Chapter 7 - Liquidity risk Flashcards by Sophie Vickers

1.1.1 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.

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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.

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how to identify liquidity risk?

Maturity ladder which compares the cash inflows and outflows on a daily basis or period of time. This analysis of net funding requirements are determined by analyzing its future cash inflows based on assumptions about the future behavior of assets, liabilities and off-balance sheet items.

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how to construct a maturity ladder? what are the inflows and outflows ranked on?

what is the starting point for a measure of a bank’s future liquidity excess or shortfall at a series of points in time?

Bank has to allocate each cash inflow or outflow to a given calendar date.

The cash inflows are ranked by the date on which assets mature or a conservative estimate of when credit lines can be drawn down.

The cash outflows are ranked by the date on which liabilities fall due.

the difference between the inflows and outflows becomes a starting point for a measure of a bank’s future liquidity excess or shortfall.

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what should a maturity ladder reflect?

liquidity needs arising from business activities
need for excess funds to support other operations

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what are the three main reasons why actual and contractual cash flows differ from actual cash receipts?

it is not possible to estimate with certainty the cash flows from all instruments. Financial instruments, such as derivatives, have very broad range of possible contractual outcomes, therefore statically modelling is used.
the existence of credit risk means that the cash may not materialize on the due date. If the credit risk is significant, it should be included in the maturity ladder, but risk-weighted.
the business may not wish to hold the instrument until maturity

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what is asset liquidity risk?

refers to the likelihood of being unable to transform assets to cash. it is closely linked to credit and market

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what are the two main factors that determine the liquidity risk of the firm’s assets?

potential marketability - how easily can be sold for cash - links to market risk
how easily the assets can be used as collateral against which to secure increase cash inflows - links to credit risk

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what is funding liquidity risk?

Funding liquidity - the way which a firm obtains liquidity from the liability side of its balance sheet.

Liability liquidity - refers to unsecured funding obtained from depositors, third parties and the wholesale market

Funding liquidity risk - refers to the likelihood that the bank’s funding will not be available when required

It is closely linked to perceived level of credit risk that a bank poses to third parties.

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7.1.2 understand impact of liquidity risk within an individual firm and across wider system

Regulator and governments treat banks differently due to their special role in providing liquidity.

They facility trade by bridging the gap between short-term cash requirements and longer term cash flows - by borrowing short to long.

Essentially it may result in cognation

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7.2.1 understand the importance of funding liquidity risk analysis - liquidity gap analysis (cash matching)

Before a liquidity analysis is done, cash matching is used to understand a firm’s portfolio liquidity risk by examining all net future cash flows.

A firm/portfolio is matched if:
- every future cash inflow is balanced with an offsetting cash outflow on same date
- every future cash outflow is balanced with an offsetting cash inflow on same date.

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what does a gap analysis do?

Aggregates the cash flows into maturity brackets and checks if cash flows in each bracket net to zero.

a liquidity gap = is any net cash flow for a bracket

disadvantage = assumes all cash flows are the same, cant be used for options, it doesn’t consider credit risk

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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.

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in estimating ‘Normal’ future needs, what are the approaches banks use?

analyzing historical patterns of roll-overs, draw downs and new request
conducting statistical analysis
making subjective high-level business projections
undertaking a customer-by-customer assessment for large customers

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7.2.2 Limitations of key measures of asset liquidity risk: Bid-offer spread

what is the size?

how can it be used to compare liquidity of assets?

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

to compare liquidity - ratio of the spread to the assets mid-price is used.

Smaller ratio = more liquid

Limitation - reflects the size of transaction cost as well as liquidity of market.

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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 the of volume of transactions needed to move prices

Deeper = higher volume needed.

Example of deep market = blue-chip companies, such as FTSE 100/Dow Jones

Drawback - market depth changes fast.

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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

7.3.1 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.

LaR

VaR can be used to estimate the likely future value of credit and market instruments. LaR estimates the likelihood of liquidity shortages in the firm. IT GIVES THE BANK AN IDEA OF ITS LIKELY FUNDING REQUIREMENT OVER A GIVEN TIME PERIOD AT DIFFERENT CONFIDENCE LEVLES

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.

3.1.7 for large wholesale deposits, what does a bank undertake?

customer-by-customer assessment of probability of rollover

3.1.7 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.

3.3 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