1. Effective Liquidity Risk Measurement and Management
Leonard Matz

2. Effective Liquidity Risk Measurement
Common liquidity metrics: strengths and weaknesses
Cash flow projections
Scenarios

3. Loan to Deposit Ratio (South Africa)
ACTUALLY A MEASURE OF ILLIQUIDITY
PRESUMES THAT ALL LOANS ARE ILLIQUID -- ANYTHING NOT A LOAN IS ASSUMED TO BE LIQUID
PRESUMES THAT THE NEED FOR LIQUIDITY IS A DEPOSIT LOSS
A RELIC FROM THE GREAT DEPRESSION
RECENT SURVY

4. 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

5. 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

6. Net Liquid Assets Balance Sheet Liquidity Model
Volatile
Liquid
Net Liquid Assets
Illiquid
Stable
ASSETS
LIABILITIES

7. 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.

8. Off Balance Sheet Items (South Africa)

9. Off Balance Sheet Items

10. FOUR IMPARATIVES FOR MEASURING LIQUIDITY
The quantity of liquidity you have or can get MUST be related to the quantity of liquidity that you think you may need.
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.
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.
The quantity of liquidity available is scenario specific. Sources available in some scenarios are less available or unavailable in others.

11. 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".

12. 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.

13. MANY VARIATIONS
TIME BUCKETS CAN BE ANY SIZE
TYPICALLY, SMALL TIME BUCKETS IN THE NEAR FUTURE
NOTICE THAT DESCRETIONARY CASH FLOWS ARE AT THE BOTTOM

14. Cash Flow Time Profile

15. Problem: Both Cash Availability And Needs Are Highly Correlated with Scenarios
asset liquidity
unused funding capacity
Needs:
deposit withdrawal
undrawn credit facility drawdown
collateral pledging
Not just undrawn credit facilities but all commitments

16. 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.

17. 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.

18. Factors Behind 29 Failures

19. Systemic Crises – A Wide Variety
1987
1990
1991
1992
1994
1995
1997
1998
1999
2000
2001
2002
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
September 11 payments system disruption
Argentine crisis

20. 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 ( )
Source: Lingren, G.J., Garcia, and N. Saal, Banks Soundness and Macroeconomic Policy, Washington DC, IMF, 1996

21. Use At Least Three Scenarios
Normal course of business, including any seasonal fluctuations
Bank specific funding crisis
Systemic liquidity crisis

22. Scenarios Monitored By A Large International Bank
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-
Scenario analysis
External
Internal
Stress testing is really looking at the counterbalancing in the worst cases.
Should we introduce a base scenario which assumes business as usual?
“Stress”

23. Define Three Characteristics For Each Scenario
Type: systemic or bank specific; local, national or international
Duration: short or long
Severity: mild or severe

24. Additional measures needed
Scenario Results
Determine total Liquidity Mismatch for each scenario
Going Squeeze Specific General
Balance sheet
Credit lines
Collateral
Gap  
Additional measures needed
Source: Bruce McLean, Forrest, UBS

25. Effective Liquidity Risk Management
Management tactics
Limits, management and reporting
Stress testing

26. Adding Liquid Assets – A Right Way and a Wrong Way
Core Assets
Liquid Assets
Volatile Liabilities
Core Funding +
Equity
Structural Liquidity
Deficit
Core Assets
Liquid Assets
Volatile Liabilities
Core Funding +
Equity
Structural Liquidity
Deficit

27. 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
All processes for securitization have been put in place — systems, tracking, investor reporting etc.
As you recall from our loan example, a loan was charged 41 bps for matched liquidity. Here, at a portfolio level, we should credit back 20 bps.
In practice, it depends on the scenario and stress level. When is an asset liquid? When is a liability volatile?

28. 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

29. Asset Securitizations
“Picking only the low-hanging fruit leaves a very illiquid balance sheet remaining!”
Source: Carl Tannenbaum, ABN Ambro

30. 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

31. 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

32. Balance Sheet Trends (South Africa)

33. Balance Sheet Trends

34. Sometimes We Can Borrow. Sometimes Not
Sometimes We Can Borrow. Sometimes Not. Wholesale Funds Providers Are Brutal Arbiters of Creditworthiness
Quickly recognize potential problems
Respond rapidly

35. 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.

36. Estimating Stickiness
Fiduciary
Agent or
Owner
Insured or
Secured
Depositor
Reliance on
Information
Depositor’s
Relationship
with the
Bank
Stickiness
Estimate
consumers
owner
yes
low
high
small business
in part
medium
Large
Commercial no
Banks
agent
Municipalities
money market
mutual funds
quasi
fiduciary

37. 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

38. 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.

39. Four Essential Liquidity Management Tools
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.
Extend liability terms to reduce liquidity risk.
Be prepared to enhance liquidity quickly at the first signs of increased potential need.
Manage cash flow profiles.

40. Key Considerations for Setting Limits
Not so big as to be meaningless.
Within the bank’s risk tolerance: the cost of put test.
Adjusted for the “path to the exit”.
Must include a “cushion”.

41. 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?

42. 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

43. 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.

44. Regulatory Approaches
Source: Dr. Paul Baneke, De Nederlandsche Bank

45. 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

46. A Reporting Dashboard (ratio of projected in-flows to out-flows)

47. STRESS LEVELS
It is imperative to use multiple degrees of severity (stress levels) for each need scenario!

48. BIS Guidelines Require Stress Testing
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

49. Why Stress Test?
Stress testing is an important element for sound risk management and contingency planning:
Stress scenarios highlight potential problems
The untimely liquidation of assets can be costly
Good advance planning can, at least potentially, prevent insolvency

50. 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.

51. 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.
Red lines indicate 2 SD

52. 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

53. Measurement and Quantification Processes
Stress testing typically applies statistical tools to provide more information about the tail.
Probability
Severity of loss
VaR
Extreme Value Theory
Other tools 14

54. Liquidity risk is highly idiosyncratic, arbitrary and inconsistent.

55. For More Information LIQUIDITY RISK MANAGEMENT and SELF PACED A/L MANAGEMENT published by: Sheshunoff Information Services, Inc written by: Leonard Matz,