1. Liquidity Risk Assessment By A V Vedpuriswar October 4, 2009

2. Introduction  Banks must have sufficient liquidity to meet commitments as they fall due.  Liquidity risk is the risk that a bank will not have sufficient liquid resources available to meet commitments.  Maturing assets might turn out to be non-performing.  This may prompt the bank to liquidate other investments.  The volume of these other investments liquidated could significantly move the market price of the assets.  In extreme cases there might not even be a viable market in which to trade. 1

3. Understanding liquidity risk  By creating a diversified mix of assets and liabilities, the bank can access markets on an orderly basis, at the best rates.  If it only went to the market in an emergency,  Or if it continually sought short term funds,  It might have to pay higher rates or even go bankrupt in extreme situations.  The simplest method of identifying liquidity risk is to list all liabilities and assets in maturity date order.  The difference between amounts payable and receivable in each time band are referred to as maturity mismatches. 2

4. Anticipating daily liquidity needs  Throughout the day a bank can only make an intelligent guess as to what the position will be at the end of the day.  With experience, banks can make a reasonable allowance for the volume of unanticipated movements.  Based upon the best information available a bank will borrow or invest funds, often on an overnight basis.  This helps to keep its working balances as low as possible, since they earn little or no interest. 3

5. Liquidity ladder  The usual way to measure liquidity requirements is by means of a liquidity ladder.  Currency by currency, all liabilities and assets are placed by reference to their ultimate maturity date.  When calculating liquidity ladders, there are a number of issues that the bank must consider:  What proportion of current and savings accounts are likely to be withdrawn on demand or at short notice?  What percentage of overdrafts will never be repaid or will have to be transformed into long-term loans?  Undrawn lending commitments: how much of these are likely to be drawn down at short notice?  How many loans are non-performing?

6. Liquidity characteristics of assets  Cash is the most liquid type of asset and yields no return.  Negotiable certificates of deposit, are more liquid, they generally yield less than a fixed deposit for the same term.  Trade paper attracts a liquidity premium by means of a relatively low yield.  Longer term personal and corporate lending is relatively illiquid.  Some high quality assets which are not naturally liquid can be liquefied by the process of securitization. 5

7. Sources of liquidity risk  Liquidity risk arises from numerous sources, including: – strategic decisions to provide liquidity to the markets – reputational problems or other negative news (for example, credit rating downgrades) – macroeconomic changes (for example, interest rate volatility and inflation) – changing market trends (for example, changes in funding sources) – specific products and activities (for example, OTC derivatives) 6

8. Types of liquidity risk  Conventional analysis of liquidity risk distinguishes between two different dimensions of liquidity risk. – Asset liquidity – Funding 7

9. Asset liquidity risk  The liquidation value of the assets may differ significantly from the current mark-to-market values.  When unwinding a large position or when the market conditions are adverse, the liquidation value may be depressed. 8

10. Funding liquidity risk  This refers to the inability to meet payment obligations to creditors or investors when they do not want to roll over their positions.  This can force unwanted liquidation of the portfolio.  What happened during the sub prime crisis?. 9

11. Collateral Issues  Most financial institutions are leveraged.  They post collateral in exchange for cash from a broker.  Usually the collateral is slightly more than the cash loaned by an amount called haircut.  This provides a buffer against decreases in collateral value. 10

12.  The value of the collateral is, however, constantly marked to market.  If this value falls, the broker will have to post some additional payment called the variation margin.  Brokers can also reserve the right to changes in collateral requirements.  Liquidity risk may also arise because of mis-matches in the timing of payments. 11

13. Liquidity Black Holes  The most severe liquidity crises occur when we have liquidity black holes.  They develop when the entire market moves to one side.  During a price decline, when everyone wants to sell, liquidity will dry up and distress sales will happen.  Liquidity holes may develop when banks with similar positions, do same trades to achieve a delta neutral position.  Liquidity can become a serious problem due to herd behavior. 12

14. Understanding herd behaviour  In a normal market, when prices fall, some people will want to buy.  A liquidity black hole results when virtually everyone wants to sell in a falling market.  Different traders use similar computer models.  Banks regulated in the same way, respond to changes in volatilities and correlations in the same way.  People start imitating other traders thinking there “must be something in it.”  13

15. The Crash of 1987  The crash of October 1987, on the New York Stock Exchange is a good example.  Many traders followed a portfolio insurance strategy.  They sold immediately after a price decline and buying back immediately after a price increase.  As a result of these trades, the market plunged sharply.  The market declined rapidly.  The stock exchange systems were overloaded.  So many portfolio insurers were unable to execute the trades generated by their models.  14

16. Regulatory issues  A uniform regulatory environment may accentuate a liquidity crisis.  When volatility increases, value-at-risk (VaR) will increase.  Consequently, all banks will be forced to increase capital.  Alternatively, they will have to reduce their exposure in which case many banks will try to do similar trades.  Similarly during a downturn, banks will be less willing to make loans.  In all these situations, a liquidity black hole may result. 15

17. Need for diversity  For black holes not to happen, at least some of the market participants should pursue contrarian strategies.  Investors can often do well by selling when most people are buying and by buying when most people are selling.  Volatilities and correlations may increase but over time, they get pulled back to the long term average.  As such, long term investors need not adjust their positions based on short term market fluctuations.  One way forward is for regulators to apply different rules to asset managers and hedge funds.  Then there will be diversity in the thinking and strategies of different market participants.  16

18. Quantifying liquidity risk  How do we quantify liquidity risk?  The markets, especially, the bid-ask spreads tell use a lot about the state of the liquidity.  Bid – ask spreads are driven by : – Order processing costs, which tend to decrease with volumes – Asymmetric information costs – Inventory carrying costs.  One way of dealing with liquidity is to adjust the VAR rather than come up with a new risk measure.  Liquidity adjusted VAR can be calculated by adding s  /2 for each position in the book, where  is the dollar value of the position and s is defined as (offer price – bid price) / mid-price. 17

19. Multiple positions  If there are multiple positions,  Liquidity adjusted VAR = VAR + Sum[(1/2)(Spread) (Size of position)] 18

20. Time horizon  Liquidity risk can be loosely factored into VAR measures by ensuring that the horizon is at least greater than an orderly liquidation period.  Sometimes, longer liquidation periods for some assets are taken into account by artificially increasing the volatility.  Alternatively, by increasing the time horizon, the capital requirement can be enhanced.  Thanks to more capital, a financial institution will be better placed to deal with a severe liquidity crisis. 19

21. Lines of defence  The first line of defense against funding liquidity risk is cash.  Another may be a line of credit.  New debt/new equity are also options but become difficult to tap during unfavorable times.  Avoiding debt covenants or options that force early redemption of the borrowed funds may also help. 20

22. Liquidity, model and market risks  Liquidity, market and model risks are interrelated.  Breakdown of markets leads to liquidity problems.  When markets are not in place, models become necessary.  Models pose various risks.

23. Standby facilities  Is it possible to draw down on standby (emergency) facilities with other banks?  These are formal agreements but it may prove very difficult to actually use them, especially if there is a general shortage of liquidity so that the providing bank is equally short of funds.  Even if funds are available from a standby facility, the supplying bank may simply withdraw other deposits or not renew deposits at maturity so the receiving bank is in no better position than before.  Utilization of standby facilities is a signal to the market that the bank is in difficulty and so other banks may aggravate the problem by refusing to deal.