MAFINRISK 2010
Market Risk
Liquidity Risk
Session 4
Andrea Sironi
Agenda
• Liquidity risk: what it is and where it comes from
• Funding liquidity risk
•
•
•
•
Stock-based approach
Cash flow based approach
Hybrid approach
Stress tests and contingency funding plans
• The Basel Committee framework
• Principles for liquidity risk management and supervision
• Liquidity coverage ratio
• Net stable funding ratio
• Market liquidity risk
2
Introduction
 The role of liquidity risk in the financial crisis  “Throughout the
global financial crisis which began in mid-2007, many banks
struggled to maintain adequate liquidity. Unprecedented levels of
liquidity support were required from central banks in order to
sustain the financial system and even with such extensive support a
number of banks failed, were forced into mergers or required
resolution. These circumstances and events were preceded by
several years of ample liquidity in the financial system, during
which liquidity risk and its management did not receive the same
level of scrutiny and priority as other risk areas. The crisis
illustrated how quickly and severely liquidity risks can crystallise
and certain sources of funding can evaporate, compounding
concerns related to the valuation of assets and capital adequacy”
 Basel Committee on Banking Supervision (2009)
3
Liquidity
 Asset and liability mismatch generates not only interest rate
risk  liquidity risk
 Different meaning of “liquidity”:
 Security  ease with which it can be cashed back or traded, even
in large amounts, on a secondary market
 Market  liquidity of the securities traded in the market 
different proxies of liquidity (e.g. bid-ask spread, volume)
 Affected by many factors: n. mkt participants, size & frequency of trades,
degree of informational asymmetry, time needed to carry out a trade
 Function of tightness (market’s ability to match supply and demand at low
cost) and depth (ability to absorb large trades without significant price impact)
 Financial institution  ability to fund increases in assets and meet
obligations as they come due, without incurring high losses
 Generally proxied by the difference between the average liquidity of assets
and that of liabilities
4
Liquidity risk
 Liquidity risk
 risk that a financial institution may not be able to pay back its
liabilities in a timely manner because of an unexpectedly large
amount of claims
 more realistically, it may be able to meet those requests only by
quickly selling (fire sale) large amounts of assets, at a price that is
below their current market value, thereby suffering a loss
 The role of banks in the maturity transformation of shortterm deposits into long-term loans makes banks
inherently vulnerable to liquidity risk
 Liquidity risk depends not only on the final maturity of
assets and liabilities, but also on the maturity of each
intermediate cash flow, including the early pre-payment
of loans or the unforeseen usage of credit lines
5
Liquidity risk
2 types of liquidity risk
 Funding risk  risk that a F.I. may not be able to face
efficiently (i.e. without jeopardising its orderly operations
and its financial balance) any expected or unexpected
cash outflows
 Market liquidity risk  risk that a F.I., to liquidate a sizable
amount of assets, will affect the price in a considerable
(and unfavourable) manner, because of the limited depth
of the market where the assets are traded
The two risk types are connected  a F.I. wishing to face
unexpected cash outflows may need to sell a large
amount of securities  potential sharp fall in price
6
Funding liquidity risk
Relevant factors
 Contractual maturity of assets and liabilities
 Optionality in bank products  e.g. demand deposits,
guarantees issued, irrevocable loan commitments (e.g.
SPVs related to securitization or CP programs), derivatives
involving margin requirements
Two main type of events
 Bank specific events  events that distress the
confidence of third parties  rating downgrades
(especially relevant when covenants or triggers 
minimum rating required)
 Systemic events  e.g. market disruption, liquidity dry up
(e.g. recent financial crisis)
7
Funding liquidity risk
Three main measurement approaches
 Stock based approach
 Measures the stock of financial assets that can promptly be
liquidated to face a possible liquidity shock
 Cash flow based approach
 Compares expected cash inflows and outflows, grouping them in
homogeneous maturity buckets and checking that cash inflows
are large enough to cover cash outflows
 Hybrid approach
 Potential cash flows coming from the sale (or use as collateral) of
financial assets are added to actual expected cash flows
 Actual cash flows - adjusted to take into account expected
counterparties’ behaviour – are used in all approaches
(not contractual ones)
8
Stock based approach
 Measures the stock of financial assets that can promptly
be liquidated to face a liquidity shock
 Requires the bank’s BS be re-stated  contribution each
item gives to creating/hedging funding risks
 Cashable assets (CA) all assets that can quickly be
converted into cash
 Volatile liabilities (VL)  short term funds for which there is
a risk that they may not be rolled over (wholesale funding
and volatile portion of customer deposits)
 Commitments to lend (CL)  OBS items representing
irrevocable commitment to issue funds upon request
 Steadily available credit lines (AL)  irrevocable
commitments to lend issued to the bank by third parties
(usually, other F.I.s)
9
Stock based approach
Cashable assets (CA)
 Short-term deposits
 Loans  short-term credit lines (e.g., o/n and other interbank
facilities) than can be easily and effectively claimed back
without endangering the customer relationships
 Securities  only unencumbered positions (not used as
collateral against loans or derivative contracts)  may also
include long term bonds or shares. Does not include securities
not traded on a liquid market and not “eligible”  not accepted
as collateral (e.g., shares in private companies held for
merchant banking purposes, unrated bonds, etc.)
 Need of a haircut for:
 possible loss relative to the market price
 difference between current value and value of the short-term loans that
could be obtained by pledging them as collateral
10
Stock based approach
Example of a reclassified B/S
Assets
Cash & equivalent
Loans (cashable)
- O/n and similar int/bank fac.s, easily cashable
Securities (unencumbered)
- Not used as collateral
- Less haircut
Total cashable assets (CA)
Loans (others)
- Credit lines not easily cashable
- Maturity loans
Securities (others)
- used as collateral
- Not cashable nor accepted as collateral
- haircut
Fixed fin. assets (minorities, participations, etc.)
Fixed real assets
Goodwill
Total per cassa
Commitments to lend (CL)
10
200
1.000
-120
1,090
580
1,500
400
20
120
150
100
40
4,000
300
Liabilities
Sort term deposits
Customer deposits
- volatile portion
100
600
Total volatile liabilities (VL)
Customer deposits
- Stable portion
Medium to long term funding
Other long term funds
Capital
1,600
1,000
300
400
Total
4,000
Steadily available credit lines (AL)
700
80
11
Stock based approach
Cash Capital Position (CCP)
CCP CA  VL  CL
• Share of cashable assets not absorbed by volatile liabilities
• Signals bank’s ability to withstand liquidity shortages due to:
• greater-than-expected volatility in funding sources
• unexpected difficulties in the mgmt of cashable assets
(e.g. increase haircuts due to unfavourable fin. markets)
• To control for bank’s size, CCP sometimes scaled by total
assets
Example previous slide
• CCP = CA – VL = 390 = 9.75% TA
• CCP = CA – VL – CL = 90 = 2.25% TA
12
Stock based approach
 Long term funding ratios (LTFR)  alternative measure of
liquidity based on stocks
  % of assets with a maturity > 5 years funded with
liabilities with maturity > 5 years or with capital
 Portion of assets with a maturity greater than n years
which is being funded with liabilities having an equally
great maturity
 Banks transform ST liabilities into MTL term loans  LTFR
usually below 100%
 Low values (or a deterioration over time) may indicate
unbalances/weaknesses in the maturity structure of
assets & liabilities
13
Cash flow based approach
 CCP based on simplified approach  assets and liabilities
are either stable or unstable (binary approach)
 In reality many different degrees of stability/liquidity exist
 Underlying logic of CF based approaches:
 restate BS items going beyond a binary logic  maturity ladder
 also called “mismatch based approach”
 Cash flows are sorted across the different maturities
based on:
 contractual maturities (including intermediate cash flows)
 bank’s expectations
 past experience
 Mismatch or liquidity gap (Gt)  net unbalance inflows
and outflows
14
Cash flow based approach
Example of expected cash flows
Maturity
bucket
(upper limit)
Expected cash inflows
Cash &
Loans
Securities equivalent
Overnight
40
1 week
10
Customer
deposits
Expected cash outflows
Other
funding
Bonds
Comm.ts
to lend
Net
flows
Net
cum.tive
flows
-20
-20
-10
0
0
30
-50
-20
-15
-55
-55
2 weeks
80
-70
-15
-20
-25
-80
1 month
70
100
-200
-15
-50
-10
-105
-185
2 months
100
90
-330
-10
-50
-10
-210
-395
3 months
200
110
-300
-10
-100
-10
-110
-505
1 year
400
100
-400
-110
-100
-110
-615
3 years
400
200
-300
-200
-300
-200
-815
5 years
300
700
-650
-450
-100
-915
10 years
650
100
750
-165
Beyond
200
50
250
85
Total
2470
1450
10
-2320
-400
-1050
-75
85
As in the stock-based approaches, demand deposits and loans are dealt with based on
15
their expected actual maturity
Cash flow based approach
Two type of indicators
• Cumulative liquidity gap  unbalance between flows
associated with a given band and all shorter maturities
CGt   Gt
i t
• Marginal liquidity gaps  Gts related to one time band
• Note that, when sorting assets and liabilities across time
bands, we are considering:
• cash flows – not stocks
• their expected maturity, not their repricing period
16
Cash flow based approach
 Negative cumulative liquidity gap  bank cannot cover
foreseeable cash payments with expected inflows 
severe warning of potential liquidity shortage
 However, one weakness  cash flows associated with
securities (including unencumbered assets) are based
on contractual maturities and coupons  assets can be
used as collateral to get new loans, also at a very short
notice
  re-write the maturity ladder taking into account role
of unencumbered assets in facing liquidity risks
Hybrid approach
17
Hybrid approach
 CF based approach  CFs from securities are sorted
into maturity buckets based on contractual maturity  a
10-year ZC bond face value €10 mln entirely associated
with “10 year” band
 Bank’s treasurer can manage liquidity shortages by
selling the bond or using it to get funded through a
collateralised loan or repo
 Haircut  funds raised would only be a share (e.g.,
90%) of the bond’s mkt value (which would be less than
face value)  e.g. €7 million  70% can be cashed
quickly, rest (interest and haircut) available in 10 years
 This only applies to unencumbered eligible assets 
assets the bank can freely sell or pledge as collateral 18
Hybrid approach
Modified expected CFs taking into account unencumbered assets
Maturity
bucket
(upper limit)
Expected cash inflows
Cash &
Loans
Securities equivalent
Overnight
40
600
1 week
30
2 weeks
Comm.ts
to lend
Net
flows
Net
cum.tive
flows
-20
-20
-10
0
600
100
-50
-20
-15
-55
645
80
100
-70
-15
-20
-25
720
1 month
70
80
-200
-15
-50
-10
-105
595
2 months
100
-330
-10
-50
-10
-210
295
3 months
200
-300
-10
-100
-10
-110
75
1 year
400
-400
-110
-100
-110
-135
3 years
400
150
-300
-200
-300
-200
-385
5 years
300
300
-650
-450
-100
-885
10 years
650
120
750
-115
Beyond
200
250
85
Total
2470
1450
10
Customer
deposits
Expected cash outflows
Other
funding
Bonds
10
-2320
-400
-1050
-75
85
Net cash flows look much better using this approach
19
Hybrid approach
• Liquidity gaps
1000
500
Loans
0
Securities
(marginal and
cumulative) for
shorter
maturities are
now positive
Cash and short-term
-500
Customer deposits
Other deposits
Bonds
-1000
Commitments lo lend
Cumulative net flows
-1500
• The bank looks
immune to
liquidity
shortages for
the shorter
maturities
20
Hybrid approach
• Results achieved so far are affected by
assumptions on timing and amounts  uncertainty
concerning:
• Amount  e.g. floating rate securities, IRS, European options
• Timing  e.g. long-term mortgages being pre-paid, demand
deposits left with the bank for years
• Both amount and timing  cash flows associated to open
credit lines or commitments to lend
It is important to consider not only an “expected” scenario,
but also check how the liquidity gaps would deteriorate in
worst case scenarios  stress test
21
Stress test
• Stress test  simulation exercise aimed at quantifying the
effects of an especially adverse scenario
• Three main approaches
• Historical approach  historical scenarios (e.g., % of demand deposits
unexpectedly withdrawn within 2 or 4 weeks)
• Statistical approach  historical data to infer probability distribution of risk
factors  reasonable estimate of potential shocks (e.g., on deposits,
haircuts, interbank loans, etc.)
• Judgement-based approach  subjective appraisals by the bank’s
management (support of risk management, supervisors or consultants)
• These approaches can be used to simulate individual risk factors
separately or jointly (worst case scanarios)
A. “bank run” on demand deposits
B. increase in market volatility  increase haircuts on unencumbered assets
C. A+B jointly
22
Stress test
• Stressed scenarios are rather intuitive in principle, but their
practical implementation can prove difficult:
1. A stress exercise is usually limited to a number of selected B/S
items (e.g. effect of an extreme scenario on the time profile of
cash flows associated only with securities, ignoring other assets
and liabilities)  a market turmoil may be accompanied by an
increase in customer deposits as investors would postpone their
asset allocation choices  indirect effects should also be included
2. When more risk factors are considered jointly (e.g., a bank run and
an increase in market volatility) a simple “algebraic” summation of
their effects may not be correct
• pessimistic if risk factors are not strongly correlated (probability)
• optimistic., if the two shocks are mutually reinforcing (impact)  e.g.
confidence crisis hitting a bank in the midst of a market-wide currency
crisis  the pressure on deposits might be stronger than it would be
in a “quiet” macroeconomic environment
23
Contingency funding plans (CFP)
• Stressed scenarios can prove useful in building “contingency
funding plans” (CFP) to be triggered in case of extreme scenario
• CFP surveys all possible sources of extra funds in the event of a
liquidity shock (e.g. temporary withdrawals of compulsory
reserves, repos with CB, secured or unsecured interbank loans)
• CFP sets priority order (ranking) in which they should be tapped
 cost and flexibility of the sources and type of liquidity shock
(e.g. interbank loans in case of an institution-specific shock vs.
intervention of Central Bank in case of a market-wide crisis
• CFP describes people and structures responsible for
implementing emergency policies and actions to be taken
• A credible CFP can quickly bring panic under control, limiting the
duration and breadth of the liquidity shortage
24
Non-maturing assets & liabilities
(NOMAL)
• Demand deposit  cash flow uncertainty due to:
•
•
•
market interest rates (attractiveness of substitute products)
interest rate applied by the bank (clients’ demand for deposits)
exogenous factors (e.g., the customer’s cash needs)
• Possibility to withdraw funds from a bank account or to pay
back an overdraft  option held by the customer
• Evaluation of these options is complex
•
•
•
•
Value depends on the entire term structure of interest rates
American option but the client does not exercise it as soon as it is ITM 
stickiness of bank interest rates when changes in market rates
Bank can influence probability of exercise by adapting customers’ interest
rates to the new market conditions
Options on both sides of B/S are affected by same underlying factors (market rates)
but do not hedge each other  tend to be exercised at different times (e.g.,
liquidity crisis could trigger a reduction in deposits but no early repayment of loans)
25
Non-maturing assets & liabilities
(NOMAL)
Two approaches
• Replicating portfolio
• An indefinite-maturity liability (asset) is invested in (funded by) a
replicating portfolio consisting of instruments with explicit and
predetermined maturities  generates cash flows matching the net
outflows arising from the options embedded in the indefinitematurity liability (asset)
• Option based approach
• Option value  difference between value of a straight bond and
value of an identical bond with an early repayment option
• Imperfect analogy  bond option may be exercised only at definite
maturities and expires with the final maturity of the bond while
products with indefinite maturity never expire and the prepayment
option may be exercised at any time
26
Non-maturing assets & liabilities
(NOMAL)
Replicating portfolio
• Static replication
•
•
•
Identifies replicating portfolio based on historical data and keeps constant
the weights of the assets in the portfolio
Criterium  minimising tracking error between replicating portfolio and
Nomal portfolio
Weights derived from the optimization process are then left constant over
time (or rather, are reviewed at discrete, wide time intervals)
• Dynamic replication
•
•
•
Weights of securities in replicating portfolio based on simulation models +
continuous adjustments (very high-frequency)
Rather than historical data, future probability distribution of risk factors
(scenarios)  portfolio weights chosen through some optimization criteria
Does not calibrate model on one set of historical factors (single scenario),
but takes into account entire tree of mkt & customer rates and volumes
27
Funding liquidity risk
Some peculiarities of funding liquidity risk vs other risks
• Liquidity risk  not necessarily risk of losses
• Assets & Liabilities mismatch does not need to be faced
by capital  by high quality liquid (unencumbered)
assets  more capital simply makes a liquidity crisis
less likely
• If the bank is made up of different legal entities, in the
event of a liquidity crisis liquid funds cannot freely be
moved from one entity to the other due to the
opposition of some supervisory authorities
28
Organizational issues
•
Liquidity risk management requires systematic approach with clear
organizational rules  systematic approach also required by Basel
•
•
LRM policy  key role of board of directors
•
•
•
•
•
E.g. Liquidity risk management (LRM)
ensures liquidity risk is correctly identified, measured, monitored and
controlled
defines risk tolerance and strategy for liquidity risk management
identifies roles and responsibilities of the LRM Unit
receives periodic reports on the liquidity situation
Examples of periodic reports
•
•
•
•
•
•
analysis of the flow of funds
contingency funding plan
list of largest providers of funds
funding gap and maturity structure
structure and composition of the bank's balance sheet
size and cost of more recent very short term funding
29
Organizational issues
• Limits are generally imposed to risk-taking units  they may
refer to different measures  examples:
•
•
•
•
•
Max absolute maturity gap
Max volume of overnight funding in relation to total assets
Max gap between liquid assets and ST liabilities
Min liquid assets net of expected erosion in case of stress
Max concentration of liabilities across counterparties
• Key role internal audit in LRM process  e.g. consistency
between policies set by senior mgmt and day-by-day risk mgmt,
adequacy of processes and soundness of measures
• Often an ALM Committee (ALCO)  representatives of all
business areas that affect liquidity risk
•
•
responsible for development of specific policies for LRM
ensuring adequacy of measurement system
30
Organizational issues
• Liquidity Risk Management unit responsible for:
•
•
•
•
•
identifying liquidity risks incurred by the bank
monitoring evolution of liquidity profile
developing policies for controlling and mitigating liquidity risk
developing appropriate rules for liquidity risk management  roles,
responsibilities and organizational structure; limits; policies and formats
for reporting to senior management
Developing liquidity contingency plan
• Early warnings events signalling liquidity shortages in advance
•
•
Internal early warnings  e.g. increased concentration of assets or
liabilities, increase of assets funded by volatile funding
External indicators  e.g. rating downgrades, decline in the bank’s stock
price; increase in the bank’s CDS spread; increase in the trading volume of
securities issued by the bank, increase in requests for guarantees,
increase in the cost of funding, request for (additional) collateral by
counterparties, reduction in the lines of credit by corresponding banks 31
Basel Committee: Principles for the
management and supervision of liquidity risk
Key elements of a robust framework for liquidity risk mgmt:
• board and senior management oversight
• establishment of policies and risk tolerance
• use of liquidity risk management tools such as
comprehensive cash flow forecasting, limits and liquidity
scenario stress testing
• development of robust and multifaceted contingency
funding plans
• maintenance of a sufficient cushion of high quality liquid
assets to meet contingent liquidity needs
32
Basel Committee: Principles for the
management and supervision of liquidity risk
Fundamental principle for the mgmt and supervision of liquidity risk
 1. A bank is responsible for the sound management of liquidity risk. A
bank should establish a robust liquidity risk management framework
that ensures it maintains sufficient liquidity, including a cushion of
unencumbered, high quality liquid assets, to withstand a range of
stress events, including those involving the loss or impairment of both
unsecured and secured funding sources.
Governance of liquidity risk management
 2: A bank should clearly articulate a liquidity risk tolerance that is
appropriate for its business strategy and its role in the financial
system.
 3: Senior management should develop a strategy, policies and
practices to manage liquidity risk in accordance with the risk
tolerance and to ensure that the bank maintains sufficient liquidity.
 4: A bank should incorporate liquidity costs, benefits and risks in the
internal pricing, performance measurement and new product approval
process for all significant business activities (both on- and off-balance
sheet)
33
Basel Committee: Principles for the
management and supervision of liquidity risk
Measurement and management of liquidity risk








5: A bank should have a sound process for identifying, measuring, monitoring
and controlling liquidity risk  projecting cash flows arising from assets,
liabilities and off-balance sheet items
6: A bank should actively monitor and control liquidity risk and funding needs
within and across legal entities, business lines and currencies
7: A bank should establish a funding strategy that provides effective
diversification in the sources and tenor of funding.
8: A bank should actively manage its intraday liquidity positions and risks to
meet payment and settlement obligations on a timely basis under both
normal and stressed conditions
9: A bank should actively manage its collateral positions, differentiating
between encumbered and unencumbered assets
10: A bank should conduct stress tests on a regular basis and use stress test
outcomes to adjust its liquidity risk management strategies, policies, and
positions
11: A bank should have a formal contingency funding plan (CFP) that clearly
sets out the strategies for addressing liquidity shortfalls in emergency
situations
12: A bank should maintain a cushion of unencumbered, high quality liquid
34
assets to be held as insurance against liquidity stress scenarios
Basel Committee: Principles for the
management and supervision of liquidity risk
Public disclosure
 13: A bank should publicly disclose information on a regular basis
that enables market participants to make an informed judgement
about the soundness of its liquidity risk management framework and
liquidity position
The role of supervisors
 14: Supervisors should regularly perform a comprehensive
assessment of a bank’s overall liquidity risk management framework
and liquidity position
 15: Supervisors should supplement their regular assessments of a
bank’s liquidity risk management framework and liquidity position by
monitoring a combination of internal reports, prudential reports and
market information
 16: Supervisors should intervene to require effective and timely
remedial action by a bank to address deficiencies in its liquidity risk
management processes or liquidity position.
 17: Supervisors should communicate with other supervisors and
public authorities, to facilitate effective cooperation regarding the
supervision and oversight of liquidity risk management
35
Basel Committee recent
proposals (Dec. 2009)
Two internationally consistent regulatory standards
• Liquidity coverage ratio
• Aimed at ensuring that a bank maintains an adequate level of high
quality assets that can be converted into cash to meet its liquidity
needs for a 30-day horizon under a liquidity stress scenario
• Stock of high quality liquid assets/Net cash outflows over a 30-day
time period ≥ 100%
• Net stable funding ratio
• Aimed at promoting more medium and long-term funding of the
assets and activities of banking organisations
• Minimum acceptable amount of stable funding based on the
liquidity of a bank’s assets and activities over a 1 year horizon
• Available amount of stable funding/Required amount of stable
funding > 100%
36
Liquidity coverage ratio
High quality assets
•
•
•
Unencumbered  not pledged either explicitly or implicitly in any way to
secure, collateralise or credit enhance any transaction (e.g. covered bonds)
and not held as a hedge for any other exposure
Liquid during a time of stress and, ideally, central bank eligible
Fundamental characteristics
•
•
•
•
•
Low credit and market risk
Ease and certainty of valuation
Low correlation with risky assets
Listed on a developed and recognised exchange market
Market-related characteristics
•
•
•
•
Active and sizable market
Presence of committed market makers
Low market concentration
Flight to quality
37
Liquidity coverage ratio
•
High quality assets  “unencumbered, high quality liquid assets”
(ununcumbered: not pledged either explicitly or implicitly in any way
to secure, collateralise or credit enhance any transaction and not held
as a hedge for any other exposure)  examples:
a) Cash
b) CB reserves
c) Marketable securities representing claims guaranteed by sovereigns,
CBs, non-central gov.t public sector entities (PSEs), BIS, IMF, or
multilateral dev.t banks as long as all the following criteria are met:
i. 0% risk-weight under the Basel II standardised approach
ii. deep repo-markets exist for these securities
iii. the securities are not issued by banks or other financial services entities
d) Gov.t or CB debt issued in domestic currencies by the country in which
the liquidity risk is being taken or the bank’s home country
38
Liquidity coverage ratio
High quality assets  some general characteristics
Fundamental characteristics
•
•
•
•
Low credit and market risk
Ease and certainty of valuation
Low correlation with risky assets
Listed on a developed and recognised exchange market
Market-related characteristics
•
•
•
•
Active and sizable market
Presence of committed market makers
Low market concentration
Flight to quality
39
Liquidity coverage ratio
Net cash outflows
• Cumulative expected cash outflows minus cumulative
expected cash inflows arising in the specified stress
scenario in the time period under consideration
• Net cumulative liquidity mismatch position under the
stress scenario measured at the test horizon
• Cumulative expected cash outflows are calculated by multiplying
outstanding balances of various categories of liabilities by
assumed % that are expected to roll-off, and by multiplying
specified draw-down amounts to various OBS commitments
• Cumulative expected cash inflows are calculated by multiplying
amounts receivable by a percentage that reflects expected inflow
under the stress scenario
40
Liquidity coverage ratio
Scenario  combined idiosyncratic & market-wide shock:
a) a three-notch downgrade in the institution’s public credit rating;
b) run-off of a proportion of retail deposits;
c) a loss of unsecured wholesale funding capacity and reductions of
potential sources of secured funding on a term basis;
d) loss of secured, short-term financing transactions for all but high
quality liquid assets;
e) increases in market volatilities that impact the quality of collateral
or potential future exposure of derivatives positions and thus
requiring larger collateral haircuts or additional collateral;
f) unscheduled draws on all of the institution’s committed but unused
credit and liquidity facilities
g) need for the institution to fund balance sheet growth arising from
non-contractual obligations honoured in the interest of mitigating
reputational risk
 many of the shocks actually experienced during the financial
crisis
41
Net stable funding ratio
• Available amount of stable funding/Required amount of
stable funding > 100%
• NSFR standard is structured to ensure that investment
banking inventories, off-balance sheet exposures,
securitisation pipelines and other assets and activities are
funded with at least a minimum amount of stable liabilities
in relation to their requirement as these inflows and
outflows are assumed to off-set each other
• The NSFR aims to limit over-reliance on wholesale funding
during times of buoyant market liquidity and encourage
better assessment of liquidity risk across all on and offbalance sheet items
42
The Basel requirements
LCR
• Similar to a CCP minimum requirement where the
denominator is substituted by a net cash outflow
estimate
• Combination of a stock based and a cash flow based
measure
NSFR
• Similar to a long term funding ratio (LTFR)
• More sophisticated as different items are assigned
different weights
43
Net stable funding ratio
Available amount of stable funding (ASF)
ASF Factor
100%
85%
70%
50%
0%
Component of AFS Category
 Capital (both Tier 1 and Tier 2)
 Preferred stock not included in Tier 2 (maturity > 1 year)
 Secured and unsecured borrowings and liabilities (including term deposits) with
maturities > 1year
 “Stable" non-maturity retail deposits and/or term retail deposits with residual
maturities < 1 year
 "Stable" unsecured wholesale funding, non-maturity deposits and/or term deposits
with a residual maturity < 1 year, provided by small business customers
 "Less stable" non-maturity retail deposits and/or term retail deposits with residual
maturities of less than one year.
 "Less stable" unsecured wholesale funding, nonmaturity deposits and/or term
deposits with a residual maturity of less than one year, provided by small business
customers
Less stable  deposits not covered by deposit insurance, high value-deposits,
deposits of high net worth individuals, deposits which can be withdrawn quickly (eg
internet deposits) and foreign currency ones
 Unsecured wholesale funding, non-maturity deposits and/or term deposits with a
residual maturity < 1 year, provided by non-financial corporate customers
 All other liabilities
44
Net stable funding ratio
Required Stable Funding (RSF): Asset Categories and Associated Factors
RSF Factor
0%



5%

20%

50%



85%
100%


Summary Composition of Asset Categories RSF Factor
Cash, money market instruments
Securities with effective remaining maturities of less than one year
Outstanding loans to financial entities having effective maturities of less than one
year.
Unencumbered marketable securities with residual maturities ≥ one year representing
claims on sovereigns, central banks, BIS, IMF, EC, noncentral government PSEs or
multilateral development banks which are rated AA or higher and are assigned a 0%
risk weight under the Basel II standardised approach, provided that active repomarkets exist for these securities.
Unencumbered corporate bonds (or covered bonds) rated at least AA with an
effective maturity of ≥ one year which are traded in deep, active and liquid markets
and which also have a demonstrated history of being a reliable liquidity source in a
stressed market environment.
Gold
Unencumbered equity securities listed on a major exchange and included in a large
capital market index and unencumbered corporate bonds (or covered bonds) rated
AA- to A- with an effective maturity of ≥ one year which are traded in deep, active and
liquid markets and which also have a demonstrated history of being a reliable liquidity
source in a stressed market environment.
Loans to non-financial corporate clients having a residual maturity of less than one
year.
Loans to retail clients with a residual maturity < 1 year
45
All other assets
Market liquidity risk
• Market liquidity risk  risk that a F.I., to liquidate a sizable
amount of assets, will end up affecting the price in a
considerable (and unfavourable) manner, because of the limited
depth of the market where the assets are traded
• Market liquidity risk can be twofold
• Exogenous  general market characteristics  outside control of bank
• Endogenous  bank’s characteristics (e.g. composition and size of its
portfolio)
• Market liquidity is measured through the lack of it  transaction
costs explicit and implicit incurred by investors to trade:
• Bid-ask spread
• Market impact  difference between actual transaction price and price
that would have prevailed if the transaction had not taken place  the
higher the lower is market liquidity
46
Market liquidity risk
• If no uncertainty on market impact  liquidation value is
equal to bid price  transaction cost
mid-quote at time t
S
C  Pt 
2
bid/ask spread
• If large sale  impact on spread  deviation from its
mean value  s + k (increasing function of position size
P and decreasing function of market size M)
 s  k  P , M   

C  P
2


47
Market liquidity risk
price
Traded volume and bid-ask spread – (Bangia, et al. 1999)
ask price
s
mid price
bid price
Quote depth
Transaction costs
can be expected to
increase with the
transaction size, or,
namely, with its
impact in relation to
market depth
Size of the Position (P)
48
Market liquidity risk
• The function linking k to P and M is not easy and tends to
change over time
• Transaction costs also depend on the time period (e.g.
gradual liquidation vs. sudden fire sale)
• Dowd (2002)  more sophisticated version of the function
1
S  2 hp
 PS 
TC  1 
( AL  )e

2
 MS 
Relative size of
the position to
liquidate
Elasticity of
transaction costs
to the relative
position size
Hp is the time period the
bank wants to liquidate
its position (holding
period)
λ2 is the elasticity of TC
to hp
Both λ need to be
estimated empirically
49
Conclusions
• Liquidity risk has been overlooked in the recent past
• As clearly shown by the financial crisis, liquidity risk is
crucial for individual financial institutions and for the
stability of the financial system as a whole
• Liquidity risk measurement methodologies are still at an
initial stage in the financial services industry
• Some indicators are already used by most banks  cash
capital position, liquidity gaps, long term funding ratios
• It is more complex to deviate from expected future cash
flows and take into account stress scenarios
• The regulators are stepping in with some new
requirements and general principles
50