Chapter 10: Liquidity risk Flashcards
Liquidity Risk
Definition
* The uncertainty in meeting (or not meeting) all obligations as they fall due.
Business Model
* Maturity transformation:
The core business of banking involves originating lending of longer-terms (assets) from deposits of short-terms (liabilities).
* Mismatch:
The maturity mismatch between the assets and liabilities creates uncertainty (i.e. liquidity risk)
* Responsibility:
Banks must at all times be able to service their obligations, as they fall due, on both sides of the balance sheet, e.g., if a depositor wants their money back or if a customer wants to use their credit card.
* Environment:
Irrespective of the economic/behavioural conditions, and without resorting to a country’s central bank as the “lender of last resort”
* Process:
Being liquid at all times means, therefore, an ability (infrastructure and liquidity management) to be able to service both their assets’ and liabilities’ cashflow needs during their lifetime.
Types of Liquidity Risks
FaT aRM
Funding liquidity risk
* The risk that a bank does not have enough cash or easily convertible assets to meet its financial obligations as they come due.
* This can happen if depositors withdraw their money unexpectedly or if the bank is unable to borrow money in the wholesale market.
Trading liquidity
* The ease with which an asset can be bought or sold in the market without significantly impacting its price.
* A liquid asset can be traded quickly and easily, while an illiquid asset may be difficult to sell without incurring a loss.
Redemption liquidity
* This is similar to trading liquidity but is only relevant as an asset approaches maturity.
Market liquidity risk
* The risk that a bank cannot sell its assets quickly enough to meet its financial obligations.
* This can happen if there are few buyers for the assets or if the assets are difficult to value.
Loan-to-Deposit Ratio (LDR) Definition
Definition
* = Total Loans / Total Deposits
* Measures the relationship between lending and customer deposits over the same period.
* Gives a view of the self-sustainability or reliance on wholesale funding as compared to deposits
* Can be monitored against a specific limits and targets to ensure sufficient customer contribution to overall funding
Ratios
* Ratio of > 100%: Can be an early warning indication of excess asset growth, or a loss of customer deposits, and a potentially risky reliance on wholesale funds.
* Ratio of < 70%: Implies excess liquidity and a potentially inadequate return on funds if these funds are invested in low yielding assets or cash
* Ratio of 85% to 95%: Best practice, but dependent on the business model and risk tolerance of the bank.
1-week and 1-month liquidity ratios
1-week liquidity ratio
* =(High-quality liquid assets maturing within 1 week) / (Total net cash outflows over the next week)
1-month liquidity ratio
(High-quality liquid assets maturing within 1 month)/(Total net cash outflows over the next month)
Interpretation:
* A higher ratio indicates a stronger liquidity position, as the bank has more liquid assets available to meet its short-term obligations.
Purpose:
* Capture gap risk by
showing net cashflows, including effect of liquidating liquid securities, as a percentage of liabilities for different maturity buckets.
* Measure structural liquidity and give an early indication of stress points.
* If the liquidity ratios worsen, management should change the funding strategy or rapidly change the balance sheet composition.
Cumulative Liquidity Model
- Extension of the liquidity ratio and is a forward-looking model of inflows, outflows and available liquidity, accumulated for a 12-month period
- Aims to identify liquidity stress points on a cash basis
Liquidity Risk Factor (LRF)
Definition
* A snapshot of the bank’s aggregate liquidity gap, indicating the extent to which the bank is relying on short-term funding to finance longer-term assets.
* AKA the maturity transformation ratio
* Compares the bank’s assets’ average tenor to its liabilities’ average tenor
* May be either (or both) behavioural and contractual tenors
Calculation:
= (Weighted Average Tenor of Assets)/(Weighted Average Tenor of Liabilities)
…weights either nominal amounts or actual balances
Interpretation:
A higher LRF indicates larger liquidity gap
= Greater liquidity risk.
Limitations:
* Static measure: does not account for potential changes in A’s and L’s over time
* Does not consider the quality or stability of the bank’s funding sources
Usage:
Typically used in conjunction with other Liquidity Risk Metrics for bank’s liquidity risk profile
Modelling Cashflows in
Liquidity Risk Management
1. Measuring Contractual Maturity (ALM) gap profile
* Bank chooses the time buckets that it wishes to report the balance sheet gap in, and place cashflows in those buckets.
2. Modelling Behavioural Profile of Demand Deposits (Liabilities)
Exercise in observations and statistics…
1. Observe month-end spot and average balances over time to build a picture of behavioural tenor, by product type
2. Observe the behaviour at expected outflow points like month-ends and quarter ends
3. Observe the behaviour at times of stress
Banks should also analyse their deposit liability/customer types according to:
(SCRIB DIT)
* Is it Secured?
* Are the funds Controlled by the owner?
* Customer’s Relationship with the bank (e.g., loans)
* Internet access?
* Is the depositor a net Borrower
* Direct depositor or via a third party?
* Is it Insured?
* Type of counterparty – level of financial sophistication?
3. Modelling Behavioural Profile of Credit Facilities (Assets)
Modelling pre-payment behaviour
* Prepayment assumptions need to be made as assets’ behaviour profiles are shorter than contractually stipulated – flows in the FTP process
* For undrawn facilities and credit cards expect full contractual tenor.
* Back-up liquidity lines (to customers) are likely to be drawn on at precisely the time when the bank will want to be preserving liquidity and lending less.
* It’s imperative that these facilities be allocated appropriate charge when they originate.
4. Modelling Behaviour of Contingent Funding Obligations
* Contingent, off-balance sheet and collateral obligations also generate term funding requirement for a bank.
* Important to understand the tenor characteristics of these cash-flows
Liquidity Coverage Ratio (LCR) Definition
Calculation
* =(Stock of HQLA)/(Total net cashflows over the next 30 calendar days)
* Needs to be >100%
Purpose:
* Short-term liquidity metric
* Promotes short-term resilience of a bank’s liquidity risk profile by ensuring it has sufficient HQLA to survive a significant stress scenario lasting for 30 calendar days
Net Stable Funding Ratio (NSFR) Definition
Calculation
* (Available amount of stable funding) / (Required amount of stable funding)
* Needs to be >100%
* Available stable funding (ASF) : measured based on broad characteristics of the relative stability of an institution’s funding sources.
* Required stable funding (RSF): measured based on the broad characteristics of the liquidity risk profile of an institution’s assets and off-balance-sheet exposures.
Purpose
* Long-term liquidity measurement metric
* Requires a bank to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.
* Promotes resilience over a longer time horizon (1 year) by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis
* A low ratio indicates a concentration of funding in shorter maturities, which can give rise to rollover and mismatch risk
How to improve NSFR
- Increase the ASF by adjusting the liability side of the BS (e.g., liabilities with higher rollover factors or longer duration)
- Decrease RSF by adjusting the asset side of the BS (e.g., assets with lower rollover factors or short duration)
- Difficult to change the shape of the BS in the short-term thus cannot change NSFR in the short term
Concentration Report
- Report that shows the extent of reliance on a single source of funds.
- Can be an indication of a possible stress point in the event of a crash
- Banks should not be reliant on a single counterparty
- Outside the retail deposit sector, they should be wary of excessive reliance on a single class of depositor
- Managed through deposit limits
Improve LCR
Addressing numerator:
1. Increase HQLA stock
Addressing denominator (net outflows over 30 days):
PLUS MUSC
1. Pricing for liquidity risk (encouraging customers to invest in longer-term products and deter customers from holding borrowing limits they don’t use or are higher than required)
2. Targeting towards Longer-term fixed deposit (outside 30 day maturity)
3. Introducing Unbreakable fixed term deposits, reducing risk of outflow in stress
4. Focus on retail/SME/operational/Stable deposit customers
5. Margin improvement (where possible, re-price fixed term deposits to reduce costs or volumes)
6. Reducing Undrawn commitment levels
7. Longer term account specification
8. Customer optimisation (e.g. specific sector)
High Quality Liquid Assets (HQLA)
aka Liquid Asset Buffer (LAB)
CERL
- low Correlation with risky assets.
- Easy to value with certainty.
- low Risk, with low or no subordination.
- must be Listed on a developed and recognized exchange.
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2.5 levels: - Level 1: Highest quality with no haircut or limit (e.g. cash, cash reserves, marketable securities from SARB or PSEs)
- Level 2A: Haircut of 15% with max of 40% of HQLA (e.g. corp and SOE debt with AA- or higher)
- Level 2B: Haircut of 50% with max of 15% of the 40% Level 2 cap of HQLA (e.g. corp and SOE debt with BBB- or higher)
Maturity Transformation Definition
The practice of using short-term deposits to fund long-term loans.
Uses for Behavioural Tenor Analysis
- FTP (Fund Transfer Pricing)
- LCR (Liquidity Coverage Ratio)
- Determining LAB (Liquid Asset Buffer) = HQLA
- Determining the strategic setting for customer pricing
Liquidity Risk Metrics
- Loan-to-Deposit Ratio
- 1-week and 1-month Liquidity Ratios
- Cumulative Liquidity Model
- Liquidity Risk Factor
- Concentration and Funding Source Report
- Inter-entity lending report (relevant to group entities).
Inter-Entity Lending Report
- Relevant for group and consolidated banking entities
- Intra-group lending is common in banking entities, and in some jurisdictions subject to cross-border and cross-legal entity regulatory limits.
- Report used to determine:
1. How reliant a specific banking subsidiary is on group funds
2. To what extent it is approaching regulatory limits.
