Presentation on theme: "Effective Liquidity Risk Measurement and Management"— Presentation transcript:
1Effective Liquidity Risk Measurement and Management Leonard Matz
2Effective Liquidity Risk Measurement Common liquidity metrics: strengths and weaknessesCash flow projectionsScenarios
3Loan to Deposit Ratio (South Africa) ACTUALLY A MEASURE OF ILLIQUIDITYPRESUMES THAT ALL LOANS ARE ILLIQUID -- ANYTHING NOT A LOAN IS ASSUMED TO BE LIQUIDPRESUMES THAT THE NEED FOR LIQUIDITY IS A DEPOSIT LOSSA RELIC FROM THE GREAT DEPRESSIONRECENT SURVY
4The Venerable, Oft Quoted and Almost Meaningless Loan to Deposit Ratio Assumes that all sources of funding other than deposits are stableAssumes that all deposits are unstableAssumes that all assets other than loans are completely liquidAssumes that all loans are completely illiquid
5Lots of Ratios Measure Relationships of Liquid, Illiquid, Stable, and Volatile Balance Sheet Volumes Large liability dependence ratiosVarious ratios of liquid assets to purchased funds
6Net Liquid Assets Balance Sheet Liquidity Model VolatileLiquidNet Liquid AssetsIlliquidStableASSETSLIABILITIES
7Traditional 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.
10FOUR 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.
11Liquidity 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".
12Rate 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.
13MANY VARIATIONSTIME BUCKETS CAN BE ANY SIZETYPICALLY, SMALL TIME BUCKETS IN THE NEAR FUTURENOTICE THAT DESCRETIONARY CASH FLOWS ARE AT THE BOTTOM
15Problem: Both Cash Availability And Needs Are Highly Correlated with Scenarios asset liquidityunused funding capacityNeeds:deposit withdrawalundrawn credit facility drawdowncollateral pledgingNot just undrawn credit facilities but all commitments
16BIS 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.
17KEY ISSUEScenarios 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.
19Systemic Crises – A Wide Variety 198719901991199219941995199719981999200020012002U.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
20IMF 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
21Use At Least Three Scenarios Normal course of business, including any seasonal fluctuationsBank specific funding crisisSystemic liquidity crisis
22Scenarios Monitored By A Large International Bank Market RiskEmerging MarketsSystemic ShockGlobal Prolonged RecessionOperational RiskMerger & AcquisitionDowngrade to A1/P1 & A1/A+Downgrade to A2/P2 & A3/A-Scenario analysisExternalInternalStress testing is really looking at the counterbalancing in the worst cases.Should we introduce a base scenario which assumes business as usual?“Stress”
23Define Three Characteristics For Each Scenario Type: systemic or bank specific; local, national or internationalDuration: short or longSeverity: mild or severe
24Additional measures needed Scenario ResultsDetermine total Liquidity Mismatch for each scenarioGoing Squeeze Specific GeneralBalance sheetCredit linesCollateralGap Additional measures neededSource: Bruce McLean, Forrest, UBS
25Effective Liquidity Risk Management Management tacticsLimits, management and reportingStress testing
26Adding Liquid Assets – A Right Way and a Wrong Way Core AssetsLiquid AssetsVolatile LiabilitiesCore Funding+EquityStructural LiquidityDeficitCore AssetsLiquid AssetsVolatile LiabilitiesCore Funding+EquityStructural LiquidityDeficit
27Beyond Liquid Assets Loans can also provide liquidity value Mortgages as collateral for borrowingsSalable and securitizable assets where bonds have not yet been issuedA $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 costAll 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?
28Asset Management: The Three Ss SyndicationEarly warning systemPricing & participation %Recent credit concernsSecuritizationAll tangible bank assets can be securitizedWhat about residuals & equity pieces?SalesSource: Fred Poorman, BNK Analytics
29Asset Securitizations “Picking only the low-hanging fruit leaves a very illiquid balance sheet remaining!”Source: Carl Tannenbaum, ABN Ambro
30Planned Responses to A Crisis: Asset Management Rank all assets by how quickly and easily they can be soldStart preparations for loan sales or securitizationsMaintain primary and secondary liquidity from assets warehousesManage pledging to free up excess collateralManage pledging to use the least readily salable assets
31By 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 BagehotTHE WELL PREPARED NEED BETTER PLANS
34Sometimes We Can Borrow. Sometimes Not Sometimes We Can Borrow. Sometimes Not. Wholesale Funds Providers Are Brutal Arbiters of CreditworthinessQuickly recognize potential problemsRespond rapidly
35Managing 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.
37Sensitivity of Funds Providers By Type Very Sensitive to Perceived Deterioration in Credit Quality or Safetymoney 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 areaOnly 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 providersinsured depositors
38Managing 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.
39Four 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.
40Key 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”.
41Setting 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?
42Liquidity 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
43Limits, 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.
44Regulatory Approaches Source: Dr. Paul Baneke, De Nederlandsche Bank
45Management 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 topicsAlways monitor potential key triggers. LIQIDITY IS A CONSUQUENCIAL RISK
46A Reporting Dashboard (ratio of projected in-flows to out-flows)
47STRESS LEVELSIt is imperative to use multiple degrees of severity (stress levels) for each need scenario!
48BIS 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
49Why Stress Test?Stress testing is an important element for sound risk management and contingency planning:Stress scenarios highlight potential problemsThe untimely liquidation of assets can be costlyGood advance planning can, at least potentially, prevent insolvency
50Why Stress Test?Holding Liquidity is Not FreeNo 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.
51Volatility 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
52Measurement 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 eventsThe 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
53Measurement and Quantification Processes Stress testing typically applies statistical tools to provide more information about the tail.ProbabilitySeverity of lossVaRExtreme Value TheoryOther tools14
54Liquidity risk is highly idiosyncratic, arbitrary and inconsistent.
55For More Information LIQUIDITY RISK MANAGEMENT and SELF PACED A/L MANAGEMENT published by: Sheshunoff Information Services, Inc written by: Leonard Matz,