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Copyright 2003 The Kamakura Corporation – Confidential Information
Managing Liquidity Risk: Preparing for
Extreme Events
Leonard Matz
2Copyright 2003 The Kamakura Corporation – Confidential Information
Why Stress Test?
“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 OrganizationsBasel Committee on Banking Supervision, Basel February 2000
BIS Guidelines Require Stress Testing
4Copyright 2003 The Kamakura Corporation – Confidential Information
What’s Normal / Extreme ?
Market Risk ‘normally’ is about ‘Normal Scenarios’
What is normal?–Quantitative tools are applicable.
Liquidity Risk is concentrated in “Extreme Scenarios’
What is extreme? …–There is no Canonical Answer
–Distinctions are derived from everyday life; however as no consensus can be reached:
–They are meaningless in a quantitative context
Adapted from material developed by Dr. Robert E Fiedler.
5Copyright 2003 The Kamakura Corporation – Confidential Information
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
10,000
Red lines indicate 2 SD
Copyright 2003 The Kamakura Corporation – Confidential Information
Measurement and Quantification ProcessesPr
obab
ility
Severity of loss
Stress testing typically appliesstatistical tools to provide moreinformation about the tail.
VaRExtreme Value TheoryOther tools
14
Copyright 2003 The Kamakura Corporation – Confidential Information
Measurement and Quantification Processes
Prob
abilit
y
Severity of loss
We can’t apply the usual statistical tools to liquidity risk stress testing!
Very few banks have had the unfortunate experience of a “near death” experience. Those that have don’t have any recent experience. The tail in any one bank’s data simply doesn’t include the sorts of stress experiences that keep liquidity risk managers awake.
KEY ISSUE
15
8Copyright 2003 The Kamakura Corporation – Confidential Information
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
9Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Testing Should Reflect Both Internal and External Scenarios
• Capital markets disruptions• Systemic shocks• Payment system disruptions• Prolonged global recession
External
•Credit losses•Operational losses•Problem merger or acquisition
Internal
10Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Environments Affect Both Cash Availability And Needs
Cash availability: asset liquidity unused funding capacity cost of borrowing
Needs: deposit withdrawal undrawn credit facility drawdown collateral pledging
11Copyright 2003 The Kamakura Corporation – Confidential Information
Systemic Crises – A Wide Variety
1987199019911992199419951997199819992000
20012002
U.S. stock market crashcollapse of U.S. high yield (junk) bond marketoil price surgeERM (European Exchange Rate Mechanism) crisisU.S. bond market crashMexican CrisisAsian crisisRussian default, Ruble collapse. LTCMgold pricesTMT (telecommunications, media & technology ) sector collapseSeptember 11 payments system disruptionArgentine crisis
12Copyright 2003 The Kamakura Corporation – Confidential Information
1. Normal course of business, including any seasonal fluctuations: VaR Works here, but who cares?
This is not a stress scenario.
2. Bank specific funding crisis
3. Systemic liquidity crisis
Use At Least Three Scenarios
13Copyright 2003 The Kamakura Corporation – Confidential Information
It is imperative to use multiple degrees of severity (stress levels) for each need scenario!
14Copyright 2003 The Kamakura Corporation – Confidential Information
Key Facts:
The amount of contingent liquidity risk varies depending on the severity of crisis.
Crises rarely occur instantaneously. They usually develop in stages.
The duration of liquidity crises has ranged from days to over a year.
15Copyright 2003 The Kamakura Corporation – Confidential Information
Stages of a Funding Crisis
16Copyright 2003 The Kamakura Corporation – Confidential Information
From Funding Liquidity Cash Flows to Contingent Liquidity Stress Tests
Source: Dr. Michael Reuther
17Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Test Process
Source: Dr. Michael Reuther
18Copyright 2003 The Kamakura Corporation – Confidential Information
Forecasting Cash Out-Flows More than Just Contractual Claims
• Perception risk
• Surviving a liquidity crisis is not the same as successful liquidation.
19Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Test Process
Source: Dr. Michael Reuther
20Copyright 2003 The Kamakura Corporation – Confidential Information
Liquidity From Assets
Source: Dr. Michael Reuther
21Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Test Process
Source: Dr. Michael Reuther
22Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Tests Detail
Stress Level 1 1 2 1 1Cash AvailabilityLiquid Assets Bills 92% 95% 99% 99% 99% Bonds 95% 90% 95% 98% 98% CP 96% 90% 97% 99% 99%Unused funding capacity Wholesale 90% 70% 90% 0% 50% Commercial 96% 80% 95% 25% 75% Retail 97% 90% 100% 50% 100%
Scenario
Economic Political Market PaymentsBank Specific
23Copyright 2003 The Kamakura Corporation – Confidential Information
Stress Tests Detail
Stress Level 1 1 2 1 1Cash NeedCredit Drawdown Risk Wholesale 10% 15% 20% 5% 0% Commercial 5% 10% 15% 5% 0% Retail 5% 5% 5% 0% 0%Deposit Risk Wholesale 10% 20% 10% 50% 0% Commercial 5% 10% 10% 30% 0% Retail 0% 5% 0% 5% 0%Collateral Risk Payments 5% 5% 5% 5% 50% Derivatives 5% 10% 5% 10% 0%
Source: Tom Bermingham
Bank Specific
Scenario
Economic Political Market Payments
24Copyright 2003 The Kamakura Corporation – Confidential Information
Should You Forecast Cash In-flows?
If you are covering today’s risk with tomorrow’s promises, you are masking risk.
But if you fail to include future cash in flows, your projection is incomplete and your forecasted quantity of liquidity need is unrealistically large.
25Copyright 2003 The Kamakura Corporation – Confidential Information
Assumption Relevanancy
Is the scenario relevant to your bank? (e.g. foreign exposure, equity exposure, etc.)
Is the scenario relevant to your balance sheet? (e.g. core funding versus wholesale funding)
Is the scenario relevant to your competitive environment? (e.g. ability to generate new deposits)
Does the scenario capture relationships between changes in credit risk, interest rate risk and liquidity risk
26Copyright 2003 The Kamakura Corporation – Confidential Information
Measurement is Not Management
Evaluate stress tests to identify major contributors to risk exposures. Requires the ability to “drill down” into detail.
Reduce risk exposures if possible. (Topic for another day.)
Combine stress testing and limits.
Combine stress testing and liquidity contingency planning.
27Copyright 2003 The Kamakura Corporation – Confidential Information
Liquidity Warehousing – the Easy Stuff
NOT cash or interbank deposits
net funds sales, repos and borrowings – BY TIME PERIOD & SCENARIO
unpledged, AFS investment securities
loans or portions of loans that can sold quickly (government guaranteed, loan sale channels, securitizations in process)
28Copyright 2003 The Kamakura Corporation – Confidential Information
Adding Liquid Assets – What Do We Accomplish?
Core Assets
Liquid Assets
Volatile Liabilities
Core Funding
+ Equity
Structural Liquidity
DeficitCore
Assets
Liquid Assets
Volatile Liabilities
Core Funding
+ Equity
Structural Liquidity
Deficit
29Copyright 2003 The Kamakura Corporation – Confidential Information
No Bank Can Afford To Hold Enough Liquid Assets to Cover All
Contingent Needs in The Worst Scenario at The Highest Stress Level
Liquid Assets Are Ideal, But …
30Copyright 2003 The Kamakura Corporation – Confidential Information
Too little liquidity may kill the bank suddenly but too much can
kill it slowly.
KEY ISSUE
31Copyright 2003 The Kamakura Corporation – Confidential Information
Beyond Liquid Assets
• Loans can also provide liquidity value – Mortgages as collateral for FHLB 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?
32Copyright 2003 The Kamakura Corporation – Confidential Information
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
33Copyright 2003 The Kamakura Corporation – Confidential Information
Most Common Contingency Plan
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
“Our Plan is Draw Down Our Committed Lines”
34Copyright 2003 The Kamakura Corporation – Confidential Information
Wholesale Funds Providers Are Brutal Arbiters of Creditworthiness
• Quickly recognize potential problems
• Respond rapidly
35Copyright 2003 The Kamakura Corporation – Confidential Information
Segmenting the Propensity to Withdraw Deposits
Insured or Secured
Depositors' Reliance On Information
Depositors' Relationship
With the Bank
Overall Assessment of Stability
consumers yes low high high
small business in part low high medium
large commercial no medium medium low
banks no high medium medium
municipalities yes high medium high
capital markets funds
providersno high low low
36Copyright 2003 The Kamakura Corporation – Confidential Information
Very Sensitive to Perceived
Deterioration in Credit Quality or
Safety
money market mutual fundsrating sensitive providerspension fundsinsurance companiesother funds providers with fiduciary responsibilitybroker/dealersregional and money center banks in your countryforeign bankslarge corporationscommunity banks in your market area
Only sensitive to credit quality and
liquidity when problems are very
bad and highly publicized.
local, uninsured, unsecured depositorscustomers who are net borrowers (their loan balances exceed their deposit balances)local, secured funds providers insured depositors
Sensitivity of Funds Providers By Type
37Copyright 2003 The Kamakura Corporation – Confidential Information
Diversification of Funding Sources
16%
4%9%15%
2%
20%
6%
28%
Retail Deposits Fiduciary
Deposits
Capital Markets Small/Mid Cap CP-CD Bank Deposits Central Bank
Deposits
Other Non-Bank
Deposits
Should this bank reduce retail deposits and increase fiduciary deposits to improve diversification?
38Copyright 2003 The Kamakura Corporation – Confidential Information
Applying Five Diversification Tools For Wholesale Funding Sources
Product type Counterpart Maturity Currency Region Deposit CD CP
Commercial bank
Central bank
Insurance Investment
company Corporates
ON 1 month 3 months 6 months 12 months
EUR USD JPY GBP
Continental Europe
Americas London Asia Pacific
Source: Michael Reuther, Deutsche Bank
39Copyright 2003 The Kamakura Corporation – Confidential Information
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.
40Copyright 2003 The Kamakura Corporation – Confidential Information
Wrapping Up
41Copyright 2003 The Kamakura Corporation – Confidential Information
Applying Stress Testing
Stress testing is not an end unto itself. Results have to be used in the risk management process.
Results should be carefully considered when setting risk limits.
Contingency plans for actions such as asset liquidations should be based on stress test results.
42Copyright 2003 The Kamakura Corporation – Confidential Information
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.
43Copyright 2003 The Kamakura Corporation – Confidential Information
For More Information
LIQUIDITY RISK LIQUIDITY RISK MANAGEMENTMANAGEMENT
and
SELF PACED A/L SELF PACED A/L MANAGEMENTMANAGEMENT
published by: Sheshunoff Information Services, Inc.
1-800-456-2340www.sheshunoff.com
written by: Leonard Matz, [email protected]