Effective Liquidity Risk
Measurement and Management
Leonard Matz
Copyright 2003 The Kamakura Corporation – Confidential Information
1
Effective Liquidity Risk Measurement
 Common liquidity metrics: strengths
and weaknesses
 Cash flow projections
 Scenarios
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2
Loan to Deposit Ratio
(South Africa)
145%
140%
135%
130%
125%
120%
115%
110%
1999
2000
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2001
2002
2003
3
The Venerable, Oft Quoted and Almost
Meaningless Loan to Deposit Ratio
• Assumes that all sources of funding other
than deposits are stable
• Assumes that all deposits are unstable
• Assumes that all assets other than loans
are completely liquid
• Assumes that all loans are completely
illiquid
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4
Lots of Ratios Measure
Relationships of Liquid,
Illiquid, Stable, and Volatile
Balance Sheet Volumes
• Large liability dependence ratios
• Various ratios of liquid assets to
purchased funds
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5
Net Liquid Assets
Balance Sheet Liquidity Model
Volatile
Liquid
Net Liquid
Assets
Illiquid
Stable
ASSETS
LIABILITIES
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6
Traditional Liquidity Measures
Leave Much to Be Desired
 Mainly retrospective – use historical data.
 Large and growing off balance sheet
commitments are too often excluded.
 Fail to capture any of the dynamics.
Liquidity needs are not all the same.
Sources available to meet those needs are
not all the same.
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7
Off Balance Sheet Items
(South Africa)
50%
Other
40%
Credit Card
30%
Irrevocable
Letters of
Credit
20%
Unutilized
facilities
10%
Indemnities
and
Guarantees
0%
ABSA
1994
SA banks
1994
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ABSA
2003
SA banks
2003
8
Off Balance Sheet Items
100
All 11,462
Commercial
Banks
90
80
All 7888
Commercial
Banks
70
60
3314 Banks
Assets
$100 Million to
$1 Billion
2,790 Banks
Assets
$100 Million to
$1 Billion
50
40
30
20
10
0
1992
1992
Loan Commitment
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2002
2002
Letters of Credit
9
FOUR IMPARATIVES FOR
MEASURING LIQUIDITY
1. The quantity of liquidity you have or can get MUST be
related to the quantity of liquidity that you think you
may need.
2. The quantity of liquidity that you need is, mainly, the
sum of current liabilities you may lose plus new assets
you may have to fund.
3. Liquidity risk, the amount of liquidity you might need, is
HIGHLY scenario specific. Liquidity cannot be
intelligently measured without using scenario analysis.
Scenarios are the language or risk measurement.
4. The quantity of liquidity available is scenario specific.
Sources available in some scenarios are less available
or unavailable in others.
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10
Liquidity Cash Flow
Projection Analysis
The essence of liquidity risk is cash
flow. Therefore, fundamentally,
liquidity gap analysis is simply an
evaluation of the two requirements:
"enough money"
and
“when we need it".
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11
Rate Risk vs. Liquidity Risk
Gap analysis is not very well
suited for capturing interest rate
risk.
Gap analysis works much better
as a tool for capturing liquidity
risk.
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12
Week
1
Week
2
Week
3
Week
4
Month
2
Month
3
Months
4-6
Months
7-12
Customer Driven Volumes
Personal loans—closed end
-49
-56
-51
-65
-211
-197
-657
-1,961
Personal loans—open end
-16
-21
-17
-15
-7
-65
-149
-1,777
-904
673
125
346
-345
-804
2,812
5,709
-87
98
81
-89
-361
-378
-1,033
-2,117
Business loans
Residential mortgage loans
Other assets
0
0
0
0
0
0
0
0
Noninterest-bearing
deposits
399
610
519
125
70
-184
-550
450
NOW accounts
529
525
472
266
50
-75
12
740
MMDAs
85
80
75
70
150
-235
600
1,200
Passbook savings
40
40
40
40
100
-50
0
200
Statement savings
50
55
60
50
150
-50
50
300
220
270
230
335
-220
-300
425
1,800
5
200
-25
-55
0
-335
685
1,260
-85
-85
-85
-85
-340
-340
-1,020
-1,940
0
0
0
0
0
0
0
0
187
2,389
1,424
923
-1,033
-3,013
1,175
3,864
CDs under $100,000
Jumbo CDs
Net noninterest income
Misc. and other liabilities
Sub-Total
Overnight
1,395
0
-1,345
-757
0
0
0
-1,100
-1,582
-1,384
-79
34
733
313
1,052
-887
Federal funds purchased
0
0
0
0
300
2,200
-1,525
-1,077
Repos and other
borrowings
0
-1,005
0
0
0
500
-502
0
Dividends
0
0
0
0
0
0
-200
-800
Sub-Total
-187
-2,389
-1,424
-923
1,033
3,013
-1,175
-3,864
Net Cash Flows
0
0
0
0
0
0
0
0
Investment securities
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13
Cash Flow Time Profile
200
150
Marginal gaps
Assets
100
50
Dollars
0
-50
1
2
3
4
5
6
-100
-150
-200
-250
Liabilities
-300
Time periods
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14
Problem: Both Cash Availability And
Needs Are Highly Correlated with
Scenarios
 Cash availability:


asset liquidity
unused funding capacity
 Needs:



deposit withdrawal
undrawn credit facility drawdown
collateral pledging
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15
BIS Recommends Scenario Analysis
“A bank should
analyze liquidity
utilizing a variety of
‘what if’ scenarios.”
BIS: “Sound Practices For Managing Liquidity in Banking
Organizations”, February 2000.
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16
KEY ISSUE
Scenarios are far more important to liquidity risk
measurement and management than for credit
risk, rate risk or operational risk !!!!
The range of potential liquidity risk scenarios is
far more varied than scenarios for other
financial risks.
Tactics that work in some scenarios are
unavailable or constrained in other scenarios.
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17
Factors Behind 29 Failures
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18
Systemic Crises – A Wide Variety
1987
1990
1991
1992
1994
1995
1997
1998
1999
2000
U.S. stock market crash
collapse of U.S. high yield (junk) bond market
oil price surge
ERM (European Exchange Rate Mechanism) crisis
U.S. bond market crash
Mexican Crisis
Asian crisis
Russian default, Ruble collapse. LTCM
gold prices
TMT (telecommunications, media & technology )
sector collapse
2001 September 11 payments system disruption
2002 Argentine crisis
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19
IMF finds numerous problems
“A review of the experiences since
1980 of the 181 current Fund
member countries reveals that 133
have experienced significant
banking-sector problems at some
stage during the past fifteen years
(1980-1995)
Source: Lingren, G.J., Garcia, and N. Saal, Banks Soundness and Macroeconomic
Policy, Washington DC, IMF, 1996
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20
Use At Least Three Scenarios
1. Normal course of business, including
any seasonal fluctuations
2. Bank specific funding crisis
3. Systemic liquidity crisis
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21
Internal
Market Risk

Emerging Markets

Systemic Shock

Global Prolonged Recession

Operational Risk

Merger & Acquisition

Downgrade to A1/P1 & A1/A+

Downgrade to A2/P2 & A3/A-
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“Stress”

Scenario analysis
External
Scenarios Monitored By
A Large International Bank
22
Define Three Characteristics For
Each Scenario
Type: systemic or bank specific;
local, national or international
Duration: short or long
Severity: mild or severe
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23
Scenario Results
• Determine total Liquidity Mismatch for
each scenario
Going
Balance sheet
Credit lines
Collateral
Gap
Squeeze
Specific
General
+54
0
+30
+30
0
+27
-22
-10
+26
-44
-10
+15


-6
-39
Additional measures
needed
Source: Bruce McLean, Forrest, UBS
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Effective Liquidity Risk Management
 Management tactics
 Limits, management and reporting
 Stress testing
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25
Adding Liquid Assets –
A Right Way and a Wrong Way
Liquid
Assets
Liquid
Assets
Volatile
Liabilities
Structural
Liquidity
Volatile
Liabilities
Structural
Liquidity
Deficit
Core
Assets
Deficit
Core
Funding
+
Equity
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Core
Assets
Core
Funding
+
Equity
26
Beyond Liquid Assets
• Loans can also provide liquidity value
– Mortgages as collateral for borrowings
– Salable and securitizable assets where bonds have not
yet been issued
• A $1 reduction in liquidity risk is just as good as a
$1 increase in liquid assets holdings.
– Do not have to hold liquid assets, therefore saves the
cost
In practice, it depends on
the scenario and stress level.
When is an asset liquid?
When is a liability volatile?
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27
Asset Management: The Three Ss
• Syndication
– Early warning system
– Pricing & participation %
– Recent credit concerns
• Securitization
– All tangible bank assets can be securitized
– What about residuals & equity pieces?
• Sales
Source: Fred Poorman, BNK Analytics
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28
Asset Securitizations
“Picking only the lowhanging fruit leaves a very
illiquid balance sheet
remaining!”
Source: Carl Tannenbaum, ABN Ambro
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29
Planned Responses to A Crisis:
Asset Management
 Rank all assets by how quickly and easily
they can be sold
 Start preparations for loan sales or
securitizations
 Maintain primary and secondary liquidity
from assets warehouses
 Manage pledging to free up excess
collateral
 Manage pledging to use the least readily
salable assets
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30
By Far The Most Common Answer:
“Our Plan is Draw Down Our Committed Lines”
OKAY, BUT
…
Every banker knows that if he has to prove that
he is worthy of credit, however good may be his
arguments, in fact his credit is gone.” Walter
Bagehot
THE WELL PREPARED NEED BETTER PLANS
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31
Balance Sheet Trends
Millions
(South Africa)
Change
in
Assets
250
Change in
Capital and
Deposits
150
50
2000
2001
2002
2003
-50
Total Equity
Growth in Loans
Growth in Other Assets
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Retail Deposits
Growth in Investments
32
Balance Sheet Trends
0.7
Change in
Assets
0.6
0.5
Change in
Capital
and
Deposits
0.4
0.3
0.2
0.1
0
1996
1997
1998
1999
2000
Total Equity Capital
Retail Deposits
Growth in Loans
Growth in Other Assets
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2001
2002
2003
Growth in Investments
33
Sometimes We Can Borrow.
Sometimes Not.
Wholesale Funds Providers Are
Brutal Arbiters of
Creditworthiness
• Quickly recognize
potential problems
• Respond rapidly
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34
Managing Funding Sources
 Rank, measure, manage for both current needs
and for contingent needs.
 Encourage funding from more sticky sources.
 Monitor borrowing spreads – not unused
borrowing commitments.
 Take advantage of market conditions to
lengthen maturities when possible.
 Maintain an appropriate amount of time
deposits and borrowing with remaining lives
greater than 90 days, 180 days and one year.
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Estimating Stickiness
Insured Depositor
Fiduciary
or
Reliance
Agent or
Secure
on
Owner
d
Information
consumers
Depositor’s
Relationshi
p
with the
Bank
Stickines
s
Estimate
owner
yes
low
high
high
small
business
owner
in part
low
high
medium
Large
Commercial
owner
no
medium
medium
low
Banks
agent
no
high
medium
medium
Municipalities
agent
in part
high
medium
medium
money market
mutual funds
quasi
fiduciary
no
high
low
low
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Sensitivity of Funds Providers By
Type
Very Sensitive to
Perceived
Deterioration in
Credit Quality or
Safety
money market mutual funds
rating sensitive providers
pension funds
insurance companies
other funds providers with fiduciary responsibility
broker/dealers
regional and money center banks in your country
foreign banks
large corporations
community banks in your market area
Only sensitive to
credit quality and
liquidity when
problems are very
bad and highly
publicized.
local, uninsured, unsecured depositors
customers who are net borrowers (their loan
balances exceed their deposit balances)
local, secured funds providers
insured depositors
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Managing Funding Sources
Key Issue:
Few, if any, liquidity risk management
tactics are more vital than managing the
time profile of maturing liabilities.
Un-matured time deposits and borrowings
are one of the most stable sources of
funding in the event of a funding problem.
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Four Essential
Liquidity Management Tools
1. Always keep some asset liquidity reserves. This
is the insurance cost of liquidity management.
But recognize that you cannot and do not want
to hold enough for a catastrophe.
2. Extend liability terms to reduce liquidity risk.
3. Be prepared to enhance liquidity quickly at the
first signs of increased potential need.
4. Manage cash flow profiles.
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39
Key Considerations for Setting
Limits
1. Not so big as to be meaningless.
2. Within the bank’s risk tolerance: the
cost of put test.
3. Adjusted for the “path to the exit”.
4. Must include a “cushion”.
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Setting Limits – What Target?
For all scenarios?
For all stress levels?
For the “worst case” of all
scenarios and stress levels you
evaluate?
For the “most likely” crisis and
stress level?
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41
Liquidity Risk Limits Should Apply
to Stress Scenarios
Banks should analyze the likely impact of
different stress scenarios on their liquidity
position and set their limits accordingly.
Limits should be appropriate to the size,
complexity and financial condition of the
bank. Management should define the specific
procedures and approvals necessary for
exceptions to policies and limits.
Source: Paragraph 19, Sound Practices for Managing Liquidity in Banking Organizations
Basel Committee on Banking Supervision, Basel February 2000
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42
Limits, Guidance and Observation Ratios
• Your bank may wish to address all three of these
problems by adopting a system that combines a few
“hard limits” with “guidance limits” and “observation
ratios”.
• The hard limits are board approved minimum liquidity
coverage ratios. Hard limits may only apply to the time
periods in a single scenario at a single level of stress.
• Guidance limits can be minimum liquidity coverage
ratios for each time period in the scenarios and stress
levels not covered by hard limits. The guidance limits
may be established by ALCO rather than by the board.
Violations of guidance limits may merely require closer
monitoring, more frequent reporting and/or additional
analysis.
• Observation ratios may be for ancillary measures of
liquidity risk such as maturity distributions.
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43
Regulatory Approaches
Quantitative
Germany
Mix
Qualitative
Austria
Belgium
Spain
Iceland
Denmark
Sweden
Finland
France
Greece
Ireland
Italy
Liechtenstein
Luxembourg
Netherlands
Norway
Portugal
UK
Source: Dr. Paul Baneke, De Nederlandsche Bank
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44
Management Report Requirements
• Manage the quantity of information. Always
use three levels of detail.
• Focus on key metrics:

cash flow coverage by time bucket and scenario
– compared to limits.

other variables, such as marketable securities,
that highlight important needs and sources for
your bank.

Periodically supplement with reports for special
situations or topics
• Always monitor potential key triggers.
LIQIDITY IS A CONSUQUENCIAL RISK
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45
A Reporting Dashboard
(ratio of projected in-flows to out-flows)
Projected Net Cash Flows
Liquidity Scenario
Ordinary course of business
minimum
Bank specific crisis – level 1
minimum
Bank specific crisis – level 2
minimum
0 - 30
days
31 - 60
days
61 - 90
days
91 - 180
days
1.37
1.25
1.21
1.20
0.85
1.10
Systemic crisis – level 1
minimum
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46
Why Stress Test?
BIS Guidelines Require Stress Testing
“The liquidity strategy should set out the
general approach the bank will have to
liquidity, including various quantitative and
qualitative targets. This strategy should
address the bank's goal of protecting
financial strength and the ability to withstand
stressful events in the marketplace.”
Source: paragraph 7, Sound Practices for Managing Liquidity in Banking Organizations
Basel Committee on Banking Supervision, Basel February 2000
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48
Why Stress Test?
Holding Liquidity is Not Free
– No bank can hold enough liquidity to
survive anything close to a “worst case”
liquidity crisis.
– The penalty for too little liquidity may be
the failure of the bank but too much
liquidity carries a penalty as well.
Optimal management of liquidity
requires a delicate balance between
liquidity risk and income.
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50
Volatility of Savings Deposits
The good news: The bank has not experienced a severe loss of
deposits.
The bad news: The historical observations tell us NOTHING about
a future stress environment.
10,000
8,000
6,000
4,000
2,000
0
-2,000
-4,000
-6,000
-8,000
Red lines indicate 2 SD
-10,000
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51
Measurement and Quantification
Conclusions
• Historical observation does not necessarily reflect
what might happen (future events)
• Modelling a (fat tail) distribution does not solve the
problem either:
–Outlying point or fat tail?
–Risk is not linear in extreme events
• The Question is not: ‘What Risk will we get if we
push out the quantiles?’ – The answer to that
question is only a matter of scaling and is
therefore meaningless!
• Instead, the question is: ‘Is there a structural
change that the bank should model?’
Adapted from material developed by Dr. Robert E Fiedler
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52
Measurement and Quantification Processes
Probability
Stress testing typically applies
statistical tools to provide more
information about the tail.
VaR
Extreme Value Theory
Other tools
Severity of loss
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14
Liquidity risk
is highly
idiosyncratic,
arbitrary and
inconsistent.
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54
For More Information
LIQUIDITY RISK MANAGEMENT
and
SELF PACED A/L MANAGEMENT
published by: Sheshunoff Information Services,
Inc.
1-800-456-2340
www.sheshunoff.com
written by: Leonard Matz,
lmatz@kamakuraco.com
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55