Liquidity Risk. Managing Funding and Asset Risk. Second Edition Erik Banks. paigrave macmiüm!

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1 Liquidity Risk Managing Funding and Asset Risk Second Edition Erik Banks paigrave macmiüm!

2 List offigures List oftables List ofboxes Preface to the 2nd Edition About the Author List of Abbreviations xi xii xiii xiv xvi 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 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 Lxternal 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 ^ Sources of Liquidity 48 Sources of Asset Liquidity 49 Liquid assets 49 Cash and marketable securities 49 v

3 vi 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

4 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 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 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

5 viii 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 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

6 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 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 Solvency II and Other Insurance Regulations 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 regulär 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

7 X Appendix: A Primer ort Gap Management 270 Notes 280 Selected References 294 Index 297

UFS. Fixed Income. John Rosenthal Senior Managing Director MetLife

UFS. Fixed Income. John Rosenthal Senior Managing Director MetLife UFS Fixed Income John Rosenthal Senior Managing Director MetLife Safe Harbor Statement These materials contain statements which constitute forward-looking statements within the meaning of the Private Securities