Chapter 7 - Liquidity risk Flashcards
definition of liquidity risk
Risk that a firm has insufficient cash to meet its cash obligations and will either become insolvent, suffer losses, selling assets below market price, or pay penalties.
what can liquidity risk not be treated in isolation from?
what is liquidity risk similar too?
- financial controls, instruments, credit risk, market risk, operational risk, business risk
operational risk because it is hard to measure.
understand the importance of a liquidity gap analysis?
disadvantages
Liquidity gap analysis is a financial tool used to assess the difference between an institution’s liquid assets and liabilities over a specific period to ensure it can meet short-term obligations.
Disadvantage
- does not consider credit risk
- cannot handle options
what is done before a liquidity gap analysis is completed?
why is it used and what does it examine?
how are they matched?
Cash matching
- used to understand a firms liquidity risk by examining all net future cash flows.
Matched if:
- every future cash inflow is balanced with offsetting future cash outflow on same date.
- every future cash outflow is balanced with offsetting cash inflow on same date.
what is stress testing? what does it take? what must be used first?
what’s needed before its done?
what should be done after this is done?
assessing how outcomes differ when individual inputs to a system are changed or stressed. Stress test takes normal assumptions and tailors them to area being tested. Normal assumptions must be used first
Before its done- contractual liquidity data collected.
Set out how it expects normal behavior to impact liquidity risk, needs to be clearly documented and based on historical data.
what is the analysis of net funding requirements based on?
involves the construction of a maturity ladder and the calculation of a cumulative net excess, or deficit of funds at maturity dates.
The maturity ladder what it compares
steps to constructing
problem
Compares cash inflows and outflows on a daily-basis or over period of time. maturing assets and liabilities
Steps to constructing
- allocate each cash inflow or outflow
- cash inflows ranked by dates on which assets mature or conservative estimate of draw down.
- cash outflows ranked by date
- must reflect the need for excess funds to support operations
Problem - never shows complete picture
what are the three main reasons why actual and contractual cash flows differ from actual cash receipts?
what will this require?
- not possible to estimate cash flows from all instruments. Such as derivatives which require statistical modeling techniques.
- Existence of credit risk means cash may not materialize on due date. This will require risk-weighted
- business may not wish to hold instrument until maturity
what is liquidity risk like?
Operational risk as it is hard to quantify
what is a banks net funding requirement based on?
analyzing future cash flows based on assumptions about behavior of asset, liabilities, and off-balance-sheet items, and calculation of cumulative net excess or shortfall for liquidity assessment.
what are the two main factors that determine the liquidity risk of firms assets?
Potential marketability - how easily they can be sold for cash, links to market risk
How easily assets can be used as collateral against which to secure increased cash inflows. Links to credit risk
what is asset liquidity risk, what is it linked to?
likelihood of being unable to transform assets into cash within preferred time period, linked to credit risk and market risk.
what is funding liquidity risk?
likelihood that the bank’s funding will not be available when required. Linked to credit risk
what does liability liquidity refer to?
unsecured funding obtained from depositors, third parties, and wholesale markets.
how are banks treated by regulators and government?
They facilitate trade by bridging the gap between short-term cash requirements and longer term cash flows.
Limitations of key measures of asset liquidity risk: Bid-offer spread
what is the size?
What is used?
Smaller ratio indicates?
Limitation?
Difference between the prices quoted by market makers for an immediate sale to them (the bid) and an immediate purchase from them (the offer)
the size is the measure of its liquidity of the market
Smaller ratio = more liquid
Limitation - reflects the size of transaction cost as well as liquidity of market.
Limitations of key measures of asset liquidity risk: Market depth
what does it measure?
the deeper, what does it mean?
example of a deep market?
drawback?
Measure of volume of transactions needed to move prices
Deeper = higher volume needed.
Example of deep market = blue-chip companies
Drawback - market depth changes fast.
Limitations of key measures of asset liquidity risk: Immediacy
what is it a measure of?
what does it depend on?
Measure of the time it takes to achieve a deal in a market.
Depends on - existence of market makers.
Limitations of key measures of asset liquidity risk: Resilience
what does it measure?
the more liquid?
Measure of the speed with which prices return to equilibrium following a large trade
More liquid = faster prices return to equilibrium
what are banks required to do to submit details of their liquidity?
give specific details
Individual liquidity Adequacy Assessment for firms subjected to ILAA regime
- Full and complete review of firms liquidity position
- review of liquidity governance
- stress testing
- contingency funding plans
- management information and reports
- review on assessment
Understand the main ways in which liquidity risk can be managed: Liquidity limits
sets limits to control the liquidity risk exposure and imposes ceilings on projected net funding requirements along maturity ladder.
There should be set of corresponding escalation procedures for each limit.
Commonly employed limit: constrains size of cumulative contractual cash flow mismatches over various time horizons
Understand the main ways in which liquidity risk can be managed: Counterparty credit limits
banks need to maintain intra-day counterparty credit limits
what are the drivers which increase likeihood of liquidity risk
- market concerns over availability of credit
- general market and economic conditions
- global shocks
what are the three specific scenarios for behaviour of cash flow?
- Going-on concerns conditions
- banks specific crisis
- general market crisis
going-on concern
- what does it establish?
- why is it useful?
- it establishes a benchmark for the ‘normal’ behaviour of balance sheet-related cash flows in the ordinary course of business at bank.
- useful to manage the banks use of deposits and other debt markets. Therefore, allowing it to managed net funding requirement so it is not met with large needs, avoiding constraints.
banks-specific crisis
- what does it provide?
- what is the underlying assumption?
- provides one-type “worst case” benchmark
- underlying assumption - bank’s liabilities could not have been rolled over/replaced and would not be repaid at maturity so bank would have to wind down.
General market crisis
- what is it?
- underlying assumptions?
- who is interested?
- where liquidity is affected at all banks in one/more markets. Second-type worst case scenario
- underlying assets - severe tiering by perceived credit quality would occur, so that differences in funding access among banks or among classes of financial institutions would widen.
Supervisors or central banks would be interested when surveying the liquidity profile of entire banking sector. the results would show the size of total liquidity buffer in banking system!
How do banks need to assign timing of cash flows for each type of asset and liability?
- by assessing the probability of behaviour of those cash flows in the scenario being examined.
why does the timings of cash inflows and outflows on the maturity ladder differ between the going-on concern approach and the two crisis scenarios?
- because they are assigned later dates due to uncertainty.
how to construct a going-on concern maturity ladder
- conservative assumptions need to be made about the behaviour of cash flows that can replace the contractual cash flows
constructing bank-specific crisis scenario?
constructing general market crisis?
- assumed that the bank will be unable to roll over or replace many or most of its liabilities that it may have to wind down its books.
- capacity may fall of sharply if few institutions unable to make cash purchases, or if high reputation bank can gain advantage.
what are the questions that banks ask when examining cash flows in the two crisis scenarios?
- which sources of funding are likely to stay, how to increase (core deposits usually stay)
- which sources of funding can be expected to run off gradually if problems arise and what rate?
- which maturity liabilities or liabilities with non-contractual maturities can be expected to run off at first sign of trouble?
- does bank have back-up facilities that it can draw out?
which other firms can benefit from constructing liquidity risk scenarios?
- securities firms, scenario analysis enables the firm to evaluate any potential cash requirements arising from early termination, collateral, other credit provisions usually found in firm derivative contract.
what does the maturity ladder give?
forward-looking picture of a bank’s funding requirements.
what is an alternative for the bank to use?
how is it calculate?
typically what occurs?
what does it provide a bank with?
Historical financial data to work out the size and frequency of its past funding requirements.
A series of ‘funding amount’ brackets can be defined, once the historic funding requirements have been assigned to their brackets, the brackets can be arranged as distribution.
Typically there is a cluster of commonly required funding amounts in middle of distribution, with lower amounts and higher amounts spread either side to form tails.
Liquidity at Risk (LaR) distribution gives the bank an idea of its likely funding requirement over a given time period at different confidence levels
how can a bank use diversification to reduce liquidity risk by diversifying its liquidity resources? how should it be diversified?
should be diversified according to:
- type of liquidity instrument
- currency of funding
- counterparties used
- firms liability term structure
- assessment of available markets for realisation of liquidity asset and funding.
to evaluate the cash flows arising from bank’s liabilities, how can a bank examine the behaviour of its liabilities under normal business conditions?
Behaviour analysis:
- establishes normal level of rollovers, effective maturity of deposits, normal growth in new deposit accounts
What is used for instant access deposit accounts?
Statistical analysis which takes account of seasonal factors, interest rate sensitivities, and other macroeconomic factors.
for large wholesale deposits, what does a bank undertake?
customer-by-customer assessment of probability of rollover
How is liquidity obtained from both sides of balance sheet?
Liability side = firms obtain funding in many forms, both secured and unsecured from variety of lenders and differing maturities.
Asset side = less liquid assets can be used as collateral to obtain liquidity through use of repurchase agreements or posted as collateral to support various trading strategies for creation of liquidity.
what are the common funding courses to avoid concentration?
- wholesale money markets
- securitisation of loan portfolios
- retail deposits
- loan facilitates with central bank
what is market dislocation?
implications
it is a period where markets cant clear at any price
implications:
- companies find it hard to borrow
- consumers cant obtain mortgages
- central banks lose the use of interest rates
