1Copyright 2003 The Kamakura Corporation – Confidential Information
Effective Liquidity Risk Measurement and Management
Leonard Matz
2Copyright 2003 The Kamakura Corporation – Confidential Information
Effective Liquidity Risk Measurement
Common liquidity metrics: strengths and weaknesses
Cash flow projections
Scenarios
3Copyright 2003 The Kamakura Corporation – Confidential Information
Loan to Deposit Ratio(South Africa)
110%
115%
120%
125%
130%
135%
140%
145%
1999 2000 2001 2002 2003
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The Venerable, Oft Quoted and Almost Meaningless Loan to
Deposit Ratio
• Assumes that all sources of funding other than deposits are stable
• Assumes that all deposits are unstable
• Assumes that all assets other than loans are completely liquid
• Assumes that all loans are completely illiquid
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Lots of Ratios Measure Relationships of Liquid,
Illiquid, Stable, and Volatile Balance Sheet Volumes
• Large liability dependence ratios
• Various ratios of liquid assets to
purchased funds
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Net Liquid AssetsBalance Sheet Liquidity Model
Illiquid
Volatile
Stable
LiquidNet Liquid
Assets
ASSETS LIABILITIES
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Traditional 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.
8Copyright 2003 The Kamakura Corporation – Confidential Information
Off Balance Sheet Items(South Africa)
0%
10%
20%
30%
40%
50%
ABSA 1994
SA banks1994
ABSA2003
SA banks2003
Other
Credit Card
IrrevocableLetters ofCredit
Unutilizedfacilities
IndemnitiesandGuarantees
9Copyright 2003 The Kamakura Corporation – Confidential Information
Off Balance Sheet Items
0
10
20
30
40
50
60
70
80
90
100
1992 1992 2002 2002
Loan Commitment Letters of Credit
All 11,462Commercial
Banks
2,790 Banks Assets
$100 Million to $1 Billion
3314 Banks Assets
$100 Million to $1 BillionAll 7888
Commercial Banks
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FOUR IMPARATIVES FOR MEASURING LIQUIDITY
1. The quantity of liquidity you have or can get MUST be related to the quantity of liquidity that you think you may need.
2. 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.
3. 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.
4. The quantity of liquidity available is scenario specific. Sources available in some scenarios are less available or unavailable in others.
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Liquidity 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".
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Rate 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.
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Week 1
Week 2
Week 3
Week 4
Month 2
Month 3
Months 4-6
Months 7-12
Customer Driven Volumes
Personal loans—closed end -49 -56 -51 -65 -211 -197 -657 -1,961
Personal loans—open end -16 -21 -17 -15 -7 -65 -149 -1,777
Business loans -904 673 125 346 -345 -804 2,812 5,709
Residential mortgage loans -87 98 81 -89 -361 -378 -1,033 -2,117
Other assets 0 0 0 0 0 0 0 0
Noninterest-bearing deposits
399 610 519 125 70 -184 -550 450
NOW accounts 529 525 472 266 50 -75 12 740
MMDAs 85 80 75 70 150 -235 600 1,200
Passbook savings 40 40 40 40 100 -50 0 200
Statement savings 50 55 60 50 150 -50 50 300
CDs under $100,000 220 270 230 335 -220 -300 425 1,800
J umbo CDs 5 200 -25 -55 0 -335 685 1,260
Net noninterest income -85 -85 -85 -85 -340 -340 -1,020 -1,940
Misc. and other liabilities 0 0 0 0 0 0 0 0
Sub-Total 187 2,389 1,424 923 -1,033 -3,013 1,175 3,864
Overnight 1,395 0 -1,345 -757 0 0 0 -1,100
Investment securities -1,582 -1,384 -79 34 733 313 1,052 -887
Federal funds purchased 0 0 0 0 300 2,200 -1,525 -1,077
Repos and other borrowings
0 -1,005 0 0 0 500 -502 0
Dividends 0 0 0 0 0 0 -200 -800
Sub-Total -187 -2,389 -1,424 -923 1,033 3,013 -1,175 -3,864
Net Cash Flows 0 0 0 0 0 0 0 0
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Cash Flow Time Profile
-300
-250
-200
-150
-100
-50
0
50
100
150
200
1 2 3 4 5 6
Time periods
Do
llars
Assets
Liabilities
Marginal gaps
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Problem: Both Cash Availability And Needs Are Highly
Correlated with Scenarios
Cash availability: asset liquidity unused funding capacity
Needs: deposit withdrawal undrawn credit facility drawdown collateral pledging
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BIS 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.
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KEY ISSUE
Scenarios 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.
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Factors Behind 29 Failures
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Systemic Crises – A Wide Variety
1987199019911992199419951997199819992000
20012002
U.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
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IMF 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 (1980-1995)
Source: Lingren, G.J., Garcia, and N. Saal, Banks Soundness and Macroeconomic Policy, Washington DC, IMF, 1996
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1. Normal course of business, including any seasonal fluctuations
2. Bank specific funding crisis
3. Systemic liquidity crisis
Use At Least Three Scenarios
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Scenarios Monitored By A Large International Bank
Market Risk
Emerging Markets
Systemic Shock
Global Prolonged Recession
Operational Risk
Merger & Acquisition
Downgrade to A1/P1 & A1/A+
Downgrade to A2/P2 & A3/A-
Ext
erna
lIn
tern
al
Scenario analysis
“Stress”
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Define Three Characteristics For
Each Scenario
Type: systemic or bank specific; local, national or international
Duration: short or long
Severity: mild or severe
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Scenario Results
• Determine total Liquidity Mismatch for each scenario
Balance sheet +54 +30 -22 -44Credit lines 0 0 -10 -10Collateral +30 +27 +26 +15
Gap -6 -39
Going Squeeze Specific General
Additional measures needed
Source: Bruce McLean, Forrest, UBS
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Effective Liquidity Risk Management
Management tactics
Limits, management and reporting
Stress testing
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Adding Liquid Assets – A Right Way and a Wrong Way
Core Assets
Liquid Assets
Volatile Liabilities
Core Funding
+ Equity
Structural Liquidity
Deficit
Core Assets
Liquid Assets
Volatile Liabilities
Core Funding
+ Equity
Structural Liquidity
Deficit
27Copyright 2003 The Kamakura Corporation – Confidential Information
Beyond Liquid Assets
• Loans can also provide liquidity value – Mortgages as collateral for 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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Asset Management: The Three Ss
• Syndication– Early warning system
– Pricing & participation %
– Recent credit concerns
• Securitization– All tangible bank assets can be securitized
– What about residuals & equity pieces?
• Sales
Source: Fred Poorman, BNK Analytics
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Asset Securitizations
““Picking only the low-Picking only the low-hanging fruit leaves a hanging fruit leaves a very illiquid balance very illiquid balance sheet remaining!”sheet remaining!”
Source: Carl Tannenbaum, ABN Ambro
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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
31Copyright 2003 The Kamakura Corporation – Confidential Information
By Far The Most Common Answer:
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
“Our Plan is Draw Down Our Committed Lines”
32Copyright 2003 The Kamakura Corporation – Confidential Information
Balance Sheet Trends(South Africa)
-50
50
150
250Mill
ion
s
Total Equity Retail DepositsGrowth in Loans Growth in InvestmentsGrowth in Other Assets
2000 2001 2002 2003
Change in Capital and Deposits
Change in Assets
33Copyright 2003 The Kamakura Corporation – Confidential Information
Balance Sheet Trends
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Total Equity Capital Retail Deposits Growth in Investments
Growth in Loans Growth in Other Assets
1996 1997 1998 1999 2000
Change in Assets
Change in Capital
and Deposits
2001 2002 2003
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Sometimes We Can Borrow. Sometimes Not.
Wholesale Funds Providers Are Brutal Arbiters of
Creditworthiness
• Quickly recognize potential problems
• Respond rapidly
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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.
36Copyright 2003 The Kamakura Corporation – Confidential Information
Estimating Stickiness
Fiduciary
Agent or
Owner
Insured
or Secur
ed
DepositorReliance
onInformati
on
Depositor’s
Relationship
with theBank
Stickiness
Estimate
consumers owner yes low high high
small business
owner in part low high medium
LargeCommercial
owner no medium medium low
Banks agent no high medium medium
Municipalities
agent in part high medium medium
money market
mutual funds
quasifiduciary
no high low low
37Copyright 2003 The Kamakura Corporation – Confidential Information
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
Sensitivity of Funds Providers By Type
38Copyright 2003 The Kamakura Corporation – Confidential Information
Managing Funding Sources
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.
Key Issue:
39Copyright 2003 The Kamakura Corporation – Confidential Information
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.
40Copyright 2003 The Kamakura Corporation – Confidential Information
Key Considerations for Setting Limits
1. Not so big as to be meaningless.
2. Within the bank’s risk tolerance: the cost of put test.
3. Adjusted for the “path to the exit”.
4. Must include a “cushion”.
41Copyright 2003 The Kamakura Corporation – Confidential Information
Setting 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?
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Liquidity 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 OrganizationsBasel Committee on Banking Supervision, Basel February 2000
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Limits, 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.
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Regulatory Approaches
Quantitative Mix Qualitative
Germany Austria Belgium Spain
Iceland Denmark Sweden
Finland
France
Greece
Ireland
Italy
Liechtenstein
Luxembourg
Netherlands
Norway
Portugal
UK
Source: Dr. Paul Baneke, De Nederlandsche Bank
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Management 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 topics
• Always monitor potential key triggers. LIQIDITY IS A CONSUQUENCIAL RISK
46Copyright 2003 The Kamakura Corporation – Confidential Information
A Reporting Dashboard (ratio of projected in-flows to out-flows)
Projected Net Cash Flows
Liquidity Scenario
0 - 30 days
31 - 60 days
61 - 90 days
91 - 180 days
Ordinary course of business 1.37
minimum 1.25
Bank specific crisis – level 1 1.21
minimum 1.20
Bank specific crisis – level 2 0.85
minimum 1.10
Systemic crisis – level 1
minimum
48Copyright 2003 The Kamakura Corporation – Confidential Information
Why Stress Test?
“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 OrganizationsBasel Committee on Banking Supervision, Basel February 2000
BIS Guidelines Require Stress Testing
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Why Stress Test?
Holding Liquidity is Not Free
– No 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.
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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
10,000
Red lines indicate 2 SD
52Copyright 2003 The Kamakura Corporation – Confidential Information
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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Measurement and Quantification Processes
Pro
babili
ty
Severity of loss
Stress testing typically appliesstatistical tools to provide moreinformation about the tail.
VaRExtreme Value TheoryOther tools
14
54Copyright 2003 The Kamakura Corporation – Confidential Information
Liquidity risk
is highly
idiosyncratic,
arbitrary and
inconsistent.
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For More Information
LIQUIDITY RISK LIQUIDITY RISK MANAGEMENTMANAGEMENT
and
SELF PACED A/L SELF PACED A/L MANAGEMENTMANAGEMENT
published by: Sheshunoff Information Services, Inc.
1-800-456-2340www.sheshunoff.com
written by: Leonard Matz, [email protected]