Transcript Managing Liquidity Risk: Preparing for Extreme Events Leonard Matz Copyright 2003 The Kamakura Corporation – Confidential Information.

Managing Liquidity Risk:
Preparing for
Extreme Events
Leonard Matz
Copyright 2003 The Kamakura Corporation – Confidential Information
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
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What’s Normal / Extreme ?
Market Risk ‘normally’ is about
‘Normal Scenarios’
 What is normal?
– Quantitative tools are applicable.
Liquidity Risk is concentrated in
“Extreme Scenarios’
 What is extreme? …
– There is no Canonical Answer
– Distinctions are derived from everyday life; however as no
consensus can be reached:
– They are meaningless in a quantitative context
Adapted from material developed by Dr. Robert E Fiedler.
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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.
10,000
8,000
6,000
4,000
2,000
0
-2,000
-4,000
-6,000
-8,000
Red lines indicate 2 SD
-10,000
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Measurement and Quantification Processes
Probability
Stress testing typically applies
statistical tools to provide more
information about the tail.
VaR
Extreme Value Theory
Other tools
Severity of loss
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Probability
Measurement and Quantification Processes
KEY ISSUE
We can’t apply the usual
statistical tools to liquidity risk
stress testing!
Severity of loss
Very few banks have had the unfortunate experience of a “near death”
experience.
Those that have don’t have any recent experience.
The tail in any one bank’s data simply doesn’t include the sorts of stress
experiences that keep liquidity risk managers awake.
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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
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Stress Testing Should Reflect Both Internal
and External Scenarios
•
•
•
•
Internal
Capital markets disruptions
Systemic shocks
Payment system disruptions
Prolonged global recession
External
•Credit losses
•Operational losses
•Problem merger or acquisition
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Stress Environments Affect Both Cash
Availability And Needs
 Cash availability:



asset liquidity
unused funding capacity
cost of borrowing
 Needs:



deposit withdrawal
undrawn credit facility drawdown
collateral pledging
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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
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Use At Least Three Scenarios
1. Normal course of business, including
any seasonal fluctuations:
 VaR Works here, but who cares?
This is not a stress scenario.
2. Bank specific funding crisis
3. Systemic liquidity crisis
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It is imperative to use
multiple degrees of
severity
(stress levels) for
each need scenario!
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Key Facts:
The amount of contingent liquidity risk
varies depending on the severity of
crisis.
Crises rarely occur instantaneously.
They usually develop in stages.
The duration of liquidity crises has
ranged from days to over a year.
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Stages of a Funding Crisis
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From Funding Liquidity Cash Flows to
Contingent Liquidity Stress Tests
Source: Dr. Michael Reuther
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Stress Test Process
Source: Dr. Michael Reuther
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Forecasting Cash Out-Flows
More than Just Contractual Claims
• Perception risk
• Surviving a liquidity crisis is not the
same as successful liquidation.
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Stress Test Process
Source: Dr. Michael Reuther
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Liquidity From Assets
Source: Dr. Michael Reuther
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Stress Test Process
Source: Dr. Michael Reuther
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Stress Tests Detail
Scenario
Economic Political
Stress Level
Cash Availability
Liquid Assets
Bills
Bonds
CP
Unused funding
capacity
Wholesale
Commercial
Retail
Market
Bank
Payments
Specific
1
1
1
1
2
92%
95%
96%
95%
90%
90%
99%
95%
97%
99%
98%
99%
99%
98%
99%
90%
96%
97%
70%
80%
90%
90%
95%
100%
0%
25%
50%
50%
75%
100%
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Stress Tests Detail
Scenario
Stress Level
Cash Need
Credit Drawdown
Risk
Wholesale
Commercial
Retail
Deposit Risk
Wholesale
Commercial
Retail
Collateral Risk
Payments
Derivatives
Economic
1
Political
1
Market
2
Bank
Specific
1
10%
5%
5%
15%
10%
5%
20%
15%
5%
5%
5%
0%
0%
0%
0%
10%
5%
0%
20%
10%
5%
10%
10%
0%
50%
30%
5%
0%
0%
0%
5%
5%
5%
5%
10%
5%
Source: Tom Bermingham
5%
10%
50%
0%
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Payments
1
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Should You Forecast Cash In-flows?
 If you are covering today’s risk with
tomorrow’s promises, you are masking
risk.
 But if you fail to include future cash in
flows, your projection is incomplete
and your forecasted quantity of
liquidity need is unrealistically large.
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Assumption Relevanancy
 Is the scenario relevant to your bank?
(e.g. foreign exposure, equity exposure, etc.)
 Is the scenario relevant to your balance
sheet? (e.g. core funding versus wholesale
funding)
 Is the scenario relevant to your
competitive environment? (e.g. ability to
generate new deposits)
 Does the scenario capture relationships
between changes in credit risk, interest
rate risk and liquidity risk
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Measurement is Not Management
 Evaluate stress tests to identify major
contributors to risk exposures. Requires
the ability to “drill down” into detail.
 Reduce risk exposures if possible.
(Topic for another day.)
 Combine stress testing and limits.
 Combine stress testing and liquidity
contingency planning.
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Liquidity Warehousing –
the Easy Stuff
NOT cash or interbank deposits
net funds sales, repos and borrowings –
BY TIME PERIOD & SCENARIO
unpledged, AFS investment securities
loans or portions of loans that can sold
quickly (government guaranteed, loan
sale channels, securitizations in process)
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Adding Liquid Assets –
What Do We Accomplish?
Liquid
Assets
Liquid
Assets
Volatile
Liabilities
Structural
Liquidity
Volatile
Liabilities
Structural
Liquidity
Deficit
Core
Assets
Deficit
Core
Funding
+
Equity
Core
Assets
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Core
Funding
+
Equity
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Liquid Assets Are Ideal, But …
No Bank Can Afford To
Hold Enough Liquid
Assets to Cover All
Contingent Needs in The
Worst Scenario at The
Highest Stress Level
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KEY ISSUE
Too little liquidity may kill the
bank suddenly but too much
can kill it slowly.
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Beyond Liquid Assets
• Loans can also provide liquidity value
– Mortgages as collateral for FHLB 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
In practice, it depends on
the scenario and stress level.
When is an asset liquid?
When is a liability volatile?
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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
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Most Common Contingency Plan
“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
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Wholesale Funds Providers Are Brutal
Arbiters of Creditworthiness
• Quickly recognize
potential problems
• Respond rapidly
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Segmenting the Propensity
to Withdraw Deposits
Insured or
Secured
Depositors'
Reliance On
Information
Depositors'
Relationship
With the
Bank
Overall
Assessment
of Stability
consumers
yes
low
high
high
small
business
in part
low
high
medium
large
commercial
no
medium
medium
low
banks
no
high
medium
medium
municipalities
yes
high
medium
high
capital
markets funds
providers
no
high
low
low
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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
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Diversification of Funding Sources
28%
20%
16%
15%
6%
Retail Deposits
Fiduciary
9%
4%
2%
Capital Markets
Small/Mid Cap
Deposits
CP-CD
Bank Deposits
Central Bank
Other Non-Bank
Deposits
Deposits
Should this bank reduce retail deposits and increase
fiduciary deposits to improve diversification?
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Applying Five Diversification Tools For
Wholesale Funding Sources
Product type
Counterpart
Deposit
Commercial
CD
bank
CP
Central

bank

Insurance

Investment
company
Corporates



Maturity
ON
1 month
3 months
6 months
12 months



Currency
EUR
USD
JPY
GBP



Region
Continental
Europe
Americas
London
Asia Pacific



Source: Michael Reuther, Deutsche Bank
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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.
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Wrapping Up
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Applying Stress Testing
Stress testing is not an end unto itself.
Results have to be used in the risk
management process.
Results should be carefully considered
when setting risk limits.
Contingency plans for actions such as
asset liquidations should be based on
stress test results.
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Four Essential Liquidity Management Tools
1. 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.
2. Extend liability terms to reduce liquidity risk.
3. Be prepared to enhance liquidity quickly at the first
signs of increased potential need.
4. Manage cash flow profiles.
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For More Information
LIQUIDITY RISK MANAGEMENT
and
SELF PACED A/L MANAGEMENT
published by: Sheshunoff Information Services,
Inc.
1-800-456-2340
www.sheshunoff.com
written by: Leonard Matz,
[email protected]
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