1. Balance-Sheet Liquidity and Approaches to Its Stress Testing

2. Koncepce likvidity Několik základních definicí (např. BdF, FSR, 02/2008): Bilanční likvidita (banky): schopnost banky dostát svým okamžitým závazkům nebo Likvidita při financování se („funding“): jednoduchost, s jakou je banka schopna získat zdroje k úhradě závazků např. z externích zdrojů; Tržní likvidita: schopnost trhu zobchodovat daný objem aktiv (cenných papírů) bez významné změny jejich cen; Měnová likvidita: se týká množství plně likvidních aktiv v bankovním systému nebo množství peněz dodávaných centrální bankou komerčním bankám…. Různé definice, úzký vzájemný vztah „ Liquidity is an elusive notion. It is easier to recognize than to define. “ (Crockett, 2008)

3. 3 Příklad: The crisis hit the Czech financial markets too The market liquidity has rapidly fallen …. The CNB introduced liquidity-providing repo operations aimed at fostering the functioning of the government bond and money market.

4. 4 Příklad: Funding liquidity of the Czech banks still good Full coverage of the credit portfolio from client deposits that keep on growing (deposits exceed loans by 40%). Excess deposits invested in liquid assets amounting to almost 30% of overall assets.

5. 5 Regulatory standards: Liquidity coverage ratio (LRC): Stock of high quality liquid assets / Net cashoutflows over a 30-day time period ≥ 100% Net stable funding ratio (NSFR) : Available amount of stable funding / Required amount of stable funding > 100% Funding liquidity in Basel III

6. 6 Liquidity coverage ratio (LRC) - builds on traditional liquidity “coverage ratio” methodologies used internally by banks to assess exposure to contingent liquidity events: Net cumulative cash outflows for the scenario are to be calculated for 30 calendar days into the future. The value of the ratio should be no lower than 100% (i.e. the stock of liquid assets should at least equal the estimated net cash outflows). Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high quality assets as a defense against the potential onset of severe liquidity stress. Banks and supervisors are also expected to be aware of any potential mismatches within the 30-day period and ensure that sufficient liquid assets are available to meet any cash-flow gaps throughout the month. In order to qualify as a „high-quality liquid asset“, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible. Funding liquidity in Basel III

7. 7 Net stable funding ratio (NSFR): : “Stable funding” is defined as those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress. The amount of such funding required of a specific institution is a function of the liquidity characteristics of various types of assets held, off-balance sheet contingent exposures incurred, and/or the activities pursued by the institution. 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 off-balance sheet items. In addition, the NSF approach would help to counterbalance the cliff-effects of the liquidity coverage ratio and offset incentives for institutions to fund their stock of liquid assets with short-term funds that mature just outside the supervisory defined horizon for that metric. Liquid enough even according to the BCBS‘ QIS

8. 8 Despite the existing favorable position we test banks for liquidity-associated risks Main objective: to investigate liquidity risk not only as a source of bank funding risk (the ability to raise cash to fund assets), but also as strong link to market liquidity (the ability to convert assets into cash at a given price).

9. 9 Assets = usage of funds Liabilities = funds LIQUIDITY SHORTFALL Promises from the past Uncertainty about the future = A bank must solve: A bank promised to lend (credit lines) but may not have enough funding sources (even more impaired financial markets, withdrawals) … a simple illustration of the lack of liquidity...

10. 10 Banks` liquidity buffer vs. stressed cash outflows Banks normally have liquidity reserves consisting of liquid securities or cash to cope with unexpected cash outflows. Unexpected cash outflows (some examples): Loss of confidence in a bank, Frozen money markets, Withdrawals of deposits, or/and Drawdowns of credit lines. The question is: Are banks` liquidity reserves sufficient and liquid enough?

11. 11 The difference between funding (liabilities) and illiquid assets (the blue rectangle) is the funds invested in liquid assets (the red rectangle). Liquidity tension: (a) impossible banks‘ securities issuance, (b) withdrawals from private individuals and (c) higher credit facilities usage. A bank with a larger liquidity reserves, a larger proportion of deposits and a smaller proportion of securities that will mature over shorter notice… …survives and its liquidity buffer is ample and liquid enough. (1) A liquidity buffer is ample and liquid enough

12. 12 The difference between funding (liabilities) and illiquid assets (the blue rectangle) is the funds invested in liquid assets (the red rectangle). Liquidity tension: (a) impossible banks‘ securities issuance, (b) withdrawals from private individuals and (c) higher credit facilities usage. A bank with a smaller proportion of deposits and higher dependence on market funding (a large proportion of securities that will mature over shorter notice)… … fully exhausts its liquidity reserves. (2) The liquidity buffer is not sufficiently ample and liquid

13. 13 The current LST for the Czech banking system examine… Top-down approach originally developed by De Nederlandsche Bank with some CNB`s modifications. The 3-Phase Test captures the impact of both bank-specific and market wide scenarios and considers both the first- and second- round effects of shocks with a survival period of one month. 1st phase (first-round effects): two dimensions: (a) a liquidity shortfall, (b) drying up of market liquidity, 2nd phase: reactions by banks to mitigate shocks and restore LB, 3rd phase: negative reputational impacts and collective behavior (second-round effects) – the feedback effects of shocks – some additional impact on LB. pressures on the initial liquidity buffer (LB)

14. 14 … whether Czech banks are being able to survive arisen liquidity tension. 3 rd 2 nd 1 st

15. 15 Initial liquidity buffer Starting point - liquidity buffer (LB 0 ) as the first line of defense LIQUID ASSETS (LB) 1.CASH 2.CLAIMS on CEBs 3. CLAIMS on other clients (non- financial, financial) on demand and due within 1 month 4.BONDS (bills) issued by government 5.BONDS (bills) issued by CEBs Liquidity buffer (LB): Banks` holdings of liquid assets in case of unexpected tensions in its balance-sheet; Definition: sum of unweighted liquid assets (initial level of banking system assets under normal conditions).

16. 16 Scenarios‘ impact Scenario ==> 1 st round effect ==> LIQUIDITY SHORTFALL, ↓ LB 1 st round of shocks: first three items above are affected at once; two premises are linked to credit and market shocks. Liquidity shortfall: difference between the amount of the aftershock assets and liabilities; Banks` reaction : sales of assets under restrictive conditions.

17. 17 Dependence on macro stress testing LST takes into account the results of the credit and market risk stress testing: The higher losses the greater outflow of liquidity, The less quality the higher haircuts.

18. 18 Liquidity shortfall A.Deposit outflows:  not all deposits are guaranteed,  fixed costs to extracting deposits from banks,  an insufficiency of the insurance funds… B.The increase of the banks` loan portfolio:  the drawdown on credit lines,  the loss of confidence.

19. 19 Mitigate the impact of shocks LIQUIDITY SHORTFALL ==> Reactions by banks ==> Mitigate 1 st round effects ==> ↓Liquidity buffer (LB 1 ) Reaction: banks can reduce assets only due to constrains on funding (the liability side can not be increased): (a)banks first liquidate the initial liquidity buffer (the most liquid assets) reflecting market liquidity, their specialization and their strength of presence in financial markets – cash, claims on CEBs, sovereign bonds…), (b)and then the other items (run out of liquidity buffer) – high haircuts.

20. 20 … a simple illustration of banks‘ reactions... Assets Selling more for lower price PRICE DECLINE NO PRICE Market dilemma: (a)Reputation risk: …Why is that bank selling?  Stigma (b) Systemic risk: …too many banks are selling, the same assets…

21. 21 Impact of the 2 nd round of shocks Reactions by banks ==> Loss of reputation and collective behavior ==> 2 nd round effects (feedback) ==> ↓Liquidity buffer (LB 3 ) The behavioural reactions have wider disturbing effects on markets and feeding back on the banks  additional haircuts on assets and withdrawals of liabilities. The feedback effect is stronger for reacting banks. Loss of reputation: signalling effect; Systemic risk (collective reaction) depends on: (i) the number of reacting banks, (ii) the similarity of the banks‘ reaction, and (iii) the size of reacting banks; Market conditions : reaction on liquid and developed versus illiquid and shallow markets.

22. 22 Scenarios CNB‘s FSR 2010/2011 (data at the end of 2010) The same scenarios as for macro stress testing (Asymmetric Developments, Renewed Recession). The Renewed Recession scenario would cause liquidity problems, but these would not be systemic in nature.

23. 23 Results CNB‘s FSR 2010/2011 (data at the end of 2010) The tested banks withstood the simulated stress and would be able to close the potential liquidity gap within one month even under worsened market conditions. Only a few banks would fully exhaust their liquidity buffers by their response to the liquidity shock.

24. 24 Zátěžové testy likvidity dopadly rovněž uspokojivě Metodologie shodná jako v minulém období (dvě kola šoků, šoky navázány na výsledky bank v testech solvence), nově však provedeny separátně pro jednoměsíční a tříměsíční horizont. Likviditní polštář by se v průměru snížil o dvě třetiny, v segmentu stavebních spořitelen by v případě tříměsíčního horizontu klesl o více než 80 %. Jedna banka (v případě 3M horizontu dvě banky) by zcela vyčerpala likviditní polštář.

25. 25 V oblasti likvidity je patrný významný rozdíl vyplývající ze specifického obchodního modelu stavebních spořitelen. Riziko likvidity – banky vs. stavební spořitelny U stavebních spořitelen je nesoulad splatností úvěrů a vkladů výraznější než ve zbytku bankovního sektoru – platí to zejména z pohledu dlouhodobých pohledávek se splatností nad 5 let. Podíl rychle likvidních aktiv na aktivech se u stavebních spořitelen v roce 2011 dále snížil na úroveň kolem 15 % a zůstává tak významně nižší než u ostatních bank.

26. 26 …for potential uses Main formulas: 1)An initial liquidity buffer: 2)A liquidity shortfall: 3)An available liquidity buffer: 4)Banks` reactions: For non-reacting banks 1)The second round of shocks: 2)Haircuts: For reacting banks 1)The second round of shocks: 2)Haircuts:

27. 27 Relevant literature Van Den End, J. W. (2008): Liquidity Stress-Tester: A macro model for stress-testing banks‘ liquidity risk, Dutch National Bank, WP No. 175 (May). IMF (2011): Global Financial Stability Report, Chapters 2 – Liquidity Risk: How to Address the “Systemic” Part (March). Barnhill, T., Schumacher, L. (forthcoming): Modeling Correlated Systemic Liquidity and Solvency Risks in a Volatile Environment with Incomplete Information, IMF WP. Wong, e., Hui, C.H. (2009): A Liquidity Risk Stress-Testing Framework with Interaction between Market and Crecit Risks, Hong Kong Monetary Authority, WP 06/2009 (March). Aikmen, D., Piergiorgio, A., Eklund, B., Gai, P., Kapadia, S., Martin, E., Mora, N., Sterne G., Willison, M. (2009): Funding Liquidity Risk in a Quantitative Model of Systemic Stability, Bank of England, WP No. 372 (June). Riskbank (2010): Financial Stability Report, 2/2010. Van Den End, J. W. (2010): Liquidity Stress-Tester: Do Basel III and Unconventional MP Work?, Dutch National Bank, WP No. 269 (December). … Adrian, T., Shin, H. S. (2009): Money, Liquidity, and MP, FED of NY, Staff Reports No. 360 (January). Cifuentes, R., Shin, H. s., Ferrucci, G. (2005): Liquidity Risk and contagion, Journal of the European economic association, (April-May). Brunnermeier, M., Pedersen, L. H. (2009): Market Liquidity and Funding Liquidity, Review of Financial Studies, 22(6), p. 2201-2238. Praet, P., Herzberg, V. (2008): Market liquidity and banking liquidity: linkages, vulnerabilities and the role of disclosure, FSR – Special issue on liquidity, Banque de France, No. 11. Adrian, T., Shin, H. S. (2008): Liquidity and financial contagion, FSR – Special issue on liquidity, Banque de France, No. 11. Nikolaou, K. (2009): Liquidity (risk) concepts: definitions and interactions, ECB WP No. 1008 (Feb.). …