Banking Week 3 Flashcards
What is liquidity
Market liquidity - is a markets ability to facilitate an asset being sold quick without having to reduce its price much
Asset liquidity - an assets ability to be sold quick without having to reduce the price much
Liquidity is about how big the trade off is between the speed of the sale and the price it can be sold for
Funding liquidity risk - ability to meet liabilities to unwind or settle their position as they come due
Reasons for liquidity :
Financing loan portfolio - asset drive.
Run off deposits- liability driven
Liquidity and funding risk
Important elements:
- cumulative net cash outflow(in and outflow)
- specific period
- Ability to convert assets into cash
Liquidity risk management :
all activities related to the identification,prioritisation and mitigation in order to reduce this risk to within the risk appetite of that organisation
Possible causes of liquidity risk
- Access to money and capital market decreases
- Bank run
- Margin calls
- Reduction of operational cash flows
- External Calamities
- Funding mismatchesp
Liquidity risks at banks inherent to the business model
Banks balances in the beginning :
- Primarily funded with short term savings deposits and some equity
- Assets were mostly long term loans (eg long term corporate loans and residential mortgages)
Risk : savings deposits can be withdrawn at any moment / short notice. Loans are closed out of a longer period (maturity mismatch)
Mitigate : bank holds a buffer of highly liquid assets. When liquidity outflow > liq inflow the buffer serves as a cushion. Banks can also apply matched funding as a control measure
Bank balances before the financial crisis :
Years before crisis bank sheets grew lots, especially loans to less credit worthy clients
This growth was financed by an ever growing dependency on short term wholesale loans
Risk: banks heavily dependent on money and capital market for refinancing short and long term bonds. Without the ability to refinance short loans bank would face a liquidity shortage
-Mitigate : banks should hold a higher buffer of highly liquid assets. In addition they should diversify their sources of funding
Phases of liquidity from 2007-2010 onwards
Pre 2007:
- Ready access to external liquidity: seeking higher yields for cash
- No need for advanced bucketing and buffer setting
- No transfer pricing
- low cost for getting it wrong
2008-9 liquidity crisis
- Safe haven for cash (large focus on cash generating and self sufficiency )
- vaporised market confidence,managing liquidity became vital
- potential distress for “liquidity scarce”
- General focus on lowering operating costs
- Introduction of the crisis management framework for ultimate stress situations
2010
- Increased emphasis on centralisation and efficient liquidity management
- focus on pooling and guarantees
- high risk for default but also potential for competitive advantage
- efficient bucketing proves to be rewarding
- Liquidity and collateral information from competitive strength
Basel 3
1) capital ratio
Higher quality and quantity of capital
2) Leverage Ratio
banks should have a healthy ratio of debt capital and own equity
3) Liquidity coverage ratio
Banks need to have enough liquid resource to meet the potential liabilities in a stress situation of 30 days
4) Net stable funding ratio
- Banks need to attract enough long term (>1) savings and (bonds) loans for financing the long term liabilities (>1 year )
Liquidity coverage ratio
The liquidity coverage ratio :
Retirement for banks to hold sufficient high quality liquid assets to cover its total net cash outflows over 30 days
High quality liquid assets / Total net liquidity outflows over 30 days >100%
NSFR
Net stable funding ratio - seeks to calculate the proportion of long term assets which are funded by long term stable funding
Available Amount of stable funding/ required amount of stable funding More than or equal to 100
Promotes medium to long term funding - reducing incentives for short term wholesale funding and supplements the LCR
Stress scenario is defined differently from the one underlying the LCR- idiosyncratic stress over 1 year
“Stable funding “ types of equity and liabilities expected to be reliable sources of funds under an extended stress of one year
Interest rate risk
Adverse changes in the interest income or interest expense as a result of changes in interest rates
Net interest margin :
interest assets -interest liabilities / balance sheet total
Repricing risk - risks related to the timing mismatch in the maturity and repricing of assets and liabilities and off balance sheet short and long term positions
Yield curve risk - risks arising from the changes in the slope and shape of the yield curve
Option risk - risks arising from hedging exposure to a rate that reprices under slightly different conditions
Methods to monitor interest rate risk
-Gap analysis
GAP= nominal maturity assets - nominal maturity liabilities
-Duration (IR sensitivity)
PV ass x Dur ass = PV lia x Dur lia + PV eq x Dur eq
Duration equity = IR sensitivity of the market value of the bank
- Scenario analysis
- Stress testing
Managing interest rate risk
1) Steering on balance
- Funding structure
- The bank’s own (liquid) portfolio
- Commercial steering on products as mortgages and savings (pricing, marketing, strategy)
2) steering off balance
For instance, use interest rate derivatives such as swaps
- A receiver swap has the same interest as a fixed rate asset and therefore increases duration (of equity)
- A later swap has the same interest rate risk as a fixed rate liability and this decreases duration (of equity )
Managing interest rates using swaps
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Stress testing
Modelling the impact of a severe change in interest rates
Impact on net interest margin and on duration of equity
Behaviour modelling
Embedded options
A special condition that attached to a security that allows the holder or the issuer to perform a specific action at some point in the future
Creates Uncertainty in timing of cash flows for the products
Creates uncertainty in depriving characteristics (affects interest rate )
Behavioural assumptions -
Products with embedded customer optionality
With specific repricing dates - loans with prepayment features or deposits with early withdrawal
Without specific repricing dates- current accounts and variable rate savings accounts
Behavioural modelling term deposit
For a deposit we want to model prepayment and extension risk
Before maturity the client has an option every month to extend or repay the deposit
At maturity the client can either fully pay or extend the deposit
