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Hermes’ Staff – Perspectives on Liquidity Risk
Nick Scott and Steven Claxton
Part I
Tacoma Narrows Bridge (1940)
Bridge Collapse in Minneapolis (August 2007)
Bank Balance Sheet
Notes to the Accounts
Illustrative Maturity Profile for Banks
<1 year 1 to 5 years > 5 years
Dol
lar
Val
ue
Contractual Maturity
Assets Liabilities
Source: NAB
Illustrative Maturity Profile for General Insurers
<1 year 1 to 5 years > 5 years
Dol
lar
Val
ue
Contractual Maturity
Assets Liabilities*
Source: NAB
• Liquidity resources of much of the banking system was inadequate
• Central bank backstop function was tested
• Cash rich non-financial corporates and insurers survived with no central bank support
2008-2009 Financial Crisis
• The practice of borrowing short-term and lending long-term
• Like alchemy, it doesn’t work
• Inherent Fragility: A well-capitalised firm faces a non-zero probability of ruin over a short-term horizon
“Maturity Transformation (MT)”
• Bids down the price of illiquid assets and value of economic liquidity
• Discourages economic incentives to provide more stable liquidity solutions (e.g. transfer and exchange mechanisms)
• Dampens market-based signals for controlling the credit growth cycle
Other Downsides of MT
• Liquidity assessment: strong to weak depending on need for central bank support
• Survival periods of 12-24 months
• Comprehensive stress scenarios to identify full range of contingent liabilities
Rating Agencies
-
50
100
150
200
250
300
350
400
Jun 06 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11
bps
3yr IG Corporate Loans 3yr Major Banks Bond Issuances 3yr Bank CDS Spread
Bond Markets Reaction
Source: NAB
• Liquidity ratio for 30 day stress scenario; funding ratio for 12 month period
• Hierarchy of “stickiness”: extremely favorable towards retail demand deposits
• Negative spread on government securities becomes the “regulatory cost of liquidity”
Basel Committee and APRA
Part II
Early Accounting
Modern Accounting
What Financial Reporting Misses
• Firms with high MT more risk higher capital cost lower value
• Cost of refinancing risk over mismatched periods (time value of funding shortfalls)
• Highly positive correlation between stresses on both sides of the balance sheet
Towards a New Standard
• Focus on contractual cashflows
• Unmatched assets have a liquidity-adjusted value (LAV)
• Value of liabilities includes refinancing costs
Steps
• Step 1: Plot out contractual cash inflows and outflows
• Step 2: Project contingent inflows and outflows based on legal obligations
• Step 3: Match up the inflows and outflows
• Step 4: Model the cost of matching cashflows
Model Basics
• The modeling of matched cashflows recognises contractual outflows can either be met with asset sales or refinancing
• Fire-sale asset values are a function of their market price volatility
• Cost of refinancing is a function of a credit spread curve
• Simulated random failure times for unmatched cash outflows
Model Outcomes
• Assets subject to funding gaps are adjusted below their credit risk-adjusted discounted value to account for liquidity
• Economic signal rewarding strongly matched firms
• Risk-based approach reconciles MtM and HTM accounting
Part III
• Establish and quantify firm-wide liquidity risk appetite
• Transfer funding costs internally based on matched maturity marginal (MMM) cost of funds
• Recognise profit generated from maturity mismatches (credit curve) after liquidity risk expires
Disciplined Pricing
• Banks pool credit risk, provide credit diversification and allow weaker counterparties to borrow
• Banks assist stronger firms raise capital market finance
• Specialisation of skills is productive: banks underwrite credit risk; Insurers underwrite property, casualty, mortality, morbidity, and longevity risk
What Works in Financial Services
• There are very few self-liquidating assets (Trade finance is an exception)
• Liquidity backstops are part of a firm’s capital structure
• Liquidity backstop providers are de-facto economic owners on a risk-adjusted basis
What We Know
• Growth in liquidity transfers that allow liquidity-rich and low-MT firms to provide liquidity during stress scenarios
• Banking services based on economic liquidity needs with special purpose withdrawal and call features
• Originate, distribute and mitigate (ODM) models
Towards Financial Stability