity of its liabilities across several refinancing cycles rather than

to maximize the maturity of the current bonds outstanding

liquid market is a market where participants can rapidly execute large-volume transactions with a small adverse impact on prices

Friction is related to the compensations paid by demanders of immediacy

(active traders who place market orders to trade immediately) to suppliers of immediacy (passive traders such asmarket makers who stand ready to trade at prices they quote) The types of intermediaries supplying liquidity and the ldquopricingrdquo of immediacy changes with the microstructural features

of marketsWe shall refer to a general case with generic market makers quoting

a mid price and a bid-ask spread (static component) for a limited amount and adjusting quotes (price impact dynamic component) in response to the flow of orders The cases of pure and mixed order driven markets can be considered as a variation on the dealer market case where the role of market-makers is performed by a varying population of traders who may perform that function explicitly

Bid Ask Spread

The bidoffer spread (also known as bidask or buysell spread) for securities (such as stock futures contracts options or currency pairs) is the difference between the price quoted by a market maker for an immediate sale (bid) and an immediate purchase (ask) The size of the bid-offer spread in a given commodity is a measure of the liquidity of the market and the size of the transaction cost

In market microstructure research market liquidity is assessed along three possible dimensions

Tightness is how far quotes and transaction prices diverge from mid-market prices and can generally be measured by the bid-ask spread

1048576 Depth denotes either the volume of trades possible without affecting prevailing market prices or the amount of orders on the order-books of market makers at a given time the deeper a market the lesser the price impact of trades on that market

1048576 Resiliency refers to the speed with which price fluctuations resulting from trades are dissipated or the speed with which imbalances on the order flows are adjusted

Liquidity of financial institutionsIn the context of a FI liquidity can have different meanings It can describeΩ Funds (central bank money held with the central bank directly or with other institutions)Ω The ability of the FI itself to attract such fundsΩ The status of the central bank account of the FI in a certain moment in the payment process (ie to have enough funds)

Liquidity as measure of solvency

SolvencyA financial institution is defined as being solvent if it is able to meet its (payment) obligations consequently it is insolvent if it is not able to meet them Insolvency lsquoin the first degreersquo basically means lsquonot having enough moneyrsquo but even if the liquid assets seem to properly

cover the liabilities insolvency can stem from variou technical reasonsInsolvency in time ndash incoming payments on central bank accounts do

not arrive in time so there is not enough coverage to initiate outgoing payments

Insolvency in a particular currency ndash this can occur by simple FX cash mismanagement The institution is unexpectedly long in one

currency and short in another but it could also be the result of an inability to buy the short currency due to exchange restrictions etc

Insolvency in a payment system ndash even if there is enough central bank money In one payment system to cover the shortage in another payment system (in the same currency) both may not necessarily be netted

LiquidityIn this context let us define the liquidity of a FI as the probability of

staying solvent More precisely let CF+(D k) and CF-(D k) be the sum of all incoming and outgoing cash flows respectively (inflows

and outflows) of one currency in one payment system at the lsquonormalrsquo end of the trading day k for a portfolio D (a positive

balance at the central bank account is regarded as inflow) The FI stays solvent as long as

CF+(D k)+CF-(D k)+CFL(D k)gt0

holds where CFL(D k) is the possible sum of all inflows the FI is able to initiate in the above settings in the very last payment round We can now defineLiquidityoProbability CF+(D k)+CF-(D k)+CFL(D k)[0) It has to be clear that this is only a quasi-mathematical definition but it illustratesthe approach we want to take Before we clarify the above

further some additional comments are requiredPL non-neutrality

It is intuitively clear that it is the task of every liquidity manager to minimize the risk of being insolvent for his or her institution He achieves this by accomplishing the highest possible liquidity for his institution So

far so good but as always there is a trade-off liquidity is not free Maximizing CF+ as well as minimizing CF- puts restrictions on the

businesses that normally result in smaller profits or even lossesEnsuring CF- does not fall below a certain threshold triggers direct costs in

general As a consequence liquidity management turns out to be the task of maximizing the liquidity of the bank under the constraint of minimizing

costs

How does insolvency occur

In general accounts with a central bank cannot be lsquooverdrawnrsquo The status of insolvency is finally reached if a

contractual payment cannot be executed by any means because not enough central bank funds are available In any case

insolvency might exist with a hidden or undetected status if such contractual payments are not initiated (and therefore their failure cannot be detected by the central bank) but nevertheless constitute a severe breach of terms leaving the other institution unclearm whether it was only an operational problem leading

to a lack of inflow or something more problematic

Lack of central bank money (CBM)A temporary lack of CBM does not necessarily mean upcoming insolvency the relation between the shortage and the capacity to attract external funds is crucial Nevertheless is it a necessary condition to be insolvent if the central bank account is long there is no necessity to act immediately Again this does not mean the institution will be solvent in the future We have to investigate further into the term structure of solvency There are intrinsic specific and systematic reasons to become

insolvent and they are decreasingly manageable for a FIforward payment structure (FPS) of the institution A negative

forward payment structure is not bad per se it only bears a problem together with a weak ability to rebalance it

Specific unexpected loss of funds caused by counterpartiesA FI might have expected inflows actually not

coming in (a counterparty becomes insolvent) thus causing an unexpected shortage of funds On the other hand unexpected outflow might be caused by the decision of counterparty to subtract funds (withdrawal of savings deposits during a run on a bank) Those factors are out

of control of the FI when they happen nevertheless there is a certain possibility of steering them in advance by selecting customers

Systemic the payment process is disturbed These events are even more out of the control of the FI Counterparties pay as scheduled but the payments simply do not get through Reasons might be technical problems as well as the unwillingness of the central bank to fix them The problem is truly systemic

Insufficient counter balancing capacityThe FI is not able to raise enough funds to

balance its central bank account There are a variety of possible reasons for that Again they can be ordered intrinsic specific and systematic reflecting the decreasing ability of the FI to manage them

Intrinsic reasonsThe FI is not able to raise enough funds because Too much money was raised in the past by means of unsecured borrowing (other FIsrsquo credit lines are not large enough)Liquid asset are not available in the right time and place with the appropriate legal framework

Specific reasonsIts rating could be downgraded If sufficient collateral is available in

time the FI could switch from unsecured to secured borrowingThere may be rumours about its solvency The ability to attract

funds from other liquid market participants is weakened Liquid assets that can be sold or repoed instantly could restore the confidence of the market

Even with undoubted standing it could be hard to raise cash the limits other institutions hold for the FI could be utilized

Systemic reasonsA lack of CBM in the system itself This is quite unlikely but it

happened in Germany after the Herstatt crisis when the Bundesbank steered the central bank money so short that many banks were unable to hold the required minimum reserves Nevertheless this could be categorised as well as

A failure in the mutual exchange mechanism of central bank money Although the central bank allots sufficient money into the market some market participants hold bigger balances than they need The reason could be an adversity to credit risk hindering their lending out of surplus funds or it could lie in the anticipation of upcoming market shortages that are forward covered

A technical problem Payments systems fail to distribute the money properly as planned by the market participants thus leaving them with unintended positions andor fulfilled payment obligations

Measurement of insolvency risk

Evaluating the forward payment structure of the FI to gain a first forecast of the FIrsquos exposure to a critical lack of funds

Assessing the correctness of this projection in order to come to an understanding of the nature and magnitude of possible departure from reality in the forecast and finally

Analysing the structure of assets of the FI to estimate its counterbalancing capacity

Evaluation of the forward payment structure (FPS)The first step is to collect all cash flows likely to arise from deals already existing That means we have to treat only business that is on the balance sheet Alterations of existing deals such as a partial early repayment of a loan will be treated as new business Assessment of the quality of the FPSNobody would expect a FPS to be totally correct

and in fact this never happens in reality lsquoHow correct is the FPSrsquo is the crucial question The answer has to be given ex ante Therefore we have to

The term ex-ante (sometimes written ex ante or exante) is a neo-Latin word meaning before the event[1] Ex-ante is used most commonly in the commercial world where results of a particular action or series of actions are forecast in advance

Estimate errors due to shortcomings in data (incorrectincomplete reporting) andEvaluate the uncertainty arising from our incorrectincomplete assumptions (no credit and operational risk) as well as deviations stemming from unpredictable developmentsAnalysis of the liquifiability of assetsIf the FPS has provided us with a good

understanding of potential future liquidity gaps we then have to investigate in our ability to generate cash

The natural way is to increase our liabilities we have to measure our ability to generate cash by means of secured or unsecured borrowing in time On the other hand we have to classify

ConclusionsThe approach to characterize liquidity as the probability of being solvent is straight forward Nevertheless it is incomplete in two senses

After having quantified a potential future lack of funds we have not clarified how large is the risk triggered by this shortage for the FI Analysing the FIrsquos counterbalancing capacities could give a solution the probability that the lack exceeds the ability to raise funds can be detected In a VaR-like approach we would try to determine the maximal forward deficit of funds in order not to exceed the existing counterbalancing capacities ndash within a predefined probability

Once we have gathered this knowledge we are still left with the problem of its economic impacts One way to transform the information into a policy could be to establish limits to restrict the business another would be to increase the counterbalancing capacity Both approaches are costly but more than that we have to compare actual expenses against the potential loss at least of the equity capital if the FI ends its existence by becoming insolvent

Re-approaching the problemThe following conceives a methodology to

consistently measure evaluate and manage liquidity risk Although it is tailored for a bank it can quite easily be adapted for other kinds of FIs

Lack and excess of liquidity symmetric approachThe idea here is to move from a simply illiquidity orientated view on liquidity risk to a view on both insufficient as well as exceeding liquidity Both cases could lead to situations where we have to bear economic losses in respect to rates relatively to the market We might be only able to attract funds at lsquohighrsquo rates as well as only being able to place excess funds at sub-market rates5 Another very good reason to consider lsquoover-liquidityrsquo is the fact that excess funds have to be loaned out and thus create credit risk if not collaterized

Cash flow liquidity risk redefinitionWe regard cash inflows (ie paid in favour of our central bank

account) as being positive and cash outflows as negative Deals between the bankrsquos entities that are not executed via third parties (internal deals) are treated like regular transactions As they match out it has to be ensured that such deals are completely reported (by both parties)

DefinitionCash liquidity risk is the risk of economic losses resulting from the fact the sum of all inflows and outflows of a day t plus the central bank accountrsquos balance Btn1 of the previous day are not equal to a certain anticipated (desired) amount

This definition aims at manifestations of cash liquidity risk such as

1 Only being able toΩ Raise funds at rates higher than orΩ Place funds at rates lower than (credit ranking adjusted) market

rates (opportunity costs)2 Illiquidity not being able to raise enough funds to meet

contractual obligations (as a limit case of the latter funding rates rise to infinity)

3 Having correctly anticipated a market development but ending up with a lsquowrongrsquo position

Liquidity portfoliosTreasury units of financial institutions often hold special portfolios in order to be able to generate liquidity for different maturities quickly and at low costs Depending on the credit rating of the FI the liquidity portfolio can have positive negative or no carry

Realrsquo currency of liquidity portfoliosAs financial institutions usually trade in many different currencies

they also have to manage their liquidity risk in many different currencies Nevertheless they usually do not hold liquidity portfolios in all these currencies for reasons of cost Therefore the question arises which currencies and locations are optimal for liquidity portfolios In practice the liquidity portfolios are located in the regional head offices and are denominated in the main currencies (USD EUR JPY)

Liquidity of liquidity portfoliosThe liquidity portfolio is a part of the liquidity reserve of FI therefore it should contain securities which willΩ Be pledgeablerepoable by the central bank or other counterpartiesΩ Have a large issue volumeΩ Have an effective marketΩ Have no credit riskΩ Be issued by international well-known issuersThese characteristics normally enable the FI to get liquidity quickly and at relatively low cost from the central bank or other counterparties

Availability Depending how quickly liquidity is requested the inventory of the portfolio should be split and held with different custodians For exampleΩ The credit line with the Bundes bank is dependent on the volume of pledge able securities held in the depot with the Bundes bankΩ If a repo is done with the market one part of the inventory should be held with a national or an international custodian to ensure settlementΩ For settlement purposes the securities should be deliverable easily in national settlement systems and inbetween international depositary systems

VolumeThe volume of the liquidity portfolio should

cover a potential liquidity gap for the period of an occurring liquidity gap

FundingThe use of the liquidity portfolio as a liquidity reserve is based on the assumption that the cash equivalent for that portfolio can be funded by the normal credit line based upon a good credit standing As a result existing inventory will be free for funding purposes Based on a normal yield curve the inventory will be funded for shorter periods producing a return on the spread difference The funding period willbe rolled every 3ndash6 months

If additional funding is needed the inventory can be used as collateral to acquire additional liquidity from other counterparties Normally funds are received at a lower interest rate because the credit risk is reduced to that of the issuer which is in most cases better than the FIrsquos own credit risk In the best case one will receive the mark to market value without a haircut (sell-buy-back trade) In the case of repo trades there will be a haircut (trades with the central bank)

If the funding of the liquidity portfolio is carried out incorrectly it can lead to an increase of the liquidity gap Therefore it would be beneficial to structure the funding into several parts These would be funded in different periods and with different counterparts One part should be covered by lsquoown capitalrsquo and the market risk shouldbe hedged

Term structure of liquidityOne of the main scopes in AL management is the classification of

balance sheet items according to their maturities The reason for this is twofold and has consequences on the concept of lsquomaturityrsquo The first reason is the management of interest rate risk and the second is the management of liquidity risk For liquidity risk management purposes classical gap analysis is misleading as the term structure of interest rates and liquidity will differ considerably for many financial instruments

Example Plain vanilla interest rate swap

For interest rate risk measurement the variable leg of an interest rate swap would lsquoendrsquo at the next fixing date of the variable interest rate For interest rate considerations the notional amount could be exchanged at that date For liquidity risk measurement the variable leg of a swap matures at the end of the lifetime of the swap The payments can be estimated using the forward rates In order to optimize their liquidity management the treasury function of a FI is faced with the problem of determining the term structure of liquidity for their assets and liabilities For many investment banking products such as derivatives and fixed-income products this is a straightforward task as payment dates are often known in advance and the estimated amounts can be derived from the pricing formulae An exception is obviously the money market and repo business A more challenging task (and more important in terms of liquidity) is the term structure of liquidity for the classic commercial banking products such as transaction accounts demand deposits credit card loans or mortgages (prepayments) as these products have no determined maturity

Liquidity of financial markets and instrumentsIt would seem straightforward to define the concept of market liquidity and the liquidity of financial instruments

A financial market is liquid if the instruments in this market are liquid a financial instrument is liquid if it can be traded at the

lsquomarket pricersquo at all times in normal or near-normal market amounts








Bid Ask Spread

























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Introduction: different types of liquidity The concept of liquidity is used in two quite different...

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