Chapter 6 - Liquidity Flashcards
What is liquidity risk?
Liquidity risk is the uncertainty in meeting all obligations when they become due.
What is the primary responsibility of a bank’s board regarding liquidity risk management?
The board is ultimately responsible for liquidity risk governance and oversight.
What is the role of the treasury department in liquidity management?
The treasury department is responsible for ensuring the bank’s liquidity needs are met and for formulating liquidity policy.
What is the purpose of a bank’s liquidity policy?
To support the realization of the strategic plan through establishing a control framework consistent with liquidity risk tolerance.
Fill in the blank: The first step in liquidity risk management limit setting is the board liquidity risk _______.
appetite statement.
What does the Loan-to-Deposit Ratio (LDR) measure?
The extent to which customer deposits cover customer lending.
What is the maximum limit set for short-term wholesale funding reliance?
Maximum of 30% of wholesale funding.
What is the purpose of liquidity reserves?
To capture the amount of liquid assets available for use in times of funding stress.
What does the liquidity coverage ratio (LCR) measure?
The amount of unencumbered, high-quality liquid assets that can be converted into cash for a 30-day liquidity need.
True or False: The Internal Liquidity Adequacy Assessment Process (ILAAP) is designed to ensure banks can fulfill their payment obligations at all times.
True.
What are the three main objectives of the ILAAP?
- Board awareness
- Liquid resources adequacy
- Documentation of the overall liquidity framework
What is the regulatory limit for market lockdown?
91 days minimum.
Fill in the blank: Liquidity risk is a major focus area for _______.
regulators.
What does the encumbrance ratio measure?
The amount of encumbered assets against total assets.
What is the internal target for the Type A : Type B ratio?
35% for Type A liabilities limit.
What does the term ‘marketable assets’ refer to in liquidity management?
Assets that are readily available to be sold or converted into cash.
What is the reporting frequency for liquidity reserves?
Monthly.
What must banks do at least once per year regarding their liquidity adequacy?
Produce a clear and formal statement on their liquidity adequacy supported by ILAAP outcomes.
What does the funding concentration measure?
Concentration of deposits, commercial paper, and certificates of deposits against a single client.
Fill in the blank: The liquidity risk appetite statement includes both qualitative and _______ elements.
quantitative.
What is the target for liquidity reserves in relation to ILAAP outflows?
Greater than 120% of ILAAP outflows.
What does the term ‘stress-testing regime’ refer to?
A framework required to ensure compliance with Basel III liquidity requirements.
What does ILAAP stand for?
Internal Liquidity Adequacy Assessment Process
ILAAP is a crucial framework for banks to assess their liquidity risks and ensure they have adequate liquidity to meet their obligations.
What is the primary purpose of the ILAAP document?
To set out the bank’s approach to liquidity and funding
It should be updated annually or more frequently based on changes in business or operational environments.
How often should banks produce a formal statement on their liquidity adequacy?
At least once per year
This statement should be supported by an analysis of ILAAP outcomes and approved by the board.
What time horizons should banks describe their liquidity profile?
Appropriate time horizons out to 12 months
This includes assessing liquidity needs under both business-as-usual and stress conditions.
What risks must banks consider in their liquidity assessments?
- Risks from retail counterparties
- Risks from wholesale counterparties
- Contingent cash flows
- Off-balance-sheet items
These risks impact both on-balance-sheet items and funding concentrations.
What is the liquidity coverage ratio (LCR)?
A measure of a bank’s ability to meet short-term liquidity needs
It involves analyzing high-quality liquid assets (HQLA) against cash outflows and inflows.
True or False: The LCR replaces the need for overall liquidity adequacy assessments.
False
The LCR is a regulatory metric but does not capture all firm-specific liquidity risks.
What is intraday liquidity risk?
The risk that a firm will be unable to meet its daily settlement obligations
This can result from timing mismatches and various operational issues.
What is the liquid assets buffer (LAB)?
A portfolio of genuinely liquid assets that banks must maintain
It is often referred to as the high-quality liquid assets (HQLA) buffer.
List some components that can be included in the HQLA.
- Cash
- Government bills
- Government bonds
- Good quality international bills/bonds
- Multilateral agency bonds
Certain structured finance bonds and investment-grade rated corporate bonds may also be included up to 40% of the HQLA.
What does funding risk refer to in the context of a bank’s ILAAP?
The risk that medium- and long-term obligations can be adequately met
This includes evaluating the institution’s funding profile and market access.
What should banks provide regarding their funding strategy?
Description of funding risk strategy and appetite
This includes the funding profile and sources/uses of funding on a gross and net basis.
What factors can reduce the stability of a bank’s funding profile?
- Market shifts
- Changes in collateral values
- Excessive maturity gaps
- Concentrations of funding sources
These factors may lead to instability in funding and impact overall liquidity.
What is the significance of the bank’s risk appetite statement?
It includes a minimum required size of the LAB as part of quantitative risk limits
Typically, this size ranges from 5% to 20% of the LCR-driven size.
What should banks analyze regarding their access to markets?
Current or future threats to market access
This includes evaluating dependencies on markets or counterparties and potential impacts from negative news.
Fill in the blank: The components of the LCR include _______.
[high quality liquid asset (HQLA) portfolio, cash outflows, cash inflows]
Banks must analyze these components to ensure compliance with regulations.
What does the governance and risk management framework evaluate in relation to a bank’s risk profile?
It evaluates the liquidity risk strategy and its tolerance, policies and procedures, risk identification, measurement, management, monitoring, reporting, and the bank’s funding and contingency plan.
What must banks describe in their ILAAP document regarding risk appetite?
They must describe their risk appetite and liquidity risk strategy, how these were devised, approved, monitored, reported, and communicated throughout the firm.
Who is ultimately responsible for establishing the liquidity risk strategy of a bank?
The board is ultimately responsible for establishing, approving, and updating the liquidity risk strategy and liquidity risk tolerance of the bank.
What is the purpose of the risk appetite statement in a bank’s framework?
To set out clear views on intended actions regarding risks in line with business strategy, including motivations for taking on or avoiding certain types of risks.
What should banks select and monitor in addition to regulatory liquidity risk metrics?
A diversified suite of liquidity risk metrics appropriate to their business model and risk profile.
What should the governance arrangements around the ILAAP include?
The involvement of the governing body and the approach to regular internal review and validation of the ILAAP.
What is the purpose of the annual review of the ILAAP?
To discuss and challenge the ILAAP by the board, senior management, and relevant committees.
What are the three lines of defence in the internal review process of the ILAAP?
- Business lines
- Independent internal control functions
- Compliance and internal audit
What must the ILAAP document be consistent with?
It must be consistent with the board’s risk appetite and the bank’s approach for measuring and managing liquidity and funding risks.
What should banks describe regarding their internal limit and control framework?
They should describe the limits and controls around liquid asset buffers and the appropriateness of the limit structure to the risk appetite.
What is the aim of a sound limit and control framework?
To clearly articulate procedures regarding the approval and review of individual liquidity risk limits and monitor compliance.
What should the control framework for liquid assets buffer govern?
The management and timely monitoring of a bank’s liquid assets buffer portfolio, including quality, concentration, and immediate availability.
What is the purpose of adequate liquidity-specific stress testing?
To understand the impact of adverse events on the bank’s risk exposure and to determine if sufficient liquidity is held to cover risks during stress scenarios.
What should be included in a bank’s internal stress-testing framework?
The process and governance of scenario design, assumptions, sensitivity analysis, and review and challenge processes.
What should stress-testing scenarios uncover?
The vulnerabilities of the firm’s funding, including potential market illiquidity.
Fill in the blank: A liquidity contingency funding plan (CFP) is a requirement of the __________.
regulator
What are early warning indicators (EWI) used for in a bank’s CFP?
To determine if market conditions are deteriorating and trigger the invocation of the CFP.
What should the CFP outline regarding governance structures?
Clear and effective governance structures, policies, and procedures that need to be followed if the CFP is invoked.
What types of actions should the CFP describe for liquidity stress scenarios?
- Actions to be taken in the first 2 weeks (idiosyncratic stress)
- Actions that could be taken after 2 weeks (during market-wide stress)
What must banks assess regarding internalisation risk?
The risk generated when client long positions are funded using proceeds from customer short trades.
What is the impact of a bank’s credit rating deterioration during stress?
It may result in contractual and behavioral outflows due to required collateral and speed of outflow.
What should the bank’s liquidity-specific stress-testing framework be integrated with?
The overall risk management strategy.
What is the reputational impact of distressed counterparties?
Negative perception and loss of trust in the institution
Distressed counterparties can lead to a loss of business and clients seeking safer alternatives.
What is a primary goal when managing liquidity risk?
Limit outflows
This includes strategies to manage withdrawals and maintain liquidity.
What are some actions a bank might take with corporate loans during a liquidity crisis?
Withdraw non-committed lines
This helps to manage liquidity by reducing potential cash outflows.
What are debt securities?
Financial instruments representing a loan made by an investor to a borrower
Includes bonds and other forms of credit.
What might a bank do in selected markets during a liquidity crisis?
Cease market-making activity
This action can help mitigate risks and reduce exposure.
What is a potential consequence of selling securities during a liquidity crisis?
P&L losses
Selling under pressure can often lead to unfavorable prices.
What is the role of additional repo lines in liquidity management?
Provide extra liquidity through repurchase agreements
Repo lines allow banks to borrow funds using securities as collateral.
How does scenario analysis assist in liquidity risk management?
Helps understand asset and liability behavior under stress
This is critical for preparing for potential liquidity crises.
What does the Basel III LCR metric ensure?
Sufficient funds to meet stressed withdrawals over 30 days
This requirement is part of global liquidity standards.
What types of stress tests are mandated under Basel III?
Idiosyncratic, market-wide, and combined stresses
Each type focuses on different scenarios affecting liquidity.
What is the Individual Liquidity Adequacy Assessment Process (ILAAP)?
An internal stress-testing process for liquidity requirements
Banks must assess their own liquidity risks and report to regulators.
What does a combined stress scenario involve?
Market-wide issues and name-specific stresses
This type of scenario considers both systemic and individual bank risks.
What is a name-specific shock?
An unforeseen event affecting a specific bank
Examples include fraud or significant operational losses.
What types of liquidity risks are defined by regulators?
- Wholesale funding risk
- Intra-group funding risk
- Intra-day liquidity risk
- Cross-currency liquidity risk
- Retail funding risk
- Size and quality of liquidity buffer
- Off-balance-sheet liquidity risk
Each risk type requires different management strategies.
What is the aim of liquidity stress testing for the treasury desk?
Determine cash outflows and required stress liquidity
This ensures the bank can survive liquidity stress scenarios.
What is the purpose of reverse stress testing?
Quantify outflows before failing over a specific time horizon
This helps banks understand their limits under stress.
What is an example of a market-wide event?
A recession or severe price dislocation
Such events typically affect the entire financial sector.
What is essential for a bank’s stress testing framework?
Formal policy document approved by senior management
This ensures accountability and structured approach to stress testing.
What is the survival horizon in the context of ILAAP?
Length of time a bank is expected to survive a liquidity stress
This is a critical metric for assessing liquidity risk.
How often should banks report their liquidity position?
Daily or monthly
Regular reporting helps regulators monitor compliance and liquidity health.
What is the significance of stable versus non-stable deposits?
Different levels of withdrawal risk during liquidity stress
Understanding this helps in stress testing customer liabilities.
What should banks do if stress testing shows vulnerability?
Make changes to strategy and balance sheet
This proactive approach can mitigate risks and enhance stability.
What is the purpose of stress tests in banking?
To assess the bank’s likelihood of surviving specific stress events, such as operational or credit losses, market-wide downturns, or combined events.
What are the three aspects of a bank’s performance evaluated during stress tests?
- The liquidity position
- The profit and loss position
- The regulatory capital position
What is the typical survival horizon for stress tests?
Usually varies between 30 days and 3 months.
What is the primary output of liquidity stress testing?
The cash-flow survival report.
What does a cash-flow survival report indicate?
The period for which a bank is expected to survive a defined liquidity stress event.
What does a liquidity Coverage Ratio (LCR) in Basel III signify?
A ratio in excess of 100% indicates that a bank can survive a liquidity stress event for longer than 30 days.
What actions can be taken if stress test results suggest a need for mitigation?
- Acquiring additional HQLA/capital
- Contingency-funding arrangements
- Hedging to reduce asset exposure
Who must approve the assumptions used in stress test results?
A senior committee in the bank, possibly the ALCO or a board risk committee.
How often should line-by-line stress test result reports be produced?
Monthly or as required by the regulator.
What are the three bases to summarize liquidity mismatches for South African banks?
- Contractual balance sheet mismatch
- Business as usual (BAU) balance sheet mismatch
- Bank-specific stress mismatch
What is included in a contingency funding plan (CFP)?
- Viable and flexible funding measures
- Estimation of funds obtainable
- Governance structures and procedures
- Communication plans
- Steps for critical payments in stress situations
What is the purpose of the Internal Liquidity Adequacy Assessment Process (ILAAP)?
- Provide board awareness of liquidity management
- Assess liquidity resources in various situations
- Document the liquidity framework comprehensively
True or False: The Federal Reserve Bank requires a Comprehensive Liquidity Assessment Review (CLAR) for financial institutions.
True
Fill in the blank: The ECB sets out _____ principles in its guide to the ILAAP.
[seven]
What should stress assumptions for bank-specific stress mismatches be?
Board approved.
What factors should be included in the liquidity impact assessment during stress testing?
- Reduction in liquid assets
- Decrease in liabilities by segment
- Impact of forex mismatches
- Outflows due to off-balance-sheet exposures
What is a suggested way for banks to optimize high-quality liquid assets (HQLA) in the LCR metric?
- Target longer-term fixed deposits
- Focus on SME customers
- Introduce unbreakable fixed-term deposits
- Reduce undrawn commitment levels
- Price for liquidity risk
