QFIP - 106 Liquidity Risk Management Ch 3

Question 1

Scenario, Sensitivity tests, Stress tests, Intergrated assumptions

Answer 1

• Scenario: description of an integrated future view
• Sensitivity tests: uni-variant tests used to establish the extent to which an outcome depends on a single variable or assumption
• Stress tests: integrated multi-variant tests that show degrees of severity in scenarios
• “Integrated”: means that assumptions for variables are interrelated

Question 2

Three hypothetical situations where liquidity is needed (ordered mild to severe)

Answer 2

1. A major unexpected withdrawal on the same day as an unexpected loan funding
2. A new consumer lease product for which deposits are expected to be sluggish
3. Earnings are wiped out by extraordinarily large additional provisions to the loan loss reserve

Question 3

Sources of Liquidity

Answer 3

• Holdings of short-term salable assets
• The capacity to increase liabilities
• Net cash flows from all sources

Question 4

Identifying and Describing Deterministic Liqduity Scenarios

Answer 4

Deterministic liquidity risk modelers must evaluate a wide variety of scenarios

• Two non-systemic standards:
  
  • A normal course of business scenario
  • A bank-specific funding crisis
• Two systemic crisis scenarios:
  
  • Capital markets disruption (flight to quality)
  • Severe recession

Question 5

Tips for creating and evaluating deterministic liquidty scenarios

Answer 5

• Normal course of business scenario should include the bank’s seasonal liquidity fluctuation
• Synchronize normal course of business scenario with the bank’s budget for consistency
• Include both long-term and short-term scenarios
• Don’t confuse stress levels and scenarios
• Some liquidity problems happen quickly; others build up over time
• Make sure scenarios are relevant to the strategic nature and stability of your bank’s liabilities

Question 6

Benefits of liquidty stress testing

Answer 6

Stress testing helps us understand whether we are holding enough liquidity to buy time to outlast an event or remedy it

• When used with sensitivity analysis, it can highlight what can go wrong, when, how badly, and for how long
• Allows implementation of measures to reduce risk
• Identifies opportunities for effective and rapid responses to funding problems
• Allows refinement of forecasts by identifying potential assumption errors and misunderstandings of risk factor correlation

Question 7

Risk factors included for systemic liquidity risk scenarios

Answer 7

• Prevailing interest rates
• Credit spreads
• Market access
• Time required to unwind specific holdings

Question 8

Risk factors included for bank-specific liquidity risk scenarios

Answer 8

• Deposit loss assumptions
• Funding requirements for off-balance sheet commitments
• Availability of new capital markets borrowings
• Rollover of maturing capital markets funding

Question 9

Methods for Scenario Stress Test

Answer 9

Central question: What differentiates normal and non-normal/extreme events?
3 methods that answer that question:

1. Value at Risk (VaR) and extreme value analysis
2. Deterministic modeling
3. Monte Carlo

Question 10

Extreme value analysis

Answer 10

• Attempts to quantify the worst case amount of a loss
• Relies on Generalized Pareto Distribution
• Often applied to fat-tailed distributions (like liquidity risk)

Question 11

Summary of VaR for Liquidty Risk

Answer 11

• VaR is popular, but not very good for liquidity risk
• Relies on the assumption that historical events reflect future events
• Does not allow modeling of structural changes
• Does not simulate portfolio performance during abnormal market periods

Question 12

Primary Advantages the Use of Hypothetical Assumptions

Answer 12

• Draw on historical experience without duplicating it
• Can be tailored to meet highly customized stress scenarios
• The results help risk managers identify the most important vulnerabilities

Question 13

Disadvantages of the Use of Hypothetical Assumptions

Answer 13

• They are inherently subjective
• They provide no information about the probability of loss (only severity)

Question 14

Deterministic Scenario Modeling at Multiple Stress Levels

Answer 14

Deterministic stress testing simulates shocks that have never occurred
Robust deterministic, scenario-based stress testing (should) reflect the following truths (i.e. these are good qualities to have):

• Liquidity problems usually don’t arise in a vacuum; they are triggered by something
• Liquidity problems usually start mild, then either end or progress into worse situations
• Funding problems can last a few days or more than a year
• Independent and dependent variables are interrelated; stress scenarios must have economic and business coherence
• Severe stress levels should be very severe

Question 15

Using Monte Carlo Modeling to Capture Liquidity Stress Levels

Answer 15

• Deterministic modeling provides information only about severity, not probability of a loss; Monte Carlo provides both
• Monte Carlo requires a starting state and parameterization (mean reversion and volatility)
• Disadvantage: historical data rarely include extreme events (Black Swan problem)

Question 16

Impact of changing interest rates on bank liquidity risk

Answer 16

The impact of changing interest rates

1. The term structure of a bank’s assets or liabilities may shift
   
   • If prevailing rates are low, customers may not renew CDs. Immediately liquidity isn’t affected, but liability term gets shorter
2. Holdings of bank assets and liabilities with embedded options
3. The volume of new bank assets
   
   • When rates are low, demand for new loans is high
4. The volume of liabilities
   
   • If rates are high, customers are more likely to disintermediate
5. The volume of assets and liabilities may change as rates track business conditions
   
   • In recessions, business demand for credit is lower

Question 17

Impact of credit risk on banks liquidity needs

Answer 17

Impact of credit risk on liquidity needs

• A bank’s cost of funds rises with its credit risk exposure
• If market awareness of credit problems rises, the availability of funds can dry up

Question 18

Quantifying Contractually Fixed Cash Flows

Answer 18

• These are the easiest to project since time is the only variable
• Liabilities that do not mature before the projected horizon are 100% stable, while short-term and amortizing assets throw off cash flows
• Few liquidity management tactics are as important as managing the maturity profile of liabilities
• Do not assume the bank will receive 100% of assets with contractual maturities within the forecast horizon

Question 19

Quantifying Cash Flows Primarily Driven by Interest Rates, Economic
Conditions, & Credit Risk

Answer 19

Most loan prepayment options will exercised rationally
Liquidity risk managers evaluating systemic stress scenarios with high interest rates can project changes in prepayments using standard rate risk models
Off-balance sheet commitments can be a major source of cash outflows in stress scenarios

• Some fluctuate with changes in credit risk associated with economic conditions
• Some fluctuate with the economic cycle

Question 20

Quantifying Cash Flows Primarily Driven by Counterparty Confidence

Answer 20

The most challenging part of building deterministic stress scenarios is quantifying confidence-driven cash flows
Insured deposits are less credit sensitive than uninsured deposits
Counterparties who own the funds tend to be less credit sensitive than counterparties who simply manage the funds for third parties
3 proxies for credit sensitivity used to segment funding providers:

1. Whether liability is insured or secured
2. Whether counterparty relies on public information for decisions
3. Whether the counterparty has a relationship with the bank

Question 21

Customer-Driven Deterministic Stress Scenario Assumption Summary

Answer 21

Subjective, hypothetical assumptions are required
Keys to implementing plausible assumptions:

1. Segment and group the changes we need to predict
   
   • Allows application of key drivers for each group
   • Drivers include contractual restrictions, interest rates, and economic conditions
2. Historical data from failed banks can be very useful, while historical data from our own bank is not

Question 22

Cash Flows Resulting from Bank Management Decisions

Answer 22

2 primary tools to increase liquidity:

• Selling securities from the bank’s standby liquidity reserve
• Selling other bank assets

Other tactics: new borrowings, raising prices to discourage new loans
Management-driven cash flows pose a serious problem

• Liquidity risk may be obscured if models assume management will sell assets
• Customer-driven and management-driven cash flows must be carefully separated

Question 23

Stress Test Procedures (9 steps)

Answer 23

1. Define the scenarios and stress levels you wish to test
2. Identify contractual cash inflows/outflows in each scenario and stress level
3. Estimate cash inflows/outflows resulting from customer behavior in each scenario and stress level
4. Add non-discretionary Treasury cash inflows and outflows
5. Sum the cash flows from Steps 3 and 4. This is the total forecast liquidity requirement for each time period
6. Calculate the net cash flow coverage ratio for each time bucket in each scenario and stress level
   
   • Cash flow cushion = Forecast cash inflows for the period/Forecast cash outflows for the period
   • Forecasts for ordinary course of business scenarios and minimal stress scenarios should always show a cushion
   • The cushion at each time period can be compared to required liquidity risk minimums
   • The number of cushion ratios can get out of hand, so it is a good idea to summarize them
7. Determine the quantity of standby liquidity available; compare to the amount needed
   
   • Determine available sources in each scenario
   • Determine the order we plan to access each source
   • Forecast how long it will take to convert each source to cash
   • Determine how much cash we obtain
8. Compare the quantity of forecast need to the quantity of forecast funds available
9. Inform management and tie the analysis to the bank’s liquidity contingency funding plan