Liquidity Risk Management After the Crisis WHITE PAPER

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1 Liquidity Risk Management After the Crisis WHITE PAPER

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3 Table of Contents Introduction... 1 New Regulations for Liquidity Risk... 2 Components of Liquidity Risk... 4 Modeling Cash Flows for Liquidity Risk... 4 Behavioral Modeling of Consumer Cash Flows... 7 Behavioral Modeling of Market Funding Sources Behavioral Modeling of Derivative Margin Requirements Cash Flow Liquidity Gaps and Liquidity Measures Diversity of Funding as an Important Lever to Control Liquidity Risk Contingency Funding Plans in Banks Pricing Liquidity Risk Counterbalancing Capacity and Market Liquidity Costs Notes on Advanced Liquidity Risk Management Probabilistic Measures of Liquidity Risk Optimizing the Counterbalancing Capacity Portfolio Conclusion About SAS Risk Management for Banking References i

4 The content providers for this paper were Jimmy Skoglund and Sumit Mathur of SAS. ii

5 Introduction The following paper discusses challenges that financial institutions face in the area of liquidity risk measurement and management. The SAS response to these challenges is to deliver an integrated risk solution, SAS Risk Management for Banking, that can meet the immediate requirements banks have while providing a framework to support future business needs. Lately, liquidity risk has received serious attention from regulators, banks and investors alike. And rightly so, as everyone witnessed how an exogenous credit crisis compounds itself into a major liquidity crisis (or funding problem), propagating very quickly through the global financial markets, leading to insolvency of major financial institutions. Management of liquidity risk has therefore become a subject of vivid discussion in bank boardrooms. The Basel Committee, the Committee of European Banking Supervisors and the UK Financial Services Authority are among the regulatory bodies that have taken the initiative to define a sound framework for its supervision. The objective of all these discussions is to equip banks with adequate liquidity going forward as per their funding profiles as well as to create a liquidity buffer comprising highly liquid assets that can be used to counterbalance a period of liquidity stress. To comply with the latest liquidity risk regulation in Basel III, banks need to prepare for a paradigm shift moving from routine liquidity management (cash management) activity to a sophisticated liquidity risk management practice in an analytical framework that takes into consideration the stochastic nature of its expected cash flows as well as stress testing of behavioral and market components and the quality and liquidity of the pool of counterbalancing capacity assets. This paper puts in perspective the analytical components of liquidity risk management that are needed to address the new Basel III era of liquidity risk management. Its key components are the cash flow scenarios as a method to measure cash outflow of encumbered assets at any given time horizon, hedging capacity of the unencumbered counterbalancing portfolio, and creating and implementing the stress testing of market and behavioral features that may negatively affect the access to liquidity. 1

6 New Regulations for Liquidity Risk Liquidity risk management is the management of the bank s ability to meet its obligations as they come due, without incurring losses. Liquidity risk management is seen to be of paramount importance and a subject of great interest for the regulators because a liquidity shortfall at a single significant institution can lead to systemwide effects. In contrast to risk-based capital for other forms of risks such as market and credit risk, the cushion for liquidity risk is not created through additional capital. Since the main purpose of the cushion for liquidity risk is to mitigate the net cumulative cash outflows, it is done by using a pool of high-quality liquid assets that can be sold immediately or used in collateral for short-term loan (repo) transactions to raise funds. Another difference between liquidity risk and other risks such as credit and market risk is that in general, liquidity risk is not the direct cause of bank failure. Indeed, liquidity risk is usually a consequential risk experienced due to significant losses due to other risks, e.g., credit losses, market events, operational risk events, etc., that are triggers for creating liquidity problems for a financial institution. Liquidity risk of an institution is also significantly affected by other market participants and the public s perception of the bank. In particular the bank s reputation is instrumental in its ability to raise funds in order to net cumulative cash outflows through unsecured funding. Since liquidity risk is a consequential risk, one can argue that effectively mitigating liquidity risk is as much about holding sufficient capital buffers for the traditional market, credit and operational risks as it is about holding a pool of unencumbered highly liquid assets to mitigate net cash outflows. By mitigating other risks by sufficient capital, one effectively guards against subsequent reputational and liquidity crisis. Liquidity risk is also different across institutions, as the liquidity risk is largely a reputational risk and, in a crisis situation, the available funding sources may differ significantly across institutions. For example, a bank that has access to the repo market may be considered, ceteris paribus, to be in a better position than a bank that has no access to the repo market. The bank with an established position in the repo market may still have access to secured funding while the bank with no access to the repo market can only rely on unsecured funding, i.e., selling liquid assets to generate cash. The potential drawback of being forced to sell liquid assets in a stress situation is that they may have to be sold at significant discounts especially if counterparties to the bank are aware of the liquidity crisis situation the bank is in. Measurement and management of liquidity risk has been a concern for regulators for quite some time. The first Basel Committee document on sound practices in liquidity risk management was first issued in 1992 and called A Framework for Measuring and Managing Liquidity. In 2000, this paper was superseded by the Basel Committee paper Sound Practices for Managing Liquidity in Banking Organizations. The paper focused on 14 guiding principles for measuring and managing liquidity risk. The principles are especially focused around developing a structure for managing liquidity, measuring net funding requirements, managing market access, contingency planning and internal controls for risk management. 2

7 In the wake of the recent crisis, the regulatory focus on liquidity risk has been further strengthened, emphasizing the importance of managing liquidity risk due to its possible systemwide repercussions. In response, in 2008 the Basel committee issued a new guiding document, Principles for Sound Liquidity Risk Management and Supervision. That document replaced the consultative document from 2000 and now contains 17 guiding principles for liquidity risk management. In December 2009, the Basel Committee approved for the so-called Basel III consultation a package of proposals to strengthen further global capital and liquidity regulations. The consultation paper Strengthening the Resilience of the Banking Sector enforces the importance of a global liquidity framework with minimum reporting standards to complement the 2008 paper s focus on guiding principles. The key minimum reporting standards in the new liquidity risk framework is a short-term 30-day liquidity coverage ratio and a longer-term structural ratio to address structural liquidity mismatches (Basel 2009, International Framework for Liquidity Risk Measurement, Standards and Monitoring). In addition, there are also monitoring liquidity metrics such as maturity mismatch, funding concentration and unencumbered (available for sale) assets available. The new liquidity risk regulations form an integral part of the announced Basel III regulation that is supposed to strengthen regulation, supervision and risk management using lessons from the recent crisis. Figure 1 displays the components of the new regulation for liquidity risk. The framework includes the Basel 2008 general guiding principles, as well as the recent Basel 2009 framework for regulatory reporting and monitoring standards. The liquidity coverage ratio measures the ratio of net funding requirements and the hedging capacity of the pool of unencumbered assets. The liquidity coverage ratio is calculated under behavioral and market stress tests and should exceed 100 percent for the cumulative horizon of 30 days. The net stable funding ratio measures the long-term viability of the balance sheet by comparing the portion of long-term assets that are funded by long-term liabilities. Finally, the regulatory monitoring standards include the traditional contractual or run-off maturity mismatch, as well as measurement of funding concentrations, the quality of the pool of unencumbered hedging assets and market monitoring. Underpinning the new regulatory requirements for liquidity risk is the Basel (2009) regulation on Principles for Sound Stress Testing Practices and Supervision. 3

8 Figure 1: A new regulation framework for liquidity risk. Components of Liquidity Risk Liquidity risk in banks can mainly be due to three reasons: 1) Contingent withdrawal of funds (also called liability-side liquidity risk). 2) Devolvement of off-balance sheet commitments that includes facilities, lines of credit, guarantees, and letters of credit (also called asset-side liquidity risk). 3) Contingent liquidity impact due to derivatives collateral. A scenario-based liquidity analysis framework that takes into account liquidity risk due to the above three components must also consider expected behavior during a liquidity crisis situation. For example, some of the standby credit facilities to generate funds may not function in a name-specific crisis, as the counterparty may not be confident in lending to a bank that is already undergoing a difficult period. Hence, the impact of how the counterparties might behave in a crisis situation needs to be considered while modeling to create liquidity sufficiency in times of crisis. Banks deal with mitigating the uncertainty of the sources of liquidity risk in two ways. The first is to create a reserve of liquid assets. The reserve of liquid assets comprises cash kept with the central bank and a liquid asset portfolio as a proportion of its liabilities 1. This approach is also called purchased liquidity management and aims to create stored liquidity as the primary mechanism to deal with liquidity risk. 1 This is mandated by regulators in most countries and is called the bank s cash reserves or statutory liquidity reserves. 4

9 The second approach is based on reliance on additional borrowed funds to meet the payment obligations. This may mean either using unencumbered assets as collateral in a repo with the central bank (or any other counterparty) or turning to the interbank market for overnight or short-term funding. However, unsecured funding and committed lines of credit might prove especially expensive in a systemic crisis, and moreover, this option may not even exist in a name-specific crisis situation. Therefore, whereas this approach is good for cash management in the normal course, it is not a prudent approach to manage crisis liquidity risk. Modeling Cash Flows for Liquidity Risk Traditionally, liquidity risk management has focused on tracking liquidity ratios and the calculation of simple net cash flow gap reports based on stock concept of liquidity. In these reports the actual cash flows of the assets and liabilities are often approximated, and in particular, the modeling and recognition of behavioral and market events that can affect those cash flows are not accounted for. In addition, key cash flows that may severely affect liquidity, such as margin requirements for OTC derivatives and rating triggers, are not always included. While regulation for the purpose of risk management often divides the balance sheet of a bank into trading book and banking book (e.g., credit risk), liquidity risk management involves the full balance sheet. The relevant distinction for the liquidity risk manager is between the assets that have been acquired for the purpose to hedge liquidity risk (stored liquidity) and the assets and liabilities that have been acquired as part of ordinary business. The first category of assets is the liquidity manager s cushion to hedge any negative cash outflows occurring from the bank s acquired assets and liabilities. In the liquidity manager s analysis of the net cash outflows from the assets and liabilities, there are key market and behavioral uncertainties that need to be addressed, including: the behavior of depositors in the stickiness of funding, the behavior of the committed facility counterparties, the reduced early amortization incentives for mortgages and loans, the potential drain of liquidity to margin requirements in OTC derivatives, and the extended call for collateral due to rating downgrade triggers. All of these potential sources affect the reduced expected inflow and increased expected outflow of cash to the bank and must be analyzed by the liquidity risk manager in order to define a suitable level of highly liquid assets that can be used in counterbalancing the net outflow. Figure 2 illustrates the net funding requirements through reduced cash inflows and increased cash outflows. 5

10 Figure 2: Net funding requirements. As we have mentioned previously, liquidity risk is consequential and an effect of either market- or bank-specific events. Hence, it is important that the potential sources that can drain cash inflow are analyzed. For example, deposit volumes and the bank s committed lines of credit by other banks might show remarkable stability under ordinary times. However, under a serious stress situation depositors may start to withdraw the deposits at a fast rate, and other banks may close previously committed lines of credit to the bank. The key principle in the analysis of liquidity is therefore that one should assume that the market and the bank are already exposed to significant stress. Capital markets funding should be assessed, recognizing that under stress markets are volatile, so refinancing (e.g., using commercial paper) may require much higher paid rates on the funding or, even worse, no willingness of market participants to roll over funding. Liquidity analysis is seen to be focused on cash flows of encumbered assets and liabilities as well as the potential hedging effect of unencumbered assets. In the cash flow modeling of encumbered assets, a distinction can be made between different types of cash flows as follows: The cash flow amount and timing is known, such as fixed-rate bonds, fixed-rate mortgages and term deposits. The cash flow amount is stochastic, but timing is known, such as floating-rate notes, variable-rate mortgages, swaps, equity dividends, variation margins for futures and payouts from European options. The cash flow amount is known, but timing is stochastic, such as loans with prepayment and callable bonds. The cash flow amount and timing is stochastic, such as demand deposits, savings accounts, commitments and credit lines, and payouts from American and Bermudan options. 6

11 The liquidity analysis proceeds by generating the cash flows of encumbered assets and liabilities under specified assumptions of market rates, credit risk, prepayment rates, customer behavior on deposit volumes, and credit line utilization. This gives a cash flow map of the encumbered assets and liabilities under the specified scenarios. The next step of the liquidity manager is to take all the unencumbered assets and make assumptions on liquidation profile, repo, etc. and add to the cash flow map of the encumbered assets and liabilities. The practice is to apply haircuts to the market values of unencumbered assets, reflecting the fact that they are sold in market distress. The bank is deemed to survive the scenario liquidity if the counterbalancing capacity of the unencumbered assets can be used to cover the cash outflows from the encumbered assets and liabilities. The resulting cash flow map obtained by adding the cash flows of the unencumbered assets to the encumbered assets and liabilities cash flow map is referred to as the net cash flow map. Figure 3 displays the up to six-month horizon cumulative cash flow liquidity gap for encumbered assets and liabilities and the net cumulative cash flow map obtained by applying the counterbalancing capacity for a base case scenario and stress scenarios 1 and 2. The net cumulative cash flow map for the base case scenario and stress scenario 1 shows that the bank will survive under these scenarios. In contrast, under stress scenario 2 the bank will become insolvent after one month as the net cumulative cash flows at the one-month horizon are negative. If the bank regards stress scenario 2 as a plausible event under which the bank should survive, it needs to strengthen the counterbalancing capacity of the hedging assets such that it can net out the cumulative negative cash flows at the one-month and two-month horizons. Since there is a significant increase in the bank s counterbalancing capacity at longer terms, such as the six-month horizon, it indicates that the bank should try and improve the liquidity of its six-month counterbalancing instruments so that it can move the hedging effect closer to shorter horizons, such as the one-month and two-month horizons. Figure 3: Cumulative cash flow liquidity gap for encumbered assets and liabilities and the net cumulative cash flow map obtained by applying the counterbalancing capacity for a base case scenario and stress scenarios 1 and 2. 7

12 Behavioral Modeling of Consumer Cash Flows As mentioned above, for many assets and liabilities the future cash flows are not known with certainty in terms of when they might occur and by what amount. For example, demand deposits have no assigned maturity, loans may have prepayment options, bonds in a similar fashion may be issuer-callable and/or holder-putable. In these situations the cash flow map of encumbered assets and liabilities needs to incorporate the uncertainty due to these unknown cash flow streams. This inclusion is important in order to capture a realistic scenario for liquidity risk. In practice there are two different approaches to analyzing customer behavior: the financial engineering approach and the statistical model approach. In the financial engineering approach the embedded option is formulated as a market-priced embedded option. The option is valued using a market model for the short-rate such as the Hull-White and the implied model parameters are extracted from similar market instruments. In the statistical model approach a model of behavior is formulated, e.g., a prepayment model or a model of deposit volume. The cash flows are evaluated under the model and the specific scenarios of customer behavior. In modeling liquidity risk the key component is the cash flows of the encumbered assets and liabilities with pricing being of limited interest, as there is in general no secondary market. We therefore focus on the statistical model approach to behavior modeling of assets and liabilities 2. In a statistical model or scenario-based approaches to cash flow evaluation of consumer options, the consumer s behavior is described using the model, and the cash flows of the contract are evaluated under the model. In contrast to a financial engineering approach, which may allow idiosyncratic valuation, these statistical models rely upon large pools and the notion of the law of large numbers to derive behavioral statistics. Traditionally two types of statistical models have been used: prepayment models and volume models for deposits and facilities. Prepayment models specify the prepayment rate of a pool of loans conditional on pool characteristics such as loan age, product type and refinancing incentive due to increasing interest rates. In the model it is beneficial to prepay if it is cheaper to refinance a new loan. Hence, prepayment should be expected when offered loan rates drop below the paying rate. However, all borrowers don t refinance even if it would be beneficial for them, and hence the prepayment rate is not a discrete 0 or 100 percent but rather increases smoothly with the spread between the paying rate and the current refinancing rate. In practice the simple conditional prepayment rate model (CPR) is used; however, more complex regression-based models with explanatory variables are also possible. In the case of simple conditional prepayment rates, the cash flows are calculated as for a standard loan though with accelerated prepayment rates acting on the contractual rate of amortization. 2 The SAS white paper Funds Transfer Pricing and Risk Adjusted Performance Measurement discusses extensively the statistical and financial engineering approach to valuation of customer-embedded options in the context of risk-based funds transfer prices. 8

13 In the case of a liquidity risk scenario, it is prudent to assume that consumer prepayment rates are relatively low, and hence additional funds generated by the prepayments decrease. The rationale is that in a crisis, the price of funding increases, and hence the prepayment incentive should decrease. With this rationale, the consumer s request for additional funding, e.g., through extensions of granted loans, should be expected to increase. At a minimum, the loan stock should be expected to increase with historical rates and thereby continue to consume funds for the bank. In addition, in a market-induced liquidity stress scenario, the bank should expect consumer default rates to increase, and hence some borrowers will be unable to meet their scheduled loan repayments. Similar to prepayment models, deposit volume models aim to capture the consumer s decisions to withdraw and place funds in the bank account. The willingness to withdraw funds is expected to decrease with the increased relative performance of other funds, e.g., equity and other bank accounts. As for prepayment, all consumers typically don t withdraw all funds and place them in alternative fund sources even if it would be beneficial to them. Common models used to describe deposit volume are regression models with logarithmic volume change being explained by key variables, for example, interest rates, GDP and seasonal terms as explanatory factors. Another type of model used frequently in practice is the core and noncore deposit models, which specify a portfolio run-off amortization scenario for the core part (for an example, see Dev and Rao, 2006, chapter 8). Approaches to valuation and cash flow generation for deposits have been extensively studied in the literature, e.g., Selvaggio (1996) and Jarrow and Van Deventer (1998). In these approaches, the value of the deposit funding increases with the spread between the funding rate and the deposit rate, the volume and time. In a liquidity crisis situation, one should expect an increased withdrawal rate of consumers deposits. In particular, consumers may withdraw because of the need foradditional funds in a crisis. Moreover, there may be a run on the bank 3. Figure 4 displays the base case and stress scenarios 1 and 2 for a deposit run-off together with the implied cash flows up to the six-month horizon. In both of the stress scenarios, we see a marked increase in the withdrawal rate up to one month. This represents the fact that the depositors who are most sensitive to the stress scenario and rumors about the bank will withdraw early. After the most sensitive customers have withdrawn, the less sensitive customers remain, and hence the withdrawal rate decreases significantly. 3 While today many banks deposit accounts are guaranteed even in case of bank failure, consumers may feel it is best to withdraw their funds in case of a crisis with rumors about the bank. 9

14 Figure 4: Base case and stress scenarios 1 and 2 for a deposit run-off together with the implied cash flows up to the six-month horizon. For universal banks, a key trend that is observed in a bank s funding profile is an upsurge in reliance on wholesale market funding that is both more volatile and costly compared to traditional sources of demand deposits. This trend has developed over a few years due to alternative sources of investments being available to consumers that provide better return compared to bank deposits. Because one purpose of banks is to attract stable core deposits, banks cannot do too much about this trend. Specifically, if a bank raises its deposit rates in response to changes in market rates, it would attract more consumer deposit inflows. However, the incremental depositors display a rateopportunistic behavior that would lead to instability of the funding base. That is, the newly attracted deposit volume would not be part of the core stable funding. Behavioral Modeling of Market Funding Sources While consumer behavior and in particular its effect on deposit funding is key to analyzing liquidity risk, there is also the behavior of other sources of funding, such as market funding, that needs to be considered in a plausible liquidity scenario. Key additional market funding sources for universal banks are the interbank market and capital markets funding. In general, a bank should not rely on only unsecured interbank funding, committed liquidity lines from other banks and long-term bond funding. Important lessons learned in the recent crisis are that diversity of funding is needed and that secured funding, such as repo funding, as well as the establishment of relationships with other banks, is of major importance to maintain a sufficient level of funding in a crisis. In a liquidity crisis situation it is prudent to assume that previously committed lines of credit are not available and that unsecured funding will dry up. Plausible specific scenarios that may be considered by the bank are as follows: Wholesale funding roll-over with a reduced roll-over term and only with counterparties that have a strong relationship with the bank. Difficulty maintaining secured funding. Repos are rolled over only if there is a strong relationship with the counterparty. Committed lines of credit are not available. 10

15 Behavioral Modeling of Derivative Margin Requirements Negative cash outflows may not only occur due to a bank s consumer and market funding behavior. Indeed, OTC-derivative contracts are usually associated with frequent margining requirements to close out counterparty risk should markets change rapidly and adversely for the bank. Similarly, contracts may contain explicit rating triggers that force the bank to post additional margins in case of a downgrade. Note that this required posting of additional margin due to rating downgrade is in addition to the expected effect that the bank will have a more difficult time obtaining unsecured funding as mentioned above. Therefore a bank-specific liquidity crisis initiated by rating downgrade can create a spiral of negative effects, ultimately causing further downgrades of the bank s rating. In a liquidity scenario of a bank-specific crisis, it is therefore important to not only consider the resulting explicit increase in margin calls but also the potential drying up of unsecured funds. Plausible liquidity stress scenarios capture both the standalone effect of a severe adverse market move, possibly causing OTC-derivative margin requirements to increase, and the effect of a downgrade of the bank s rating, as well as these effects in combination. In addition, the market- and bank-specific rating induced negative cash outflows due to margin requirements may very well happen in conjunction with a general market liquidity crisis, seeing a substantial withdrawal rate of consumer deposits and further market-induced drying up of funding. Cash Flow Liquidity Gaps and Liquidity Measures Traditionally, cash flow liquidity gaps are based on a run-off portfolio. This usually means that as banks are doing maturity transformations, i.e., funding parts of their long-term assets with short-term market funding, the cash flow gap will eventually become negative. Using a run-off assumption, banks put limits on the time to insolvency, i.e., the first time the gap becomes negative. Typically, due to the assumption that no short-term funding is rolled over, the net cash flow gap represents an extreme assumption that all lines of credit (secured as well as unsecured) are closed down for the bank. Figure 5 displays a net cumulative cash flow liquidity gap using a run-off assumption for the assets and liabilities. The cumulative gap eventually becomes negative as banks are partially funding long-term assets with short-term revolving funding. 11

16 Figure 5: Net cumulative cash flow liquidity gap using a run-off assumption for the assets and liabilities. While a simplified view of a liquidity crisis, the net cumulative cash flow gap with run-off continues to be an important monitoring element for the regulators under the new Basel regulation for liquidity risk (Basel 2009, International Framework for Liquidity Risk Measurement, Standards and Monitoring ). Additional required standard monitoring by banks includes monitoring concentration of funds and the level of unencumbered assets as well as their liquidity. However, two key reporting measures are put forward as the standard for supervisors of liquidity risk. These are the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). In the application of both of these measures the bank must consider behavioral scenarios rather than using a run-off assumption. The LCR measures the ratio of high-quality unencumbered assets that are available to hedge the cash outflow from encumbered assets and liabilities. The stress is measured under a short-term horizon of up to 30 days, and the stress scenario(s) examined should contain both institution-specific shocks (e.g., downgrade) and a systemic liquidity crisis. This includes a loss of deposits and unsecured funding, as well as increases in margin calls for derivatives and calls on the bank s committed credit lines. Under the horizon of 30 days the LCR of the bank should always exceed 100 percent. That is, the counterbalancing capacity of the unencumbered assets should neutralize any negative outflows from the encumbered assets and liabilities under the stress scenario. The stock of counterbalancing capacity assets should be assets that retain liquidity even under severe stress conditions. The regulators define the set of liquid assets as cash, government or central bank debit, or claims guaranteed by sovereigns, central banks, etc. Such assets qualify for a 0 percent haircut applied to the market value when used for hedging the liquidity gaps of encumbered assets and liabilities. Other assets such as corporate and covered bonds may be used under certain circumstances based on their liquidity and rating and qualify for a 20 or 40 percent haircut applied to the market value. 12

17 If a bank fails the test of achieving an LCR of 100 percent for the time horizon of 30 days under the stress scenarios, then the bank must adjust its pool of unencumbered assets accordingly. Figure 6 illustrates the regulatory cash flow scenarios used for the net funding requirements of the encumbered assets and liabilities and the counterbalancing capacity to measure the LCR. Figure 6: The scenarios used in the calculation of the LCR. While the LCR measures the short-term impact of liquidity stress and in particular the survival of the bank during a 30-day term, it does not measure structural funding liquidity. Effectively, a bank can have structural problems with stability of its funding channels (e.g., only unsecured channels) over a longer term and still satisfy the LCR regulatory requirements with a sufficient base of short-term liquid assets. During a longer-term crisis, however, eventually the counterbalancing capacity of the hedging assets is reduced and the bank must resort, at least partially, to stable funding channels that function even in stress. The regulators proposed NSFR measures this stability of funding channels by considering a one-year horizon. The NSFR is closely related to the so-called cash capital position (CCP) used by, e.g., Moody s. Moody s uses this measure to analyze the liquidity structure of a bank s balance sheet as part of its external rating assignment. The CCP concept simply compares the amount of unsecured short-term funding (e.g., less than one year) as well as the level of noncore deposits to the hedging capacity of the unencumbered assets. The CCP is the difference between the amounts, and a bank with a positive CCP is deemed to have a stable liquidity structure, meaning it does not rely extensively on short-term unsecured funding, the funding being diversified into either secured or long-term funding (or both). While the CCP measure is consistent with the regulatory incentive behind the NSRF, to promote diversification of funding sources to long-term funding and secured funding, the regulatory NSRF metric is defined a bit differently as the ratio of available stable funding and required stable funding. The NSRF for a bank is required to exceed 100 percent. 13

18 Figure 7 illustrates the calculation of the NSRF for a bank s balance sheet. The available stable funding is obtained by multiplying the bank s liabilities by regulatory factors that measure the funding liability degree of stability. The required stable funding is obtained by multiplying the assets by regulatory factors that measure to which extent the asset is long-term. Figure 7: The calculation of the NSRF for a bank s balance sheet. Diversity of Funding as an Important Lever to Control Liquidity Risk The NSFR ratio promotes banks to steer part of their funding toward long-term stable funding. However, the funding is not necessarily diversified across counterparties, regions, products, etc. Therefore NSFR ratio per se would not enable a bank to create a more diversified funding base. The recent Basel 2009 paper International Framework for Liquidity Risk Measurement, Standards and Monitoring therefore identifies key types of funding concentrations for the bank to measure continuously. These are: A. Counterparty concentration. B. Product concentration. C. Currency concentration. 14

19 The purpose of the concentration monitoring is to identify those key counterparties, products and currencies, which if severely restricted in terms of funding could cause significant liquidity problems for the bank 4. This encourages banks to create a balanced funding program that minimizes concentration and over-reliance on a single type of funding source. Currently, in order to monitor banks funding diversity, banks create funding limits across markets, geographies, products, maturities and investors. With regard to markets, the limit process begins at a macro level through establishment of limits both in absolute amount and percentage on what can be drawn from any broad marketplace, such as Commercial Paper (CP), medium-term notes, retail, or long-term bonds. If conducive to the business model, geographic or national market restrictions can also be imposed. The percentage of the funding portfolio is also limited by product type. For example, a bank might cap CP funding at 8 percent of total funding, shortterm interbank deposits at 15 percent, subordinated debentures at 20 percent, and so on. As a result, a bank would reduce its vulnerability to financial loss should productspecific financing be unavailable for a certain time period in a liquidity stress situation. The contractual and behavioral maturity of liabilities (contingent liabilities) must also be considered so that the bank does not face an excessive repayment or rollover burden in any specific time bucket to see that redemptions are equitably spread as much as possible. In this context, banks set limits to liability products with put options that give depositors a right to ask for a premature withdrawal anytime. Limits are usually set so that the all puts are not exercisable at a given time but rather spread out (for example, seven, 30 and 60 days). Staggering reduces the risk of sudden funding withdrawal. It is also important to reduce excessive reliance on a single type of investor, product/ instrument, market, currency or time bucket. In time of stress, a single type of investors (for example, within the same industry, rating grade or business group) with the same set of exogenous factors affecting them would exhibit higher correlation and might cause them to demand liquidity at the same time, thus drying up that supply of funds. Contingency Funding Plans in Banks The essence of a liquidity risk management plan in a bank is to manage the response of the bank to low-probability and high-severity liquidity risk situations that may cause the risk of insolvency. A contingency funding plan (CFP) helps banks strategize their responses to liquidity crises. A CFP therefore describes procedures for counteracting cash flow shortfalls in stress situations. CFPs form an integral part of the Basel 2008 guidance paper Principles for Sound Liquidity Risk Management and Supervision (see Principle 11). See also Matz (2007) for an overview of liquidity crisis contingency planning for banks. 4 The concentration ratios for counterparty, product and currency concentration are reported across maturity buckets of less than one month, one to three months, three to six months, six to 12 months, and for longer than 12 months. 15

20 While creating a CFP, banks take into consideration how a funding crisis evolves in different stages as a trigger, even more important compared to its duration or ultimate severity. This is due to the fact that while a liquidity crisis unfolds, the initial stage presents liquidity managers with a unique opportunity to take remedial action that may not be available in the later stages of the crisis. Therefore, a CFP should incorporate preparedness of a bank to deal quickly at the first signs (like an early-warning indicator) of an increased potential funding need. Therefore, identification of predefined triggers for what could be a major liquidity crisis is an important element of a CFP. Since CFPs are a way to address stress situations broadly classified into bank-specific (idiosyncratic) and/or systemic, the triggers defined in the CFP also can be classified as events or checks that affect bank funding as a result of bank-specific (Class I) and/ or systemic (Class II) reasons. While defining appropriate triggers, banks consider events that are forward-looking and not retrospective, like a ratings downgrade. Important examples of Class I triggers could be an increase in funding spreads relative to peer banks, liquidity risk limit breaches, etc. Class II triggers could be swings in overnight interbank rates in the money markets, an abnormal increase in credit spread of a generally liquid investment grade security (flight-to-quality), etc. CFPs are developed to fulfill two important objectives: 1) to increase future cash generation; and 2) to maintain the market goodwill of the bank. It is interesting to note that in fulfillment of the second objective, some banks might even take liquidityreducing actions in the initial stage in order to signal market confidence in its viability. A good practice is to form a plan that manifests actions during the early-warning indication stage itself (i.e., no current funding problem yet heightened level of liquidity risk) and includes low-cost steps to improve liquidity, for example, increasing standby liquidity reserves. An example is to attempt to alter the mix and maturity of assets and liabilities to decrease net cash outflow from sight to 90-day horizon. Another example is to intensify building liquidity reserves constituted by certain predefined securities that are highly liquid in all kinds of stress situations. Other than the CFP spanning different stages of a potential liquidity crisis (i.e., actions involved during the early-warning stage to mild crisis stage to a severe crisis unfolding), it also needs to address administrative policies and procedures during the span of a liquidity crisis. For example, what is the responsibility of the senior management during a funding crisis? What are the contact details of members of the crisis team? Which team would be responsible for identifying assets that can be sold or repurchased? Which team would be mobilized to talk to significant investors in the bank? etc. 16

21 Pricing Liquidity Risk The pricing of risk costs such as interest rate mismatch and credit risk is used by banks in funds transfer pricing in order to spread profit maximization incentives 5. While the practice of pricing liquidity risk is not as common as for other risks, it is important because liquidity (just like capital) is a scarce resource, and liquidity pricing should be instituted in a way that rewards providers of liquidity and penalizes its users. Inclusion of liquidity risk in a bank s (funds transfer) pricing is also a regulatory requirement. In particular, the Basel (2008) document Principles for Sound Liquidity Risk Management and Supervision specifies under Principle 4 that banks should incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval process for all significant business activities. When pricing liquidity risk, there are several components that can be considered 6. Specifically, one would expect a term liquidity charge to be applied to long-term illiquid loans as well as a liquidity credit for long-term stable funding, such as core deposits. Such a term spread is used in funds transfer pricing and provides relative incentives to business units to acquire shorter-term loans and longer-term funding. However, it is important to note that the liquidity premium (extra charge for longer-term funds) is usually included already for fixed-rate assets (liabilities) since they are being priced off the bank s funding curve with liquidity cost (credit) already built in. However, floating rate products are usually priced off the swap (interbank) curve and should get a liquidity charge or credit. The term spread is derived from the spread between the bank s funding curve and the swap (interbank) curve. Figure 8 displays an example calculation of the mismatch liquidity premium for a 5 year loan. Figure 8: Example calculation of the liquidity premium for a 5 year loan. 5 See the SAS white paper Funds Transfer Pricing and Risk Adjusted Performance Measurement for an in-depth discussion of funds transfer pricing. 6 Neu, et al. (2007), discuss a framework for pricing liquidity risk. The framework has three main components. Funding mismatch liquidity risk, contingency liquidity costs and market liquidity costs. 17

22 The assigned liquidity spread for the loan is then used in the calculation of the funds transfer price for the loan using the bank s allocated credit spreads, other charges and capital. Figure 9 calculates the funds transfer price of the loan with a liquidity term premium, credit spread, other spreads e.g., costs as well as capital charges. Figure 9: Calculating the funds transfer price of the loan with a liquidity term premium, credit spread and cost of capital. When calculating funds transfer prices, there is a cost component reflecting opportunity cost of capital, which measures the bank s foregone investment in the high-yield business due to having to hold capital for the risk. However, for liquidity risk, there is no capital held, and the pricing of the unexpected risk due to liquidity events must focus on the opportunity cost of holding counterbalancing capacity for liquidity contingency. The opportunity cost of stand-by liquidity is the difference between unsecured and secured (repo) funding and represents the opportunity cost of having to acquire counterbalancing capacity for unsecured funding. Just like capital costs, the contingency liquidity costs for unsecured funding should be charged in order to raise the funds needed to cover the opportunity costs of holding unencumbered assets to hedge the contingency. As an example, Figure 10 considers a stand-by unsecured liquidity facility where the mismatch liquidity costs are attributed to the core drawn part, as well as the undrawn part with a drawdown factor. The liquidity contingency costs are assigned to the undrawn contingent part with a drawdown factor. The part of the spread that is attributed to the contingency liquidity cost is the liquidity risk equivalent to the capital opportunity cost of other risks. 18

23 Figure 10: Calculating the mismatch liquidity costs and the contingency liquidity costs for an unsecured facility. Counterbalancing Capacity and Market Liquidity Costs The continuous monitoring of the counterbalancing capacity of the unencumbered assets is the key to understanding their usability in a liquidity crisis situation 7 specifically, grouping asset nominal amounts by their ability to be liquified or repoed (the ability to be to be collateralized after application of haircuts is important to understanding their potential use in hedging liquidity gaps). Moreover, the pricing of liquidity costs of the unencumbered assets is needed to provide incentives for traders to maintain sufficient quality and liquidity of the unencumbered assets. Figure 11 illustrates the grouping of the nominal flows of an unencumbered six-month term asset into a 30 percent haircut portion (the portion that remains on balance sheet until maturity), the sellable 50 percent portion (which is distributed over the term), and the 20 percent portion that is deemed eligible for collateral in repo agreements 8. The assumption is that the bank can use this portion of the nominal of the asset to shift the cash flow of the security toward the shorter time horizon, thereby satisfying any immediate short-term liquidity needs. On the medium-term horizon, the security is bought back and hence negative nominal flows are generated. These are occurring at the same time as significant sales generate nominal cash inflows. The total available nominal liquidity generated corresponds to the sum of the liquidity by sale, repo (buyback) and maturity cash flows at the corresponding time buckets. There are two types of maturity cash flows the hold-to-maturity haircut portion and the repo portion that is ultimately bought back. Using this approach, the counterbalancing capacity of the unencumbered asset can be estimated, and the total hedging capacity of all the unencumbered assets is derived from their corresponding grouping. 7 Monitoring of banks unencumbered assets that are eligible for collateral in secondary markets (repo) and eligible for central bank facilities is part of the Basel 2009 standard framework in International Framework for Liquidity Risk Measurement, Standards and Monitoring. 8 We refer to these flows as nominal flows, as the actual cash flows are determined by the nominal flows and the actual price during the term. That is, the actual flows are computed as nominal times the market price for the term of the flow. 19

24 Figure 11: The grouping of an unencumbered six-month term asset into a 30 percent haircut portion (the portion that remains until maturity), the sellable 50 percent portion (which is distributed over the term), and the 20 percent portion that is deemed eligible for collateral in repo agreements. While this grouping of unencumbered assets with the purpose of estimating total available liquidity is important in order to understand the bank s hedging capacity using the unencumbered assets, it is also of importance to provide incentives to traders to maintain a cushion of a sufficiently high-quality set of assets. This is similar to how liquiditybased funds transfer pricing is used to generate incentives to business units for holding stable funding and short-term assets; the incentive system for holding unencumbered assets should promote assets that can generate sufficient liquidity during a short period of time. This means specifically that the unsecured portion of the asset (that is, the liquidated part and the hold-to-maturity haircut part) should be marked up with the liquidity costs of the term. For the haircut portion, this corresponds to assigning the liquidity spread that is consistent with the maturity term of the asset, and, for the sellable portions, the corresponding portion s maturity term dictates the liquidity spread maturity. For the secured funding part, i.e., the part that is deemed to be usable as collateral in repo, one needs to take into account the fact that funding may not be rolled over fully. That is, we need to assign contingency liquidity costs for this possibility. 20

25 Notes on Advanced Liquidity Risk Management Probabilistic Measures of Liquidity Risk While our focus so far has been on scenario-based (e.g., stress testing) approaches to liquidity risk measurement, in practice sophisticated banks may also consider single probabilistic measures of liquidity risk combining the effect of expected cash flows and liquid asset value. Through this method, the information regarding cumulative liquidity exposure and counterbalancing capacity would be combined. In particular, using models for customer behavior and market evolution, we can generate many scenarios and record the net cumulative cash outflows under each scenario for a given term, T. In particular, the bank is solvent at horizon T if the net cumulative cash flows are greater than zero at T and for all t>t. In this setting the value at risk (VaR) of the scenario liquidity profile is calculated using the distribution of all the net cumulative cash flows accumulated at horizon T. In the monitoring of the liquidity VaR the objective of the bank is that with a certain high confidence level, say p, the VaR at confidence level p should not exceed a certain number, e.g., zero. The monitoring of liquidity VaR limits is here similar to monitoring the bank s VaR-based limits for market risk. However, to ensure solvency for each t=1,..,t this monitoring should be done for each day in the time horizon, i.e., for all t=1,..,t for example, up to 30 days or even 90 days. Figure 12 illustrates the probability distribution of net cumulative cash flows accumulated at times t=1,..,t. Figure 12: Probability distribution of accumulated net cumulative cash flows. 21