Jeremy Ford – Risk Manage Ltd. Liquidity Risk: And are there lessons to be learnt from Northern...

Jeremy Ford – Risk Manage Ltd.

Liquidity Risk:Liquidity Risk:And are there lessons to be learnt And are there lessons to be learnt

from Northern Rock? from Northern Rock?

Black holes and other disasters!Black holes and other disasters!


LiquidityLiquidity RiskRisk

• Defining Liquidity– An asset is perfectly liquid if one can trade immediately, at

the indicated market price and in the quantity that you desire

• This gives us three pointers when considering liquidity, or more strictly illiquidity, risk– TIME– PRICE– QUANTITY

• All relating to the availability of, access to, or convertibility into cash

• Why you might need this cash is a separate set of issues!


LiquidityLiquidity Risk RelativityRisk Relativity• The term ‘liquidity’ can be used in various ways:

• A financial system (i.e.£) is said to be ‘liquid’ if there is a free interchange of credit, assets and cash between all elements in the market – (From individuals, banks, savings and through to central bank)

• A market (i.e.$ TBills) is said to be ‘liquid’ if the instruments traded can easily be bought or sold in quantity with little impact on market prices.

• An institution (i.e. a bank) is said to be ‘liquid’ if it can easily meet its needs for funds either because it has cash on hand or it can raise or borrow money.

• A trader (i.e. a Gilt trader) would say an asset is ‘liquid’ if that asset can be bought and sold at any time.

• At the extreme a “junk bond” trader would consider an asset liquid if he can get any kind of price for it!


Liquidity Scale? Liquidity Scale?

Transparent

Translucent

Opaque

What?

Government Bonds, CPFutures, REPOOrdinary SharesBank Bills, CommoditiesConvertible BondsMBS, MTN’s etc.High Yield/ Junk BondsPropertyVintage CarsArt etc.etc.

Pricing

The scale changesover timedue to events,supply and demand


Liquidity can be a complex subject!

Linkages

Source: gtnews - www.gtnews.com

Managing liquidity Risk, Christian Kronseder Credit Suisse


Identifying IlliquidityIdentifying Illiquidity

• We all know or feel we can identify the issues that surround illiquidity

• Illiquidity in markets is reflected in general by the behaviour bid/offer spreads

• Illiquidity in institutional context is reflected in cost (and availability) of funds

• Illiquidity for individual assets is reflected in specific bid/offer spreads


Liquidity managementLiquidity management

• Purchased liquidity– Government funds market or repo market.– Managing the liability side preserves asset side of

balance sheet. – Borrowed funds likely to be at higher rates than

interest paid on deposits. • Deposits are insured

• Regulatory concerns: growth of wholesale funding


Liability ManagementLiability Management

• Alternative: Stored Liquidity Management – Liquidate assets.

• In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more.

– Downside: low yield and hence opportunity cost of reserves.

– Decreases size of balance sheet– Requires holding excess non interest-bearing assets

• Combine purchased and stored liquidity management


LiquidityLiquidity Risk MeasurementRisk MeasurementThe Heart of Liquidity Risk ManagementThe Heart of Liquidity Risk Management

Net Funding Requirement

Back Testing

Liquidity Management

Liquidity Risk Measurement

Liquidity Risk Policy

Liquidity Risk Reporting

Data Gathering


Measuring Liquidity ExposureMeasuring Liquidity Exposure

• Net liquidity statement: shows sources and uses of liquidity.– Sources: (i) Cash type assets, (ii) maximum

amount of borrowed funds available, (iii) excess cash reserves

– Uses include: borrowed or money market funds already utilized, and any amounts already borrowed from (or with) a central bank.


Measuring Liquidity RiskMeasuring Liquidity Risk

Financing Gap and the financing requirement

Financing Gap = Average Loans - Average Deposits

or, Financing Gap + Liquid Assets = Financing Requirement

• The gap can be used in peer group comparisons or examined for trends within an individual institution

• In retrospect in both cases Northern Rock came out poorly against peer groups


Institutional (or funding )LiquidityInstitutional (or funding )Liquidity

• The liquidity of an institution depends on: – the institution's short-term need for cash,

– cash in hand,

– available lines of credit,

– the liquidity of the institution's assets,

– the institution's reputation in the marketplace

– credit rating

• How willing are counterparties to transact trades with, provide normal terms of business or lend to, this institution?


Market LiquidityMarket Liquidity


Market LiquidityMarket Liquidity

• A market is liquid if its participants can easily convert positions in that market into cash.

• The liquidity of a market can be measured in terms of the bid/offer spread seen across the products being traded

• Examples of markets that are viewed as liquid include:

• foreign exchange of the major currencies

• stocks that form part of the major global equity indices

• recently issued Government bonds.


Taxonomy of Market RiskTaxonomy of Market Risk

Uncertainty in Market Value

Uncertaintyin Product Returns

(Outright Risk)

Uncertainty due to Liquidity Risk

Exogenous Illiquidity Endogenous Illiquidity


Exogenous IlliquidityExogenous Illiquidity• Exogenous Illiquidity

– Result of market characteristics

– Is common to all market players

– Unaffected by the actions of any one player

• G7 liquid securities– High volume, small & stable bid/offer spreads, good

marking to market abilities, low liquidity costs

• Illiquid Securities– High Yield Bonds - thinly traded, high volatility of

spread, low quote depth and trading volume


Endogenous IlliquidityEndogenous Illiquidity

• Endogenous Illiquidity– Specific to position in the market

– Varies across market participants

– Exposure is affected by participants’ own actions

– The larger the size of the position the greater the endogenous illiquidity

– Another fine mess you have got us into!


Who Provides Market Liquidity?Who Provides Market Liquidity?• The Market Makers ‘cut’ - “The

effective spread between bid and offer” –

• covers– Order-processing and

inventory costs– Dangers of taking the other

side of an “information based” trade

– Market makers cannot distinguish between informed and uninformed trades and should be rewarded accordingly and in practice are regulated by profits or loss outcome in providing liquidity

Liquidity Risk

MarketRisk

2

3

1

4

Market Risk

Cross

1 & 3 = “normal” risk/liquidity positions


Market Risk CrossMarket Risk Cross1. The higher the market risk the

greater the liquidity risk (i.e. anything that makes you money!!!!)

2. Low market risk but some liquidity risk (i.e. off the run guvvie’ bonds)

3. Low market risk tends to lower liquidity risk (i.e. on the run guvvies’, money markets)

4. Low liquidity risk but higher market risk (i.e. futures?)

1 & 3 are the more “normal” risk/liquidity positions but all can be changed by size of position relative to market, timing etc.

Liquidity Risk

MarketRisk

2

3

1

4

Market Risk

Cross


Identifying IlliquidityIdentifying Illiquidity• This can be due to a number of factors:

– Credit fears (fact and fiction)– Fear!– T - Timing (the New Year’s Eve trade)/ Out of hours– Q – Quantity/Scarcity– Adverse news reports (wars, hurricanes, floods, terrorism)– Physical conditions (Fires, power cuts, strikes) – General market conditions– P - Wide price becomes no price

Comment: A central bank may be able to tell illiquidity from insolvency but commercial banks find it very difficult (information asymmetry + role of interest rates in solvency of market funded bank ).


Q = Quantity - Effect of Position Size on Q = Quantity - Effect of Position Size on Liquidation RiskLiquidation Risk

• Security PriceASK

BID

Point of Endogenous Illiquidity

Market maker

Bid/Offer%

Quote

Depth

Size of quote

< $20mm

< $25mm

< $30mm

< $50mm


Liquidity Vacuum – Indicating Liquidity Vacuum – Indicating systemic liquidity issuessystemic liquidity issues

• A liquidity vacuum when bid/offer spreads for the financial instruments widen to beyond the point of trade

• Seen in derivative instruments and bonds where liquidity is assumed but unproven

• Can even be due to “trivial” reasons• In the worst kind of liquidity crisis, even your

favourite market makers refuse to answer the phone! They have their own problems.


Systemic Risk ExamplesSystemic Risk Examples“The markets in trouble! Now what?” “The markets in trouble! Now what?” • Risk that a specific problem in the financial markets causes a

chain of events which ultimately threatens the market. • Such as default by individual market participants

– Barings Nikkei 225 Options and futures

– Enron Oil futures and physicals• Specific market conditions

– UK property crash Secondary bank liquidity crisis in the ’70’s

– US MBS 2007 credit crisis– Northern Rock 2007 Liquidity crisis

• International Issues– Japans economic woes Japanese funding premium– US Banking crisis in the early ’90’s– US Savings and Loans Mid 1980’s


Systemic Risk Systemic Risk

• All these examples caused liquidity problems for similar and in some cases completely dissimilar institutions.

• This might cause those institutions either to fail to make payment on their own obligations, provoking a funding crisis.

• One of the purposes of financial regulation is to ensure that the markets operate in a manner that minimizes systemic risk.


Examples of Liquidity RiskExamples of Liquidity RiskLTCMLTCM

• An excellent example of the perils of liquidity risk is the downfall of LTCM, Long-Term Capital Management.

• Started in 1994 by John Meriwether, the hedge fund LTCM seemed destined for success with investors contributing a combined $1.3 billion of capital.

• They believed that LTCM's financial strategy was bound to be profitable; through convergence trades, LTCM took large and highly-leveraged positions but demonstrated that the net risk was minimal because their long and short positions were highly correlated.

• However, when the Russian government defaulted on its debts in 1998, liquidity suddenly evaporated from international financial markets. Asset prices plummeted.

• LTCM suffered massive losses because it could not liquidate its assets before the value of its portfolio dropped. By the end of the year, LTCM had been all but destroyed, a victim of "flight to liquidity".


Events and non-sequential causesEvents and non-sequential causesMG Rover FailureMG Rover Failure

• MG Rover was forced into Receivership due to steady erosion of liquidity– The initial “Phoenix” business case was weak! – There were speculative reports of slow trading– There was a clear need of a product range revamp– High costs were involved in developing a new V8 powered “super

saloon” and sports coupe plus upgrades to the existing range– External factors came into play such as: the then Iraq situation /Oil

prices/plus over production of cars in the far east– Tightening banking facilities (availability/price/term)– Terms of trade and c.o.d. demands of suppliers rapidly eroded

company liquidity, finally pushing the company over the edge and into liquidation


What happened to Northern What happened to Northern Rock?Rock?


Was what happened to Northern Was what happened to Northern Rock inevitable?Rock inevitable?

• Banking adage: – Bank new loans = 5%, new deposits = 5% result happiness

– Bank new loans = 10% new deposits = 5% result disaster

• This relationship or something like it is something all banks and regulators understand

• So why was this gap between long term assets and supporting liabilities ignored?


Management state of mindManagement state of mind

• Did management forget the old adage?

or • Did the seeming successes

– increasing market share

– increasing profits

– increased market standing of this asset led strategy

– All increasingly funded by securitisation and/or short term market liquidity, drive management into thinking they had cracked the problem?


The Inevitable?The Inevitable?• YES – They felt they had securitisation to lean on and an

infinite ability to grow the balance sheet and fund it through securitisation

• Background - House price inflation – 2001 = 8.4%,– 2002 = 17%, – 2003 = 15.7%, – 2004 = 11.8%, – 2005 = 5.6%,– 2006 = 6.3%, – 2007 = c.10%.

• Nominal GDP Growth = 4% - 6% throughout • What can go wrong?


The ProblemThe Problem

• Obtaining liquidity by selling investments or loans ….called “shiftability”….

• Management tactics that rely on “shiftability” are not well suited for systemic liquidity needs.

• Any scenario analysis or stress testing for a mortgage lender and a liquidity crises would includes the loss of “shiftability” and a concurrent reduction of property related liquidity lines.


In defence In defence • Sources of liquidity:-

– Net cash flow – Capacity to borrow additional wholesale funds– Stock of marketable assets– Sterling stock liquidity

• Constraint on illiquidity:-– Name in market – Limits (gross)

• Wholesale borrowing guidelines • No funding problems but market very credit quality sensitive • ‘Flight to quality’ an identifiable possibility.• Commitments – CP backup lines, • No Committed lines to competitors for liquidity the need for

additional Capital to support balance sheet growth.


ButBut

• Could liquidity become a significant problem? • This did not just come out of the blue!• UK ALMA 11th Annual Conference 29th/30th January 2004 -

Subject: Liquidity, Liquidity, Liquidity!!• The core problem identified was asset (especially mortgage)

growth• This was due to affordability, and at the time there was no

sign that this would reduce• Hence wise heads regarding liquidity as the major future

concern due to asymmetry between asset and liability growth• Although the current experience was showing otherwise,

concerns were raised over the long term/structural viability of derivative solutions to this problem (i.e. securitisation)


How were others approaching these How were others approaching these same issues?same issues?


Practical managementPractical management

• Following Basel II All Financial institutions now place asset and liability management responsibilities at the top of the management tree

• ALM being the strategic element of running a balance sheet

• The day to day management of this process is usually delegated to an Asset and Liability Committee (ALCO) that include interested parts of the business


Lets have a Bank ALCO meeting?Lets have a Bank ALCO meeting?

• We are XYZ Bank and we are having a regular ALCO• It is Feb 07, concerns are being voiced about liquidity in

markets (The knock-on effect of the credit story of US sub-Prime mortgages)

• We are lucky in that we are an organisation with an historically strong (loyal) deposit base

• We are not as reliant on market funding as other UK banks , although we do fund opportunistically

• Following board level concerns, apart from the usual review of positions, exposures and business events there are two main issues to be discussed:– Liquidity risks - Define liquidity, assess impact, suggest mitigating

actions– Securitisation - Can securitisation help us in the short/long term?


Funding Liquidity Definitions• Exogenous Liquidity – The liquidity

that comes from the funding base, ability to hold assets even in extreme market or credit circumstances (LIABILITY DRIVEN – an issue of confidence in the Institution)

• Endogenous Liquidity – The liquidity that comes from the ability to fund assets through a market (ASSET QUALITY DRIVEN – an issue of confidence in asset values and availability of short term funds)

Total Defaults

Notes for our ALCO MeetingNotes for our ALCO Meeting

-100%

0%

100%

1981 1986 1991 1996 2001

Year

Extr

a D

efau

lt Pe

rcen

tage


Measuring Liquidity RiskMeasuring Liquidity Risk

Financing Gap and the financing requirement

Financing Gap = Average Loans - Average Deposits

or, Financing Gap + Liquid Assets = Financing Requirement

• Establish the current financing gap• Scenario Analysis

– Identify the financing requirement under two scenario’s – Reduced liquidity – systematic liquidity failure


Let have a look at SecuritisationLet have a look at Securitisation• Is it a Tactic Or a Strategy?

• Only one UK bank elevates securitisation to a strategy – Northern Rock

• All others maintained it as a tactic, often despite attacks in the press for losing market share e.g. Barclays/Woolwich, HBOS & others


Securitisation as a strategySecuritisation as a strategy

• A bad idea – (and virtually everyone knew it!)• Why?

– Market Liquidity

– UK has none of the financial infrastructure necessary to support mass securitisation.

– B of E support operations conducted only through (primarily) government obligations i.e. it supports the UK Sterling stock rules. (Is lender of last resort)

• ECB much wider discount role, but it is no lender of last resort.


Securitisation as a strategySecuritisation as a strategy• US has Fannie Mae and Freddie Mac – lenders of

first resort against conforming mortgage assets.• Note mixing LOLR with liquidity support introduces

‘moral hazard’ (and hence B of E concerns)– Haircut Sir? (A No 3 and they can pay, No 1 and they

can’t!).

• So should we have or could we have securitisation as a strategy?

• Must be thought through and OK only if we have fully understood the consequences. (it’s a no then!)


Our ALCO conclusionOur ALCO conclusion• In the light of global concerns, take defensive measures to

increase (actual and potential) liquidity – it is recognised as increasing the costs to the business but is deemed prudent for future stability

• How?– Monitor Liquidity and Market conditions– Limit and properly price new business – Issue new fixed rate retail savings product and compete for loans 1-2

years (actual cash)– Review fixed income investments and switch into - lower yielding -

but more liquid govt securities (near cash)– Sell, where possible, illiquid higher risk assets move to lower yielding

but lower risk assets (nearer cash)– Review/increase contingent funding arrangements (cash in the event

of)– Bring forward any securitisation opportunities and if necessary ease

our required margin to do so (reduce funding gap)


So what has happened in markets?So what has happened in markets?• More or less what most scenarios predicted.

– “Flight to quality”.

– Refusal of uncommitted lending.

– Big banks holding on to cash at all costs

– Market trade volumes falling significantly

– New banking business drying up

– Regulators (globally) increasingly concerned over systematic risk

– Newspaper and market commentator speculation

• Real unwillingness in UK to give liquidity support– Where does this leave market participants?


Liquidity Risk SummaryLiquidity Risk Summary

• Liquidity Risk arises from the failure to recognize or correctly address sudden (and in some cases not so sudden) changes in overall market conditions (All liquidity problems are investigated with 20/20 hindsight!)

• Liquidity Risk is the current and prospective risk to earnings or capital arising from an organisation’s inability to meet its obligations when they become due.

• Liquidity Risk also relates to the liquidity of specific instruments and not related to general market conditions

Jeremy Ford – Risk Manage Ltd. Liquidity Risk: And are there lessons to be learnt from Northern...

Documents

Transcript of Jeremy Ford – Risk Manage Ltd. Liquidity Risk: And are there lessons to be learnt from Northern...