QFIP - 147 Liquidity Risk Management Ch 2 Flashcards
Key Differences Between Liquidity Risk, Capital, and Other Financial Risks
“Liquidity” is different from “capital”
Liquidity risk is different from other types of risk:
- Liquidity risk or “consequential risk” is secondary risk: its increases always follow one or more spikes on other financial risks
- We usually hold capital against potential losses in a net asset value through VaR framework; this does not work for liquidity risk, where the risk is to meet the net cumulative cash outflow (NCO)
- For liquidity risk, capital is replaced by a combination of risk reduction management to reduce NCO and unencumbered eligible assets to offset NCO
When is liquidity riks adequately covered?
Liquidity risk is adequately covered if the cash inflow generated from unencumbered eligible assets within a time interval t exceeds the NCO within the same time interval t
Dependencies of NCO and the cash inflow after selling unencumbered securities
- The bank’s total balance sheet position in the market
- Whether the market can absorb these additional assets when sold by the bank
Two points to consider when calculating potential liquidity from unencumbered assets
- The cash equivalent from liquid securities may differ for banks that have different market access
- Whether banks will actually let other troubled banks draw on committed liquidity lines
Sources of Liquidity Risk
- Liquidity risk can arise on both sides of the balance sheet
- In most cases a trigger event meets an already existing vulnerability in a bank’s balance sheet and causes an adverse liquidity outcome
Examples of liqudity risk trigger events
- Liquidity mismatches between assets and liabilities (most common)
- Significant short options of the bank with respect to counterparties and customers
- The crystallization of market, credit or operational losses in the bank
- Damages to the bank’s reputation
- Market-wide liquidity stress
- Large losses in trading portfolios that cause unsecured funding from other banks to cease
- Declines in the market value of a derivative trading position
- Downgrade of a bank’s external rating
Impaired liquidity can cause insolvency and even generate systemic risk if the institution is large
Quantitative Frameworks For Liquidity Risk Measurement
To assess liquidity risk quantitatively, banks apply three types of analysis:
- Balance sheet liquidity analysis
- Cash capital analysis
- Maturity mismatch analysis
Balance Sheet Liquidity Analysis
This approach matches up items on the asset side of the balance sheet with the liability side
- Sticky assets are funded by stable liabilities
- Liquid assets are funded by volatile liabilities
Problems with Balance Sheet Liquidity Analysis
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Missing time dimension
- Liquidity risk managers generally only have access to stand-by liquidity when problems arise
- Most liquidity needs are not instantaneous shocks; they develop in stages
- Holding prudential or stand-by liquidity buys time
- Impact of accounting rules. Balance sheet figures are based on accounting rules, which do not necessarily reflect the economic cash flows of the bank
- Off-balance sheet commitments. Activities that are not shown on the balance sheet can expose the bank to contingent liquidity risk
- Marketability of securities. The balance sheet shows current market or book values, but future collateral value or cash value when pledging or selling is more important
- Commercial papers. Commercial papers should be treated like unsecured money market funding
- Non-bank deposits. Although a core level can be considered as stable, a fraction of non-bank deposits will always be volatile
Cash Capital Position
Moody’s originally invented the cash capital concept
Main idea: Measure a bank’s ability to fund its assets on a fully collateralized basis assuming that the access to unsecured funding has been lost
- Cash capital = (Collateral value of unencumbered assets) - [(Short-term inter-bank funding) + (Non-core parts of non-bank deposits)]
Unencumbered assets are assets available for use as collateral
- Unencumbered securities = long securities
- short security position
- reverse repo’d securities
- repo’d securities
- borrowed securities
- lent securities
Collateral value = (MV of unencumbered securities) - (Haircuts)
Borrowed securities may be counted as unencumbered securities because they can be used as collateral
Maturity Mismatch Approach
- The maturity-mismatch approach is an alternative metric that measures liquidity risk per time period, and addresses the missing time dimension issue in Cash Capital Analysis
- The NCO and unencumbered assets must be estimated per time period and under different scenarios
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Liquidation cash flows from all liquefiable balance sheet and off-balance sheet items are mapped to a maturity ladder 4 categories:
- Category I: Cash flow amount and cash flow timing are deterministic
- Category II: Cash flow amount is stochastic and cash flow timing is deterministic
- Category III: Cash flow amount deterministic and cash flow timing is stochastic
- Category IV: Cash flow amount and cash flow timing is stochastic
Liquidity Gap Profile
For each time period, net cumulative liquidity gap = (net cumulative inflows) - (net cumulative outflows)
- A positive net cumulative gap indicates that the bank can cover all its outflows by liquidating its unencumbered assets
- A negative gap means the liquidation of the bank’s inventory may not be sufficient to cover its outflows
The Funding Ratio shows the funds available after n years as a percentage of assets maturing n years or later:
- Sum of available funding above n years/sum of assets maturing above n years
The funding ratio is a useful tool monitoring the long-term funding structure
Liquidity gap analyses are usually done under different scenarios
- Operating liquidity scenario
- General market disruption
- National macroeconomic disruption
- Banking industry disruption
- Bank-specific crisis
- Downgrades
- Loss of a big investor
- Bank runs
Liquidity Ratio
Banks look at a number of ratios or indicators that measure their ability to meet liquidity needs under going concern and stressed market conditions
Most banks target a liquidity ratio well above 100%
Cash Flow Modeling for Securities
Securities generate short-term liquidity inflow
Must estimate the liquefiability of a security position under different scenarios
Criteria: position size, rating, issuer group, country group and country rating, etc.
According to these criteria, securities should have different liquidation horizons
Highly liquid bonds have a short horizon; more illiquid securities have a longer liquidation horizon
Cash Flow Modeling for Revolving Loans and Committed Credit Lines
Liquidity risk managers must monitor risks in loan commitments, lines of credit, performance and financial guarantees
The amount and timing of potential cash flows from off-balance sheet claims must be estimated by the banks
A portfolio approach must be used. It has 2 parts:
- Current usage is separated into a core usage (long-term) and a volatile usage (short-term)
- Portfolios should recognize that distinct types of off-balance sheet requirements must be evaluated differently:
- (a) Funding under some types of commitments tends to be correlated with changes in macroeconomic conditions
- (b) Funding under some types of commitments is highly correlated with the counterparty’s credit quality
- (c) Funding under some types of commitments is highly correlated with changes in the bank’s credit quality
The liquidity term structure with respect to q-confidence
