Chapter 7: Liquidity risk

Question 1

what does the liquidity of an institution depend on?

Answer 1

its immediate need for cash, how much cash it currently has and its available lines of credit

Question 2

what internal and external controls can liquidity risk cannot be treated in isolation from?

Answer 2

• financial controls
• instruments that generate cash
• credit risks
• operational risks
• business risks

Question 3

what can impaired liquidity result in?

Answer 3

can result in insolvency, can have repercussions for the market as a whole, causes tighter liquidity conditions in affected markets and potential systematic risk

Question 4

what tools can be used identify liquidity risk?

Answer 4

construction of a maturity ladder, analysis of actual and contractual cash receipts

Question 5

what is the maturity ladder?

Answer 5

device for comparing cash inflows and outflows

Question 6

how is a maturity ladder constructed?

Answer 6

cash inflows are ranked by the date on which liabilities fall due (earliest), should be applied to assets which are ‘slotted in’ to reflect market risks, significant interests and cash flows should also be included, must also reflect the need for excess funds to support other operations

Question 7

what are the three main reasons why actual and contractual cash flows shown in the maturity ladder will differ from the actual cash receipts?

Answer 7

• not possible to estimate with certainty the cash flows from all instruments
• even when cash flows can be properly estimated, existence of credit risk may nullify this
• business may not wish to hold onto instrument until maturity

Question 8

what is asset liquidity?

Answer 8

cash obtained from mature or sold assets, or the use of these assets as collateral in secured funding for repurchase agreements

Question 9

what are the two main factors that determine the liquidity risk of the firms assets?

Answer 9

• potential marketability
• how easily the asset can be used as collateral

Question 10

what is funding liquidity and its risk?

Answer 10

the way in which the firm obtains liquidity from the liability side of its balance sheet, risk is that the banks funding will not be available when required

Question 11

what is the potential impact of liquidity risk?

Answer 11

firm may not be able to meet its obligations as they fall due, firm will face a loss due to the cost of borrowing to meet obligations

Question 12

why do bank failures have contagion effects?

Answer 12

consumers start to lose confidence in the banking system as a whole, rather than simply the failed bank

Question 13

what needs to happen before liquidity gap analysis is done?

Answer 13

technique called cash matching is used to understand a firm’s or portfolio’s liquidity risk, by examining all net future cash flows. Every future cash inflow is balanced with an offsetting cash outflow

Question 14

what does liquidity gap analysis do?

Answer 14

aggregates the cash flows into maturity brackets and checks if cash flows in each bracket net to zero, maturities can be grouped into brackets based on time of maturity

Question 15

what are the shortcomings of liquidity gap analysis?

Answer 15

• doesn’t consider credit risk, and assumes all cash flows will occur
• can’t handle options in a meaningful way
• cash flows have magnitudes and timing that is highly uncertain

Question 16

how do banks estimate ‘normal’ future funding needs?

Answer 16

• analyse historical patterns
• conducting statistical analysis
• making subjective high-level projections
• undertaking customer assessment for its larger customers

Question 17

what are the key measures of asset liquidity risk?

Answer 17

• bid-offer spread (difference between quoted prices for buy and sell in a market)
• market depth (volume of transactions within a market)
• immediacy
• resilience

Question 18

what is the process for managing liquidity risk?

Answer 18

• bank must be readily able to determine its contractual liquidity position
• bank should overlay the view on its contractual liquidity position with assumptions about normal behaviour
• should undertake stress testing
• bank can assess its current level of liquidity provision

Question 19

what techniques can banks use to ensure they stay within their risk appetite and profitability goals?

Answer 19

• setting and monitoring liquidity limits
• setting and monitoring counterparty credit limits
• scenario analysis
• liquidity at risk techniques
• diversification
• behavioural analysis

Question 20

what must firms subject to ILAA provide their regulator with?

Answer 20

• full and complete review of the firm’s liquidity position
• review of liquidity governance

Question 21

how do liquidity limits manage risk?

Answer 21

controls its liquidity risk exposure, imposes a ceiling on the projected net funding requirements along the maturity ladder. set of corresponding escalation procedures for each limit breach

Question 22

what scenarios provide useful benchmarks for determining whether a bank is sifficiently liquid?

Answer 22

• banks ‘going on’ concern
• bank specific crisis
• general market crisis

Question 23

what is liquidity at risk used for?

Answer 23

used to estimate the likelihood of liquidity shortages within the firm, uses historical financial data to work out the size and frequency of its past funding requirements

Question 24

what is behavioural analysis?

Answer 24

examines the behaviour of its liabilities under normal business conditions

Question 25

what is market dislocation?

Answer 25

when liquidity disappears in the market and no one will lend, regardless of price, banks behaviour starts to become unpredictable

Question 26

what are the implications of market dislocation?

Answer 26

• companies finds it harder to borrow
• consumers find it hard to obtain mortgages
• central banks lose the use of interest rates as their main economic lever