The Next Challenge in Portfolio Management: Accounting for Liquidity in Pricing and Risk. Amnon Levy, Managing Director, Head of Portfolio Research

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1 The Next Challenge in Portfolio Management: Accounting for Liquidity in Pricing and Risk Amnon Levy, Managing Director, Head of Portfolio Research November 2010

2 2 Bank Funding Costs Continue to be a Maor Concern European Sovereign Debt Crisis Bear Stearns Lehman Brothers *Represents the median CDS spread for the 20 largest financial institutions in the United States (by Market Cap.)

3 3 Regulatory Emphasis on Contingent Liquidity Basel: the maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs. FSA: A Contingency Funding Plan should set out a firm s strategy for addressing liquidity shortfalls in stressed conditions. Fed: a cushion of liquid assets, and a formal well-developed contingency funding plan (CFP) as primary tools for measuring and managing liquidity risk.

4 4 Economic Guidance Mostly in the form of motivating relationships:» Banks assets and liabilities are often maturity-mismatched, with long-term assets funded through short-term liabilities» In periods of distressed liquidity conditions, the bank may face elevated funding costs as it refinances its short-term funding» At the same time, the bank s borrowers may increase their use of bank funds, forcing the bank to raise additional funds. But a formal framework and quantitative guidance are limited:» What amount of liquid assets should a financial institution hold in order to absorb potential losses due to adverse funding conditions?» How should a financial institution account for these dynamics when originating loans or when calculating a transfer price?

5 5 Agenda 1. An economic framework for describing contingent liquidity 2. Measuring liquidity economic capital 3. Pricing liquidity capital 4. Extensions to framework

6 Economic Framework Capital Pricing Extensions 6 Measuring Contingent Liquidity Risk in a Stylized Economic Setting Consider a simplified two-period setting:» A bank extends lines of credit to a pool of homogeneous borrowers Borrowers demand for liquidity (line utilization) is uncertain» The bank funds the credit line using short-term debt, refinanced at each period Future funding costs are uncertain» The bank s funding cost and the borrowers line usage are correlated What amount of liquid assets should the bank hold in order to absorb potential losses due to adverse funding conditions?

7 Economic Framework Capital Pricing Extensions 7 Measuring Bank Loss Time Bank Funding Spread Borrower Line Usage Bank t0 r0 0 Bank t1 1 r Usage 1 To absorb losses with 99.9% confidence, Net Cash Flow to Bank at End of Period Bank Usage Usage 0( r r0 ) rl L L must satisfy: Borrower Usage r r r L ( Borrower Bank 1 1 ) Cost of carry of liquidity buffer Pr Borrower Bank Usage1 ( r r 1 ) rl L L 99.9% L Size of liquidity buffer

8 Economic Framework Capital Pricing Extensions 8 Characterization of the Funding Cost To absorb losses with 99.9% confidence, L must satisfy: Pr Borrower Bank Usage1 ( r r 1 ) rl L L 99.9% Within a structural model of default, the funding spread charged to the bank at the time of refinancing can be written as: 1 log ( ) t 1 r 1 N N PD t 1, t 2 RSQ t2 t1 t 2 1 Probability of bank default between t 1 and t 2 Market risk premium

9 Economic Framework Capital Pricing Extensions 9 Correlations Between Bank Asset Returns and Innovations in Risk Premium are Elevated During Crisis Periods Bank composite index asset value Market risk premium Correlations over a three year moving window

10 Bank Economic Framework Capital Pricing Extensions 10 Modeling the Joint Dynamics Bank Funding Spread Bank Credit Migration Asset Value 1bps 10bps 100bps 1000bps Market Risk Premium Borrower Asset Value Bank Gains/Losses 12% 8% 4% Borrower Usage 12% 8% 12% 8% Borrower Credit Migration 4% 0% 4% 20% 40% 60% 80% -12% -8% -4% 0% 4% 8% 0% 0% 20% 40% 60% 80% 20% 40% 60% 80%

11 Economic Framework Capital Pricing Extensions 11 Case Study: Liquidity Provisioning for a Portfolio of Homogeneous Borrowers Bank Characteristics Maturity of short-term debt: 1 year Cost of long-term debt: 1.2% 1 year default probability: 25bps LGD: 60% RSQ: 35% Borrower Characteristics No. of Homogeneous Borrowers: 1,000 Maturity of credit line: 2 years Contractual Usage Fee: 2.5% 1 year default probability: 1.8% RSQ: 25%

12 Economic Framework Capital Pricing Extensions 12 Liquidity Buffer Under Different Assumptions Constant λ (λ = 0.5) Independent λ Correlated λ Cor(λ,Bank)=-20% Pr Borrower Bank Usage1 ( r r 1 ) rl L L 99.9%

13 Contractual Fee = 268bps FTP = 221bps Economic Framework Capital Pricing Extensions 13 Incorporating Contingent Liquidity Costs in Funds Transfer Pricing Base Case: λ = 0.5, Corr(Bank,Borrower) = 16.5% Commercial Margin Credit Spread 201bps Contingent Liquidity Spread 20bps Reference Rate

14 Economic Framework Capital Pricing Extensions 14 Extensions I Accounting for default Borrower Pr Bank Usage1 (1 NoDefault r r1 ) r 99.9% L L L Defaults are correlated with other inputs and will increase likelihood of liquidity shortfall

15 Economic Framework Capital Pricing Extensions 15 Extensions II Accounting for various assets classes Pr ( Bank r L r1 ) A 99.9% i i rl L L i The return of various assets is uncertain Allowing for fire sales Bank Pr ( r i r1 ) Ai rl L PLk Ak L 99.9% i k The price of various assets will depend on market conditions, which will be correlated with the other inputs

16 Economic Framework Capital Pricing Extensions 16 Extensions III Accounting for additional sources of funds including bank runs ShortTerm Pr Borrower V Usage Bank k 1 r r k r L L 99.9% ShortTerm k V k k Required return from sources of funds depends on market conditions. In some cases, returns cannot support financing leading to bank runs and other limits to financing.

17 Funds Transfer Price Economic Framework Capital Pricing Extensions 17 Extensions III General approach to Funds Transfer Pricing: Commercial Margin Credit Spread Option Spread Funding Liquidity Spread Contingent Liquidity Spread Reference Rate The expected cost of funds required to support the exposure during its remaining life The cost of maintaining a sufficient cushion of high quality liquid assets to meet sudden or unexpected obligations

18 18 Summary Economic framework introduced that describes:» the level of liquid assets a financial institution should hold in order to absorb potential losses due to adverse funding conditions» how a financial institution should account for the cost of holding liquidity reserves when originating loans or when calculating a transfer price Accounting for correlation between borrowers funding needs, bank s liquidity requirements, and the market price for risk is imperative in understanding liquidity risks The economic framework is flexible and allows for integration with credit and other risks

19 Amnon Levy Managing Director Head of Portfolio Research Moody s Analytics San Francisco Tel: +1 (415) Amnon.Levy@mkmv.com moodys.com

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