1. CHAPTER 14 Funding-Liquidity Risk ( 資金流動性風險 ) in ALM What is in this Chapter? INTRODUCTION LIQUIDITY-RISK MANAGEMENT SUMMARY

2. INTRODUCTION The ALM unit is also involved in the management of the funding- liquidity risk( 資金流動性風險 ) that arises from mismatches between the assets and liabilities. This risk arises because banks generally fund themselves with liabilities that have very short contractual maturity (e.g., demand deposits such as checking accounts). Banks take the money they receive from these liabilities, set aside a small amount in cash, and invest the rest in assets that have long maturity, e.g., commercial loans. In general, customers leave most of their money in the demand deposits for a long time, and the small amount of cash that the bank sets aside is sufficient to meet customers' requests for withdrawals. However, if withdrawals are unusually high, there is a risk that the bank would not have enough cash to meet the demand.

3. INTRODUCTION In such a situation, the bank's choices can be simplified into three borrow money from other banks, if they are willing and able to supply more cash; sell some of the loans, possibly at deeply discounted prices; or default to the customers, and go out of business. This risk of defaulting or being forced to sell at a loss is called funding- liquidity risk or cash-crisis risk.

4. INTRODUCTION Funding-liquidity risk is different from the liquidity risk discussed in the chapter trading risk. The liquidity risk in trading arises from the possibility of the bank’s losing money by being locked into a position that is losing value. But in ALM, we are concerned that the bank will be unable to raise enough cash to pay its customers, or that it will be forced to sell ("cash in") assets at an awkward moment, incurring a significant liquidation cost. In this chapter, we discuss in more detail how funding- liquidity risk arises, how it can be measured, and how it can be managed.

5. INTRODUCTION MEASUREMENT OF LIQUIDITY RISK Let us begin our analysis of liquidity risks by considering the bank's uses and sources of funds. The uses of funds are the outflows of payments from the bank to customers or other banks. The sources of funds are inflows from customers and other banks We classify payments as scheduled, unscheduled, semidiscretionary, and discretionary. Scheduled payments are those which have previously been agreed on by the counterparties. Unscheduled payments arise from customer behavior. Semidiscretionary payments occur as part of the bank's normal trading operations but can be quickly changed if necessary. The discretionary transactions are those carried out by the bank's funding unit to balance the net cash flow each day. The measurement of funding requirements can be considered for three situations: expected requirements, unusual requirements, and crisis conditions.

6. INTRODUCTION Expected Funding Requirements The expected requirements are relatively easy to measure conceptually, although they require a large amount of daily data collection. For example, if the total balance of the checking-account portfolio is expected to increase steadily over the next few months, this would create a net expected inflow. A more detailed, daily model would probably find that balances on personal checking accounts were expected to decline steadily towards the end of the month, then jump up as wages are paid. The mirror image of this is that corporate accounts would be expected to increase steadily, then drop as they pay wages. In this case, the net flow to the bank would be close to zero.

7. INTRODUCTION An important component of the scheduled funding requirements are new asset originations. For example, if the commercial lending unit is planning to give a $500 million loan to a corporation, this will cause an additional expected outflow of $500 million. For such a loan, the ALM and funding units should have advanced warning that they will need to source additional funds on the day that the loan is disbursed to the company. Unusual Funding Requirements The unscheduled demand will usually be above or below the mean. As part of normal business, the bank should be ready to make payments easily on days when the net outflow of funds is 2 standard deviations above the daily mean. Two standard deviations for a Normal distribution corresponds to a 2% tail probability; therefore, such an event can be expected 5 times per year. This is not a crisis, just an unusual day.

8. INTRODUCTION On any day, the net inflow of discretionary funds to be raised (I D ) equals the scheduled, unscheduled, and semidiscretionary outflows minus the scheduled, unscheduled, and semidiscretionary inflows: The scheduled flows are known, but the unscheduled and semidiscretionary flows evolve randomly according to the behavior of customers and the bank's normal operations. Let us group these random terms into a single variable, R:

9. INTRODUCTION We can now say that the amount of discretionary funds to be raised (Ions equal to the scheduled flows plus the random term: The funding requirement on unusual days is then the scheduled requirement, plus the average for R, plus an additional two standard deviations of R: It is tempting to use this analysis with a higher multiple of the standard deviation to get to a higher level of confidence.

10. INTRODUCTION The analysis above give us the amount of funds that should be available to make payment one unusual day If we wish to be protected for an unusual period, we can make the bold assumption that cash flows from one day to the next are not correlated, and therefore can use the “square-root-of-T” approximation to the scale up the standard deviation from one day to multiple days:

11. INTRODUCTION Crisis Funding Requirements and Economic Capital By their nature, crises are rate, and there is little direct data to study. An alternative approach to measuring the risk in a cash crisis is to use two steps. First, estimate the possible funding 'requirement by modifying the model that we used above. Then go on to estimate how much value would be lost in such a crisis. This gives us an indication of the economic capital required to be held against funding-liquidity risks The times of greatest liquidity risk are those in which there is a general market crisis. In such a crisis, customers lose confidence in the bank, and other banks are not able or willing to lend. In this situation, the bank may disrupt its normal business to minimize semidiscretionary outflows of cash, such as buying new securities.

12. INTRODUCTION The bank will generally do everything it can to maximize its net cash available. It may also maximize the discretionary and semidiscretionary inflows The next step is to estimate how much value the bank could lose in such a crisis. The loss would arise from selling assets that are usually illiquid but have been discounted to "fire-sale" prices to get cash.. The estimate of the loss can be achieved by making a list of the bank's assets in the order in which they would be sold to generate cash. Then, for each asset, estimate the amount of “fire-sale” discount that would be required to sell it immediately. Table 14-1 illustrates such a compilation.

13. INTRODUCTION

14. If our analysis had shown that $13 billion of additional funds would be required in a crisis, then we would expect that we would need to sell all the cash, money-market instruments, and government bonds. This would indicate that $220 million of economic capital should be maintained to absorb this potential loss.

15. LIQUIDITY-RISK MANAGEMENT Borrow long-term funds in the interbank market or issue bonds. Then use the proceeds to buy liquid assets Establish contingent standby lines of credit with other- banks, whereby the bank providing the line of credit guarantees to give funds in a time of crisis. Establishing such a line can be expensive, especially if the bank providing the line sees that it is likely to be called when it is also in trouble. Limit the amount of funds that are lent for long maturities in the interbank market. Reduce the liquidity of the bank's liabilities. For example, the bank could promote fixed deposits instead of savings accounts, and it could encourage customers with short-term FDs to move to longer-term FDs.

16. LIQUIDITY-RISK MANAGEMENT It is also important that management should plan the optimal liquidation of the balance sheet for times of crisis. The funding desk should have a crisis-response plan prepared in advance so they know all the possible places in the bank that can either reduce their requirements for cash, get cash back if it has been lent or pledged, or ~e cash inflow. The plan for generating cash inflow should list the order in which securities will be sold to minimize the amount of discount required.