Current Issues in Liquidity Risk

Transcription

1 Current Issues in Liquidity Risk Leonard Matz May, 2009 sitemap

2 Copyright Notice Large portions of this presentation are copyrighted by my publishers, John Wiley and Sons and Sheshunoff Information Services, Inc. No part may be reproduced in any form or incorporated in any information retrieval system without prior written permission from the copyright owner.

3 BRANDING AGENDA

4 1. New regulations and regulatory guidance: BIS Committee on Banking Supervision Council of European Bank Supervisors FSA (UK) 2. Lessons learned from the crises 3. Liquidity FTP 4. Scenarios 5. Stress tests 6. Best practice reports.

5 BIS Principles for Sound Liquidity Mgmt in a Nutshell Cash/Intraday Management Continuous Control & Review of Liquidity Position Multi-Entity & Multi Currency (Principle 6) Intraday Control (Principle 8) Cash/Intraday Management Continuous Control & Review of Liquidity Position Multi-Entity & Multi Currency (Principle 6) Intraday Control (Principle 8) Cash Flow Projection Stress Tests Funding Strategy Liquidity Pricing Liquidity Risk Tolerance Principle 5 Bank Specific/Systemic Events (Principle 10) Testing of Funding Plans Contingency Funding Plan (Principle 11) Funding Diversification/Monitoring (Principle 7) Principle 4 Principles 2 and 3

6 The FSA Requirements in a Nutshell Systems and Controls Requirements ILAS Groups Reports Strategic Tactical Operative Cash/Intraday Management Collateral Management Cash Flow Projection Scenario Generation Funding Transfer Pricing Liquidity Risk Tolerance Intra-day Liquidity Risk Management Management of Collateral Positions Stress Testing Contingency Funding Plans Pricing Liquidity Risk Governing Body & Senior Management Oversight Diversification Market Access Individual Liquidity Adequacy Standards Group Wide Management Legal Entities Business Lines, Currencies Reporting Weekly/Daily

7 BRANDING LESSONS FROM THE CRISIS

8 Liquidity Lessons from the Sub-Prime Crisis Rigorous monitoring, real-time liquidity controls, and cash-flow projections must be imposed and should have minimum standards. Retrospective and concurrent measures of liquidity (e.g., loanto-deposit ratio, funding ratio) have little value, while prospective views including off-balance-sheet exposures and instability scenarios of deposits are critical. Going-concern analyses are useless, while scenario-based stress analyses linked to contingency planning must be mandatory. Forward-looking risk mitigation measures such as collateral management for contingencies, contingency funding planning, and funding diversification must become the norm. Peter Neu and Philippe Morel, All Dried Up: The Impact of the Subprime Crisis on Liquidity Risk Management, BCG Discussion Paper, 25 April 2008, page 2.

9 Liquidity Lessons from the Sub-Prime Crisis As liquidity risk is a consequence of other risks, it is of the utmost important that stress scenarios consider interactions between market, credit, and operational risks, and that they include contagion and P&L effects. Peter Neu and Philippe Morel, All Dried Up: The Impact of the Subprime Crisis on Liquidity Risk Management, BCG Discussion Paper, 25 April 2008, page 3.

10 Liquidity Lessons from the Sub-Prime Crisis In the unlikely event of a funding crisis, good contingency planning can make the difference between being in control or being at the mercy of forces that can lead a bank on a downward spiral. Peter Neu and Philippe Morel, All Dried Up: The Impact of the Subprime Crisis on Liquidity Risk Management, BCG Discussion Paper, 25 April 2008, page 4.

11 BRANDING LIQUIDITY FTP

12 BIS Guidance for Liquidity Risk CBA Principle 4: A bank should incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole. Principles for Sound Liquidity Risk Management and Supervision, Basel Committee on Banking Supervision, September 2008.

13 BIS Guidance for Liquidity Risk CBA Institutions should have in place an adequate internal liquidity cost/ benefit allocation mechanism supported where appropriate by a transfer pricing mechanism which provides appropriate incentives regarding the contribution of liquidity risk of the different business activities. This mechanism should incorporate all costs of liquidity (from short to long term, including contingent risk). SECOND PART OF CEBS STECHNICAL ADVICE TO THE EUROPEAN COMMISSION ON LIQUIDITY RISK MANAGEMENT, CEBS, June 17, 2008, page 8.

14 FSA - Quantification and pricing of liquidity risk 3.26 we are of the view that many firms failed to incorporate pricing for either asset price liquidity or funding liquidity into their processes, with the result that the risk taking incentives of individual business lines were misaligned with the liquidity risk to which the firm as a whole was exposed as a result of its activities We therefore put forward an evidential provision for firms accurately to quantify the liquidity costs, benefits and risks in relation to all significant business activities whether or not they are accounted for on-balance sheet and to incorporate them in their (i) product pricing; (ii) performance measurement; and (iii) approval process for new products. The quantification of costs, benefits and risks should include consideration of how liquidity would be affected under stressed conditions We will expect firms to ensure that those costs, benefits and risks identified are explicitly and clearly attributed to business lines and are understood by business line management. Consultation Paper 8/22, Financial Services Authority, December 2008, page 23.

15 BRANDING SCENARIOS

16 FSA - Quantification and pricing of liquidity risk 1. Principle 10: A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and marketwide stress scenario (individually and in combination). 2. Principal 10, Paragraph 95: Stress tests should enable a bank to analyse the impact of stress scenarios on its consolidated group-wide liquidity position as well as on the liquidity position of individual entities and business lines. 3. Principal 10, Paragraph 99: A bank should consider short-term and protracted, as well as institution-specific and market-wide, stress scenarios in its stress tests, including: a simultaneous drying up of market liquidity in several previously highly liquid markets; severe constraints in accessing secured and unsecured funding; restrictions on currency convertibility; and severe operational or settlement disruptions affecting one or more payment or settlement systems. Principles for Sound Liquidity Risk Management and Supervision, Basel Committee on Banking Supervision, September 2008.

17 Systemic Crises Expect the Unexpected Collapse of U.S. high yield (junk) bond market Oil price surge (first Gulf war) ERM (European Exchange Rate Mechanism) crisis U.K. Small Banks Crisis U.S. bond market crash Mexican Crisis Asian crisis Russian default, Ruble collapse. LTCM bailout gold prices TMT (telecommunications, media & technology ) sector collapse September 11 payments system disruption Argentine crisis government default German banking crisis Russian banking crisis U.S. subprime mortgage collapse, oil price surge, U.S. investment banking collapse

18 Bank Specific Crisis Wide Variety until

19 Cyclical Stress Differences in Duration, Differences in Severity US Economy Recessions Since WW II

20 BRANDING STRESS TESTS

21 Evaluation of the Standby Liquidity Reserve Bank Specific Scenario at Stress Level 2

22 Liability Stickiness FORGET CORE DEPOSITS Inconsistent definitions Binary concept THE FOCUS IS ON STICKINESS a continuum

23 Characteristics of Sticky or Volatile Liabilities

24 Sensitivity of Funds Providers By Type Amount Percent Very sensitive to perceived deterioration in credit quality or safety Money market mutual funds Rating sensitive providers Pension funds Insurance companies Broker / dealers Minimize These Regional and money center banks in your country Foreign banks Large corporations Community banks in your market area Diversify These Only sensitive to credit quality and liquidity when problems are very bad and highly publicized Local, uninsured, unsecured depositors Customers who are net borrowers (their loan balances exceed their deposit balances) Local, secured funds providers Insured depositors Maximize These

25 Example definitions of liquidity buffer: What can we sell? Capital Markets Flight to Quality Fraud / embezzlement loss MILD MODERATE SEVERE MILD MODERATE SEVERE US government bills, notes, bonds US government guaranteed Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Non-MBS US GSE Yes Yes Maybe Yes Yes Yes A1 / P1 CP MBS Maybe Not likely No Yes Yes Yes AAA Corp Maybe No No Yes Yes Yes AAA muni Doubtful No No Yes Yes Yes

26 BRANDING CONNECTING STRESS TESTS AND CONTINGENCY PLANNING

27 Stress Levels Problems Unfold Over Time Amount of Available Funds Green: Ordinary Course of Business Yellow: No current funding problems but a heightned level of risk. Orange: Reduction of Confidence and some funding problems. No access to new unsecrued funds. Limited or no access to new secured funds. Red: Serious funding problems. Too late to enhance liquidity.

28 Excerpt From a KRI Report

29 e.g. quantitative EWS report Funding differential between Fortis and Peers moving in opposite directions for more than 1 period AND differential larger than 3 bps..

30 Applying Stress Testing Stress testing is not an end unto itself. Results have to be used in the risk management process. Results should be carefully considered when setting risk limits. Contingency plans for actions such as asset liquidations should be based on stress test results.

31 Connecting the CFP and Stress Testing Notably, CFPs are generally linked to stress testing scenarios. In cases where a firm has more than one stress test, it is not uncommon to see variations tailored to each scenario to highlight the proposed actions for accessing liquidity in the scenario. The management of liquidity risk in financial groups, (Survey of 40 large, complex financial groups) The Joint Forum," Basel Committee on Banking Supervision, International Association of Securities Commissions, International Association of Insurance Supervisors, page 13, May 2006

32 BRANDING BEST PRACTICE REPORTING

33 Survival Horizon Summary Sample Report Normal Operations STRESS LEVEL SURVIVAL HORIZON USING ONLY THE CBC THAT IS APPROPRIATE FOR THE SCENARIO AND STRESS LEVEL - SEE GRIDS STRESS TEST FORECAST RESULT REQUIRED MINIMUM (POLICY LIMIT) OBSERVATION MINIMUM OR SOFT LIMIT - TRIGGERS ALCO DISCUSSION * 14 months 12 months none Bank Specific Fraud loss Mild 11 months 12 months None Moderate 7 months None 9 months Severe 2 months None 6 months Systemic Global recession Mild Moderate Severe * DOES NOT NECESSARILY TRIGGER THE CFP. First purpose of ALCO evaluation is to evaluate why hard or soft limit was breached. Identify weaknesses that may be fixed. Second purpose of ALCO evaluation is to evaluate the sufficiency of the liquidity reserve. Third purpose is to evaluate and potentially increase the remedial actions listed in the CFP. Fourth purpose is to recommend changes in balance sheet 33 structure to reduce MCO if previous steps are insufficient.

34 Diversification of Funding Sources Should this bank reduce retail deposits and increase fiduciary deposits to improve diversification?

35 Volatility Liability Dependence 300,000 60% 250,000 50% 200,000 40% 150,000 30% 100,000 20% 50,000 10% CDs > $100K MMDAs > $100K Other DDAs > $100K Savings > $100K 0% TOTAL DEPOSITS > $100K RATIO Net Federal Funds Purchased (if applicable) LIMIT

36 Example Maturity Concentration Report Option Profits Amount Days 3 6

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