Liquidity and Treasury Risk Measurement and Management ...

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FRM PART II Liquidity and Treasury Risk Measurement and Management

（Foundation Class）

——— Gloria 陆

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Liquidity and Treasury Risk Measurement and Management

Chapter 1 Liquidity RiskChapter 2 Liquidity and LeverageChapter 3 Early Warning IndicatorsChapter 4 The Investment Function in Financial-Services ManagementChapter 5 Liquidity and Reserves Management: Strategies and Policies Chapter 6 Intraday Liquidity Risk Management Chapter 7 Monitoring LiquidityChapter 8 The Failure Mechanics of Dealer BanksChapter 9 Liquidity Stress TestingChapter 10 Liquidity Risk Reporting and Stress Testing Chapter 11 Contingency Funding Planning Chapter 12 Managing and Pricing Deposit ServicesChapter 13 Managing Nondeposit LiabilitiesChapter 14 Repurchase Agreements and FinancingChapter 15 Liquidity Transfer Pricing: A Guide to Better PracticeChapter 16 The US Dollar Shortage in Global Banking and the International Policy ResponseChapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency BasisChapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration TechniquesChapter 19 Illiquid Assets

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LIQUIDITY RISK

Liquidity Risk

‣ The credit crisis that started in the middle of 2007 has emphasized the importance of liquidity risk for both financial institutions and their regulators.

‣ It is important to distinguish solvency from liquidity. • Solvency refers to a company having more assets than liabilities, the value of its equity is

positive. • Liquidity refers to the ability of a company to make cash payments as they become due.• Financial institutions that are solvent can - and sometimes do - fail because of liquidity problems

‣ Consider a bank whose assets are mostly illiquid mortgages. Suppose the assets are financed 90% with deposits and 10% with equity. The bank is comfortably solvent. But it could fail if there is a run on deposits with 25% of depositors suddenly deciding to withdraw their funds.

‣ Liquidity is also an important consideration in trading. A liquid position in an asset is one that can be unwound at short notice. As the market for an asset becomes less liquid, traders are more likely to take losses because they face bigger bid - offer spreads.

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LIQUIDITY RISK

Liquidity Trading Risk‣ Shares and debt of companies in emerging markets are likely to be even less easy to

sell.‣ The price at which a particular asset can be sold depends on:

1.The mid-market price of The asset, or an estimate of its value2.How much of the asset is to be sold3.How quickly it is to be sold4.The economic environment

‣ The Importance of Transparency• One thing that the market has learned from the credit crisis of 2007 is that

transparency is important for liquidity. If the nature of an asset is uncertain, it is not likely to trade in a liquid market for very long.

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LIQUIDITY RISK

Liquidity Trading Risk

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LIQUIDITY AND LEVERAGE

Causes of Transactions Liquidity Risk ‣ In order to understand transactions liquidity risk, it is important to understand market microstructure

fundamentals. These fundamentals are:• Trade processing costs. The first cost is associated with finding a counterparty in a timely fashion.• Inventory management. Dealers provide trade immediacy to market participants. The dealer must

hold long or short inventories of assets and must be compensated by price concessions.• Adverse selection. There are informed and uninformed traders (知情和不知情的交易者). Dealers (交易

商) must differentiate between liquidity or noise traders and information traders. Information traders know if the price is wrong. Dealers do not know which of the two are attempting to trade and thus must be compensated for this lemons risk (指在交易中隐藏信息的一方对交易另一方利益产生损害的风险) through the bid-ask spread.

• Differences of opinion. It is more difficult to find a counterparty when market participants agree (e.g., the recent financial crisis where counterparties were afraid to trade with banks because everyone agreed there were serious problems) than when they disagree. Investors generally disagree about the correct or true price on an asset and about how to interpret new information about specific assets.

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Measure Market Liquidity

‣ Factors such as tightness, depth, and resiliency are characteristics used to measure market liquidity.• Tightness (or width) refers to the cost of a round-trip transaction, measured by the bid-ask

spread and brokers' commissions. The narrower the spread, the tighter it is. The tighter it is, the greater the liquidity.

• Depth describes how large an order must be to move the price adversely. In other words, can the market absorb the sale? The market can likely absorb a sale by an individual investor without an adverse price impact. However, if a large institution sells, it will likely adversely impact the price.

• Resiliency refers to the length of time it takes lumpy orders to move the market away from the equilibrium price. In other words, what is the ability of the market to bounce back from temporary incorrect prices?

‣ Both depth and resiliency affect how quickly a market participant can execute a transaction.

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Example Ø Recent financial crises have emphasized the importance of a robust financial system that is able to

absorb sudden and severe changes in market liquidity. To help firms measure and monitor changes in liquidity, a set of liquidity metrics, or dimensions, has been introduced. Which of the following correctly describes the corresponding liquidity dimension?

A. Market depth will decline as the number of market participants increases and will increase as trading volumes in the market decrease

B. In less liquid exchange-traded markets, dealers can improve the immediacy of the market by providing quotes to buy and sell assets on a continuous basis.

C. The resilience of the commodity markets can be determined by separating the commodities into different asset classes and then comparing the liquidity across these asset classes.

D. In over-the-counter markets for derivatives, both depth and tightness will generally be higher than in exchange-traded markets.

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LIQUIDITY RISK

Measuring Market Liquidity

‣ One measure of the market liquidity of an asset is its bid-offer spread. This can be measured either as a dollar amount or as a proportion of the asset price. The dollar bid-offer spread is

p = Offer price − Bid price‣ The proportional bid-offer spread for an asset is defined as

s = Offer price − Bid priceMid-market price

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LIQUIDITY RISK

Cost of Liquidation

‣ Cost of liquidation (normal market conditions)

‣ n: The number of positions; Note that although diversification reduces market risk, it does not necessarily reduce liquidity trading risk.

‣ si: Estimate of the proportional bid-offer spread for the ith instrument.

‣ � i, is the dollar value of the position in the instrument.

si� i

2Cost of liquidation (normal market) = Σ n

i=1

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LIQUIDITY RISK

Example

‣ Suppose that a financial institution has bought 10 million shares of one company and 50 million ounces of a commodity.

‣ The shares are bid $89.5, offer $90.5. The commodity is bid $15, offer $15.1. ‣ The mid-market value of the position in the shares is 90 × 10 = $900 million. ‣ The mid-market value of the position in the commodity is 15.05 × 50 = $752. 50

million. ‣ The proportional bid-offer spread for the shares is 1/90 or 0.01111. ‣ The proportional bid-offer spread for the commodity is 0.1/15.05 or 0.006645. ‣ The cost of liquidation in a normal market is: 900 × 0.01111/2 + 752.5 × 0.006645/2 = 7.5 or $7.5 million.

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LIQUIDITY RISK

Example

An investor holds two positions:‣ Short shares worth $10,000 where the proportional bid-offer spread is 0.030, and‣ Long shares worth $17,000 where the proportional bid-offer spread is 0.040What is the approximate cost to the investor to unwind this two-position portfolio?A. $490.00B. $750.00C. $980.00D. $1,300.00

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LIQUIDITY RISK

Cost of liquidation

‣ Cost of liquidation (stressed market conditions)

‣ � i and � i is the mean and standard deviation of the proportional bid-offer spread for the ith instrument;

‣ λ: Required confidence parameter for the spread. If, for example, we are interested in considering “worst case” spreads that are exceeded only 1% of the time, and if it is assumed that spreads are normally distributed, then λ = 2.326.

(� i + � � i)� i

2Cost of liquidation (stressed market) = Σ n

i=1

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LIQUIDITY RISK

Example

‣ Suppose that in Example 1.1 the mean and standard deviation for the bid-offer spread for the shares are $1.0 and $2.0, respectively. Suppose further that the mean and standard deviation for the bid-offer spread for the commodity are both $0.1.

‣ The mean and standard deviation for the proportional bid-offer spread for the shares are 0.01111 and 0.02222, respectively. The mean and standard deviation for the proportional bid-offer spread for the commodity are both 0.006645.

‣ Assuming the spreads are normally distributed, the cost of liquidation that we are 99% confident will not be exceeded is

0.5 × 900 × (0.01111 + 2.326 × 0.02222) + 0.5 × 752.5 × (0.006645 + 2.326 × 0.006645) = 36.58 or $36. 58 million.

This is almost five times the cost of liquidation in normal market conditions.

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LIQUIDITY RISK

Liquidity-Adjusted VaR

‣ Normal market conditions

‣ Stressed market conditions

si� i

2Liquidity-Adjusted VaR = VaR + Σ n

i=1

Liquidity-Adjusted VaR = VaR + Σ n

i=1

(� i + � � i)� i

2

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Adjusting VaR for Position Liquidity

‣ Adjusting VaR for liquidity requires an estimate of the number of days it will take to liquidate a position. The number of trading days is typically denoted T. Assuming the position can be divided into equal parts across the number of trading days and liquidated at the end of each trading day, a trader would face a 1-day holding period on the entire position, a 2-day holding period on a fraction (T − 1) / T of the position, a 3-day holding period on a fraction (T − 2) / T of the position, and so on. The 1-day position VaR adjusted by the square root of time is estimated for a given position as:

‣ However, this formula overstates VaR for positions that are liquidated over time because it assumes that the whole position is held for T days. To adjust for the fact that the position could be liquidated over a period of days, the following formula can be used:

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LIQUIDITY RISK

Liquidity Funding Risk

‣ Liquidity funding risk is the financial institution's ability to meet its cash needs as they arise.

‣ Financial institutions that are solvent (i. e., have positive equity) can, and sometimes do, fail because of liquidity problems.

‣ Liquidity funding problems at a financial institution can be caused by:① Liquidity stresses in the economy (e.g., a flight to quality such as that seen

during the 2007 to 2009 crisis).② Overly aggressive funding decisions. There is a tendency for all financial

institutions to use short-term instruments to fund long-term needs, creating a liquidity mismatch.

③ A poor financial performance, leading to a lack of confidence. This can result in a loss of deposits and difficulties in rolling over funding.

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LIQUIDITY RISK

Liquidity Funding Risk

‣ The main sources of liquidity for a financial institution are:1.Holdings of cash and Treasury securities 2.The ability to liquidate trading book positions 3.The ability to borrow money at short notice 4.The ability to offer favorable terms to attract retail and wholesale deposits at

short notice 5.The ability to securitize assets (such as loans) at short notice 6.Borrowings from the central bank

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LIQUIDITY RISK

Lessons learned from NORTHERN ROCK (北岩银行)

‣ Northern Rock, a British bank, was founded in 1997 was one of the top five mortgage lenders in the United Kingdom.‣ Northern Rock relied on selling short-term debt instruments for much of its funding. Following the subprime crisis of

August 2007, the bank found it very difficult to replace maturing instruments because institutional investors became very nervous about lending to banks that were heavily involved in the mortgage business. The banks assets were sufficient to cover its liabilities so it was not insolvent. But Northern Rock's inability to fund itself was a serious problem.

‣ On September 13, 2007, the BBC business editor Robert Peston broke the news that the bank had requested emergency support from the Bank of England. On Friday, September 14, there was a run on the bank. Thousands of people lined up for hours to withdraw their funds. This was the first run on a British bank in 150 years.

‣ During the months following September 12, 2007, Northern Rock 's emergency borrowing requirement increased. Northern Rock raised some funds by selling assets, but by February 2008 the emergency borrowing reached £25 billion. The bank was then nationalized and the management of the bank was changed.

‣ The Northern Rock story illustrates just how quickly liquidity problems can lead to a bank spiraling downward. If the bank had been managed a little more conservatively and had paid more attention to ensuring that it had access to funding, it might have survived.

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LIQUIDITY RISK

Lessons learned from ASHANTI GOLDFIELDS (加纳阿散蒂金矿公司)

‣ Ashanti Goldfields, a West African gold -mining company based in Ghana, experienced problems resulting from its hedging program in 1999. It had sought to protect its shareholders from gold price declines by selling gold forward.

‣ On September 26, 1999, 15 European central banks surprised the market with an announcement that they would limit their gold sales over the following five years.

‣ The price of gold jumped up over 25%. Ashanti Was unable to meet margin calls and this resulted in a major restructuring, which included the sale of a mine, a dilution of the interest of its equity shareholders, and a restructuring of its hedge positions.

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LIQUIDITY RISK

Lessons learned from METALLGESELLSCHAFT (德国金属公司)

‣ In the early 1990s, Metallgesellschan: (MG) sold a huge volume of 5- to 10-year heating oil and gasoline fixed-price supply contracts to its customers at six to eight cents above market prices. It hedged its exposure with long positions in short-dated futures contracts that were rolled forward.

‣ As it turned out, the price of oil fell and there were margin calls on the futures positions. MG 's trading was made more difficult by the fact that its trades were very large and were anticipated by others.

‣ Considerable short-term cash flow pressures were placed on MG. The members of MG who devised the hedging strategy argued that these short-term cash outflows were offset by positive cash flows that would ultimately be realized on the long-term fixed-price contracts.

‣ However, the company's senior management and its bankers became concerned about the huge cash drain. As a result, the company closed out all the hedge positions and agreed with its customers that the fixed-price contracts would be abandoned. The outcome was a loss to MG of $1.33 billion.

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LIQUIDITY RISK

Regulation (监管要求)

‣ Basel III introduced two liquidity risk requirements: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

① The LCR requirement is:

② The NSFR requirement is:

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LIQUIDITY RISK

BIS Principles For Sound Liquidity Risk Management

1. A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity.

2. A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.

3. Senior management should develop a strategy, policies, and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity.

4. A bank should incorporate liquidity costs, benefits, and risks in the internal pricing, performance measurement, and new product approval process for all significant business activities. thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.

5. A bank should have a sound process for identifying measuring, monitoring, and controlling liquidity risk.6. A bank should actively monitor and control liquidity risk exposures and funding needs within and across

legal entities, business lines and currencies, taking into account legal, regulatory, and operational limitations to the transfer ability of liquidity.

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LIQUIDITY RISK


7. A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding.

8. A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.

9. A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets.

10. A bank should conduct stress tests on A regular basis for a variety of short - term and protracted institution - specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank's established liquidity risk tolerance.

11. A bank should have A formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations.

12. A bank should maintain A cushion of unencumbered, high quality liquid assets to be held as insurance against A range of liquidity stress scenarios, Including those that involve the loss or impairment of unsecured and typically available secured funding sources.

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LIQUIDITY RISK


13. A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position

Recommendations for banks supervisors are:14. Supervisors should regularly perform a comprehensive assessment of a bank's overall liquidity risk

management framework and liquidity position to determine whether they deliver an adequate level of information Resilience to liquidity stress given the bank 's role in the financial system

15. Supervisors should supplement their regular assessments of a bank's liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports, And market information

16. Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position

17. Supervisors should communicate with other Supervisors and public authorities, such as central banks , both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management.

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LIQUIDITY RISK

Liquidity Black Hole (流动性黑洞)

‣ A liquidity black hole describes a situation where liquidity has dried up in a particular market because everyone wants to sell and no one wants to buy, or vice versa. It is sometimes also referred to as a "crowded exit".

‣ In a well-functioning market, the market may change its opinion about the price of an asset because of new information. However, the price does not overreact.

‣ If a price decrease is too great, traders will quickly move in and buy the asset and a new equilibrium price will be republished. A liquidity black hole is created when a price decline causes more market participants to want to sell, driving prices well below where they will eventually settle. During the sell-off, liquidity dries up and the asset can be sold only at a fire-sale price.

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LIQUIDITY RISK

Positive and Negative Feedback Traders

‣ Changes on the liquidity of financial markets are driven by the behavior of traders. There are two sorts of traders in the market: negative feedback traders and positive feedback traders. Negative feedback traders buy when prices fall and sell when prices rise; positive feedback traders sell when prices fall and buy when prices rise (追涨杀跌).

‣ In liquid markets, negative feedback traders dominate the trading. Negative feedback restores the price to a more reasonable level. The result is that the market is liquid with reasonable prices and a balance of buyers and sellers.

‣ When positive feedback traders dominate the trading. Market prices are liable to be unstable and the market may become one-sided and illiquid.

‣ There are a number of reasons why positive feedback trading exist, for example:1. Trend trading. Trend traders attempt to identify trends in an asset price. They buy when the asset price

appears to be trending up and sell when it appears to be trending down.2. Stop loss rules. Traders often have rules to limit their losses. When the price of an asset that is owned

falls below a certain level, they automatically sell to limit their losses.3. Dynamic hedging. Hedging a short option position(call or put) involves buying after a price rise and

selling after a price decline. This is positive feedback trading that has the potential to reduce liquidity.

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LIQUIDITY RISK

Positive and Negative Feedback Traders

4. Creating options synthetically. Hedging a short position in an option is equivalent to creating a long position in the same option synthetically. It follows that a financial institution can create a long option position synthetically by doing the same sort of trading as it would do if it were hedging a short option position. This leads to positive feedback trading that can cause market instability and illiquidity.

5. Margins. A big movement in market variables, particularly for traders who are highly leveraged, may lead to margin calls that cannot be met. This forces traders to dose out their positions, which reinforces the underlying move in the market variables.

6. Predatory trading(掠夺性交易). If traders know that an investor must sell large quantities of a certain asset. they know that the price of the asset is likely to decrease. They therefore short the asset. This reinforces the price decline and results in the price falling even further than it would otherwise do. To avoid predatory trading, large positions must usually be unwound slowly.

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Sources of Liquidity Risk

‣ Liquidity has two essential properties, which relate to two essential forms of risk. • Transactions liquidity deals with financial assets and financial markets. • Funding liquidity is related to an individual’s or firm’s creditworthiness.

‣ Risks associated with liquidity include:• Transaction liquidity risk is the risk that the act of buying or selling an asset will result in an adverse

price move.• Funding liquidity risk or balance sheet risk results when a borrower’s credit position is either

deteriorating or is perceived by market participants to be deteriorating. Balance sheet risks are higher when borrowers fund longer term assets with shorter term liabilities. This is called a maturity mismatch.

• Systemic risk is the risk that the overall financial system is impaired due to severe financial stress.

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Example

Ø Jackson Grimes, a trader for Glenn Funds, works on the repurchase agreement (repo) desk at his firm. Markets have been highly volatile but Glenn Funds has a large capital base and is sound. Grimes reports to the CEO that in the last month, the firm Glenn Funds borrows from has been consistently increasing collateral requirements to roll over repos. From the perspective of Glenn Funds, this represents:

A. Systematic risk.

B. Transactions liquidity risk.

C. Balance sheet risk.

D. Maturity transformation risk.

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Liquidity Transformation by Banks

‣ Banks engage in asset-liability management (ALM). This is a technique for aligning available cash and short-term assets with expected requirements. a well-managed bank leaves an ample buffer of cash and highly liquid assets for unexpected redemptions of deposits and other funding.

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Systematic Funding Liquidity Risk

‣ Systematic funding risks were apparent in many market sectors during the subprime mortgage crisis. As loans become shorter term, lenders and borrowers are exposed to greater liquidity risks. Borrowers must be able to refinance in order to repay short-term loans. The risk is systematic in that it affects borrowers and lenders at the same time.

‣ Liquidity issues arose during the recent financial crisis for a variety of investment strategies including:① Leveraged buyouts (LBOs): Leveraged loans became the dominate type of syndicated bank loans

(银团贷款) as LBOs and private equity grew before the crisis. Leveraged loans accounted for a large part of collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs), which provided funding for LBOs. During the subprime mortgage crisis, LBO deals fell apart as funding dried up.

② Merger arbitrage hedge funds: Merger arbitrage hedge funds. Hedge funds engaged in merger arbitrage experienced losses in the early stages of the subprime mortgage crisis. After a merger is announced, the target’s stock price typically increases and the acquirer’s price sometimes declines due to increased debt. The merger arbitrage strategy exploits the difference between the current and announced acquisition prices. Hedge funds experienced large losses as mergers were abandoned when financing dried up.

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Systematic Funding Liquidity Risk

③ Convertible arbitrage hedge funds. Convertible arbitrage strategies rely on leverage to enhance returns. When financing becomes unavailable due to market conditions, as experienced in the 2007–2009 financial crisis, convertible bond values drop precipitously. The funding liquidity problem was compounded by redemptions.

‣ Money market mutual fund (MMMF): In general, underlying MMMF assets are high credit quality instruments with short maturities (e.g., a few weeks to a few months). However, the values of the underlying assets in the fund, despite their relative safety, are subject to change.

‣ MMMFs use a form of accounting called the amortized cost method, under the Securities and Exchange Commission’s (SEC) Rule 2a−7. This means that MMMF assets do not have to be marked-to-market each day, as required for other types of mutual funds. The reason behind the difference is that extremely short-term securities are not likely to revalue based on changes in interest rates and credit spreads. MMMFs set a notional value of each share equal to $1.00. However, credit write-downs cannot be disregarded and it is possible for net asset values (NAVs) to fall below $1.00. This is known as breaking the buck (跌破面值).

‣ Liquidity risk can also cause NAVs to fall below $1.00. MMMFs, like depository institutions, are subject to runs. If a large proportion of investors try to redeem shares in adverse market conditions, the fund may be forced to sell money market paper at a loss.

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Example

ØWith respect to the valuation of money market mutual fund (MMMF) assets, funds:

A.are not required to mark-to-market the underlying assets daily.B.must reflect changes in the values of underlying assets that are the result of

changes in credit risks but may ignore value changes that are the result of changes in interest rates.

C.will set the notional values of each of the underlying assets equal to $1.00.D.are not allowed to invest in any asset with a rating below AAA because asset

values must not fluctuate outside of a 10% range around the historical value in order to keep the notional value equal to $1.00.

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Economics of The Collateral Market

‣ Collateral markets have two important purposes. First, they enhance the ability of firms to borrow money. Second, collateral markets make it possible to establish short positions in securities.

‣ The full value of the securities is not lent in a collateralized loan. The difference is called a haircut (垫头). For example, a lender may be willing to lend $95 against $100 of collateral.

‣ Collateral values fluctuate and most collateralized borrowing arrangements require that variation margin be paid to make up the difference (called remargining).

‣ The securities pledged to one firm are often loaned or pledged again, hence the collateral circulates. This process is known as rehypothecation or repledging.

‣ Markets for collateral take the following forms:① Margin loans: The margin loan is collateralized by the security.② Repurchase agreements or repos③ Securities lending (证券借贷): Securities lending involves the loan of securities to another party in exchange

for a fee, called a rebate. The lender of the securities continues to receive the dividends and interest cash flows from the securities. Lenders of securities are often hedge funds or other large institutional investors of equities. (借券人必须向债权人提供担保或抵押品)

④ Total return swaps: In a total return swap (TRS), one party pays a fixed fee in exchange for the total return (both income and capital gains) on a reference asset, typically a stock.

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Leverage Ratio and Leverage Effect

‣ A firm’s leverage ratio is equal to its assets divided by equity (total assets / equity). That is:

‣ Return on equity (ROE) is higher as leverage increases, as long as the firm’s return on assets (ROA) exceeds the cost of borrowing funds. This is called the leverage effect. The leverage effect can be expressed as:

rE = L×rA − (L − 1) × rD

‣ The effect of increasing leverage is rA − rD

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ØCharleston Funds intends to use leverage to increase the returns on a convertible arbitrage strategy. The return on assets (ROA) of the strategy is 8%. The fund has $1,000 invested in the strategy and will finance the investment with 75% borrowed funds. The cost of borrowing is 4%. The return on equity (ROE) is closest to:

A. 4%.

B. 32%.

C. 20%.

D. 12%.

Example

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‣ Purchasing stock on margin or issuing bonds are examples of using leverage explicitly to increase returns. However, there are other transactions that have implicit leverage. It is important to understand the embedded leverage in short positions and derivatives, such as options and swaps. By constructing economic balance sheets for investors and/or firms, it is possible to measure the implicit leverage of these transactions.

1. Margin Loans and Leverage2. Short Positions and Leverage3. Derivatives and Leverage

Explicitly and Implicit Leverage

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Margin Loans and Leverage

Ø First, assume that a firm has $100 cash invested by the owners (i.e., no borrowed funds) The balance sheet in this case is:

• If the firm uses the cash to purchase stock, the balance sheet is:

• Thus, the leverage ratio is equal to 1(i.e.,$100/$100 or 1.0/1.0)

Assets Liabilities and EquityDebt $0

Cash $100 Equity $100Total assets $100 TL and OE $100

Assets Liabilities and EquityDebt $0

Stock $100 Equity $100Total assets $100 TL and OE $100

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Margin Loans and Leverage

Ø Next, assume that a the firm uses 50% borrowed funds and invests 50% equity to buy shares of stock. Immediately following the trade, the margin account balance sheet has 50% equity and a $50 margin loan from the broker. That is:

• The full economic balance sheet as a result of the borrowed funds (remember, owners put in $100 of equity initially so the firm now has $100 of stock and $50 of cash) is:

• Thus, the leverage ratio increased to 1.5 (i.e.,$150/$100 or 1/0.667). Note that the broker retains custody of the stock to use as collateral for the loan.

Assets Liabilities and EquityMargin loan $50

Stock $100 Equity $50Total assets $100 TL and OE $100

Assets Liabilities and EquityCash $50 Margin loan $50Stock $100 Equity $100

Total assets $150 TL and OE $150

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Example

ØAssume a broker provides a margin loan to a U.S. hedge fund that puts up the minimum equity amount (50%) required by the Federal Reserve. If the hedge fund wants to take a $250,000 total position, determine the margin loan amount and the leverage ratio of this position.

A. Margin loan = $125,000; leverage ratio = 1.0B. Margin loan = $125,000; leverage ratio = 2.0C. Margin loan = $250,000; leverage ratio = 0.0D. Margin loan = $250,000; leverage ratio = 1.0

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Funding Liquidity Risk Management

‣ Redemption requests, especially in times of market stress, may require hedge fund managers to unwind positions rapidly, exposing the fund to transactions liquidity risk. If this happens to many funds at once, fire sales (大甩卖) may result. Hedge funds manage liquidity via:• Cash. Cash can be held in money market accounts or Treasury bills and unencumbered liquidity. Cash is not

wholly without risk, however, because money market funds may suspend redemptions in times of stress or crisis, and broker balances are at risk if the broker fails.

• Unpledged assets (未抵押资产). Unpledged assets, also called assets in the box, are assets not currently being used as collateral. They are often held with a broker. Price volatility of the assets affects their liquidity. Only Treasury securities, and more specifically Treasury bills, may be used as collateral during a financial crisis. Even government agency securities were not sufficient collateral during the 2007–2009 financial crisis. Unpledged assets can be sold, rather than pledged, to generate liquidity. However, in times of market stress, asset prices are often significantly depressed.

• Unused borrowing capacity. This is not an unfettered (不受限制的) source of liquidity as unused borrowing capacity can be revoked (取消) by counterparties by raising haircuts or declining to accept pledged assets as collateral when it is time to rollover the loan. These loans are typically very short term and credit can, as it did during the 2007–2009 financial crisis, disappear quickly.

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45

EARLY WARNING INDICATORS

Early Warning Indicators

‣ As an integral part of liquidity risk management (LRM), bank leadership has the responsibility to both identify and manage underlying liquidity risk factors. One of the critical aspects of a bank’s LRM involves first devising (设计) and then monitoring a set of indicators to enable the risk identification process to spot the emergence of new or increasing vulnerabilities. Negative trends serve as early indicators may warrant (保证，

授权) an assessment and also a potential response by management in order to mitigate a bank’s exposure to any emerging risk.

‣ The global financial crisis of 2007-08 has put the spotlight (聚光灯) on LRM . The Basel Committee on Banking Supervision (BCBS) issued its “Principles of Sound Liquidity Management and Supervision” in September 2008, followed closely by details on standardized metrics such as the LCR and the Net Stable Funding Ratio (NSFR). This overarching (包罗万象的) framework includes the use of EWIs.

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BCBS Recommended EWIs 1. Rapid asset growth, especially when funded with potentially volatile liabilities2. Growing concentrations in asset or liabilities3. Increases in currency mismatches4. Decrease of weighted average maturity of liabilities5. Repeated incidents of positions approaching or breaching internal or regulatory limits6. Negative trends or heightened (增强的) risk associated with a particular product line7. Significant deterioration in the bank’s financial condition8. Negative publicity (负面报道)9. Credit rating downgrade10.Stock price declines11.Rising debt costs12.Widening debt/credit-default-swap spreads13.Rising wholesale/retail funding costs14.Counterparties requesting additional collateral or resisting (抵制，阻止) entering into new transactions15.Drop in credit lines (信用额度下降)16.Increasing retail deposit outflows17.Increasing redemptions of CDs before maturity18.Difficulty accessing longer-term funding19.Difficulty placing short-term liabilities (短期负债难以承担)

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Key Supervisory Guidelines

OCC-20121 BCBS-20082

‣ A bank should have EWls that signal whether embedded triggers in certain products (i. e., callable public debt, OTC derivatives transactions) are about to be breached, or whether contingent risks are likely to materialize

‣ Early recognition of a potential event allows a bank to enhance a bank's readiness (准备就绪). EWl's may include:

• A reluctance of traditional fund providers to continue funding at historic levels

• Pending regulatory action (未决监管行动) or CAMELS component or composite rating downgrade(s)

• Widening of spreads on senior and subordinated debts, credit default swaps, and stock price declines

• Difficulty in accessing long-term debt markets • Reluctance of trust managers, money managers, public entities, and

credit-sensitive funds providers to place funds • Rising funding costs in an otherwise-stable market • Counterparty resistance to off-balance-sheet products or increased

margin requirements • The elimination of committed credit lines by counterparties

‣ A bank should design a set of indicators to identify the emergence of increased risk or vulnerabilities in its liquidity risk position or potential funding needs

‣ Early warning indicators can be qualitative or quantitative in nature and may include but are not limited to

• Rapid asset growth, especially when funded with potentially volatile liabilities

• Growing concentrations in assets or liabilities • Increases in currency mismatches • Decrease of weighted average maturity of

liabilities • Repeated incidents of positions approaching or

breaching internal or regulatory limits • Negative trends or heightened risk associated

with a particular product line

CAMELS: “骆驼”评级法。五项考核指标，即资本充足性(Capital Adequacy)、资产质量(Asset Quality)、管理水平(Management)、盈利状况(Earnings) 和流动性 (Liquidity)

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Key Supervisory Guidelines

BCBS-20123 SR 10-64

‣ Intraday liquidity monitoring indicators include:

• Daily maximum liquidity requirement • Available intraday liquidity • Total payments• Time-specific and other critical

obligations • Value of customer payments made on

behalf of financial institutions customers (代表金融机构客户支付的客户款项价值)

• Intraday credit lines extended to financial institution customers

• Timing of intraday payments • Intraday throughput (每日吞吐量)

‣ Institution management should monitor for potential liquidity stress events by using early-warning indicators and event triggers. The institution should tailor these indicators to its specific liquidity risk profile.

‣ Early recognition of potential events allows the institution to position itself into progressive states of readiness as the event evolves, while providing a framework to report or communicate within the institution and to outside parties.

‣ Early-warning signals may include, but are not limited to:• Negative publicity concerning an asset class owned by the

institution • Increased potential for deterioration in the institution's financial

condition • Widening debt or credit default swap spreads • Increased concerns over the funding of off-balance-sheet items

1: OCC: liquidity booklet of the OCC‘s comptroller’s handbook (货币监理署主计长流动性手册)2: BCBS: Basel Committee in Banking Supervision, “Principles for Sound Liquidity Risk Management and Supervision” (2008)3: BCBS: Basel Committee in Banking Supervision, “Monitoring Indicators for Intraday Liquidity” (2012)4: Interagency Policy Statement on Funding and Liquidity Risk Management (2010) (资金与流动性风险管理政策的联合声明)

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Framework Components: M. E.R. I.T.

‣ The EWI framework can be summarized as M. E.R I.T (Measures, Escalation (升级), Reporting, Integrated systems, and Thresholds). While an appropriate set of measures is the first essential building block for robust EWI framework, it will be mere academic exercise if the framework is eventually not linked to escalation processes. The journey from measures to escalation is facilitated by timely reporting with the support of integrated systems and data as well as relevant and property calibrated thresholds.

1. Measures• Principle 5 from the BCBS’ Sound Principles articulates the hallmarks of EWIs. The principle states that “to

obtain a forward looking view of liquidity risk exposures, a bank should use metrics that assess (a) the structure of the balance sheet as well as metrics that (b) project cash flows and future liquidity positions, taking into account (c) off-balance sheet risks”.

2. Escalation• Although escalation criteria are bespoke (定制的) to a bank, an effective escalation policy should ensure that

limit breaches are escalated to the appropriate level of management with the authority to undertake corrective actions. Modest responses such as increasing the liquid asset buffer may usually be done within the delegation of the corporate treasurer; however, an EWI that signals a potentially large cash outflow may require the asset-liability committee (ALCO) to authorize a check on future asset growth. The most extreme cases may require management to initiate the bank’s contingency funding plan (CFP).

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Framework Components: M. E.R. I.T.

3. Reporting • EWI reporting needs to be timely in order to provide management with sufficient lead time to make

adjustments in response to potential crisis events. It is common practice to have the EWI dashboard reported on a daily basis. While most institutions perform some level of daily liquidity reporting, leading institutions are moving toward intraday reporting of certain measure.

• Reporting also needs to strike a balance between being (a) broad enough to provide wide coverage, and (b) specific enough to communicate only key messages.

4. Integrated Systems• Integrated data and systems within the bank are essential in providing liquidity managers with the

capability to ensure that reported metrics are (a) accurate, and (b) in sync with each other.5. Thresholds

• Firms generally use a stoplight system (刹车灯系统) in representing and communicating their performance against the thresholds of their EWIs. A green indicator means that the measure is within normal bounds. A measure that is classified as amber (黄褐色) according to the threshold framework should be investigated further while a red indicator should be a source for significant concern and may warrant an immediate response.

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THE INVESTMENT FUNCTION IN FINANCIAL-SERVICES MANAGEMENT

Investment Instruments Available to Financial Firms

‣ The number of financial instruments available for financial institutions to add to their portfolios is both large and growing. Moreover, each financial instrument has different characteristics with regard to expected yields, risk, sensitivity to inflation, and sensitivity to shifting government policies and economic conditions.

‣ To examine the different investment vehicles available, it is useful to divide them into two broad groups :

‣ (1) money market instruments, which reach maturity with in one year and are noted for their low risk and ready marketability and;

‣ (2) capital market Instruments, which have remaining maturities beyond one year and are generally noted for their higher expected rate or return and capital gains potential.

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Investment Instruments Available to Financial Firms

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Popular Money Market Investment Instruments

1. Treasury Bills: a debt obligation of the United States government that, by law, must mature within one year from date of issue.

2. Short-Term Treasury Notes and Bonds: have relatively long original maturities: 1 to 10 years for bonds.3. Federal Agency Securities: Marketable notes and bonds sold by agencies owned by or sponsored by the

federal government. (Securities issued by corporations and agencies created by the US government, such as the Federal Home Loan Bank Board and Ginnie Mae.)

4. Certificates of Deposit(CD): Is simply an interest-bearing receipt for the deposit of funds in a depository institution.

5. International Eurocurrency Deposits: Are time deposits of fixed maturity issued in million-dollar units by the world's largest bank.

6. Bankers' Acceptances (银行承兑汇票): Represent a bank's promise to pay the holder a designated amount of money on a designated future date.

7. Commercial Paper: is an unsecured note that is sold by only the most creditworthy firms.8. Short-Term Municipal Obligations: State and local government issue a variety of short term debt

instruments to cover temporary shortages.

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Key Advantages and Disadvantages

Treasury Bills Short-Term Treasury Notes and Bonds Federal Agency Securities Certificates of Deposit

Key advantages

Safety and high liquidity Good collateral for borrowing Can pledge behind government deposits (可以用政府存款作抵押)

Safety Good resale market Good collateral for borrowing Offer yields usually higher than T-bill yields

Safety Good to average resale market Good collateral for borrowing Higher yields than on U.S. government securities

Insured to at least $100,000Yields higher than on T-billsLarge denominations often marketable through dealers

Key disadvantages

Low yields relative to other financial instruments Taxable income

More price risk than T-bills Taxable gains and income

Less marketable than Treasury securities Taxable gains and income

Limited resale market on longer-term CDsTaxable income

International Eurocurrency Deposits Bankers’ Acceptances Commercial Paper

Short-Term Municipal

ObligationsLow risk Higher yields then on many domestic CDs

Low risk due to multiple credit guarantees

Low risk due to high quality of borrowers

Tax-exempt interest income

Volatile interest rate Taxable income

Limited availability at specific maturities Issued in odd denominations Taxable income

Volatile market Poor resale market Taxable income

Limited resale market Taxable capital gains

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Popular Capital Market Investment Instruments

‣ Treasury Notes and Bonds‣ Municipal Notes and Bonds: issued by state and local governments to finance capital

expenditures, such as construction projects.‣ Corporate Notes and Bonds‣ Asset-Backed Securities: a financial security such as a bond or note which is collateralized by a

pool of assets such as loans, leases, credit card debt, royalties, or receivables.

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Key Advantages and Disadvantages

Treasury Notes and Bonds Municipal (State and Local Government) Bonds

Corporate Notes and Bonds Asset-Backed Securities

key advantages

Safety Good resale market Good collateral for borrowingMay be pledge behind government deposits

Tax-exempt interest income High credit qualityLiquidity and marketability of selected securities

Higher Pretax yields than on government securities Aid in locking in higher long-term rates of return

Higher pretax yields than on Treasury securities Collateral for borrowing additional funds

key disadvantages

Low yields relative to long-term private securitiesTaxable gains and incomeLimited supply of longest-term issues

Volatile marketSome issues have limited resale potential Taxable capital gains

Limited resale marketInflexible terms Taxable gains and income

Less marketable and more unstable in price than Treasury securitiesMay carry substantial default risk Taxable gains and income

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Factors Affecting Choice of Investment Securities

Ø The investments officer of a financial firm must consider several factors in deciding which investment securities to buy, sell, or hold. The principal factors bearing on which investments are chosen include:

1. Expected rate of return• Including any interest payments promised and possible capital gains or losses• Yield to maturity (YTM) & holding period yield (HPY)

2. Tax exposure• The tax status of state and local government bonds• The impact of changes in tax laws

3. Interest rate risk• Rising interest rate lower the market value of previously issued bonds and notes, with the longest-term issues

suffering the greatest losses.4. Credit or default risk

• The investments made by banks and their closest competitors are closely regulated due to the credit risk displayed by many securities, especially those issued by private corporations and some governments.

5. Business risk• Financial institutions of all sizes face significant risk that the economy of the market area they serve may turn down,

with falling sales and rising unemployment. These adverse developments, often called business risk.

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Factors Affecting Choice of Investment Securities

6. Liquidity risk7. Call risk

• Many corporations and some governments that issue securities reserve the right to call in those instruments in advance of maturity and pay them off, Such as callable bond.

8. Prepayment risk• A form of risk specific to asset-backed securities is prepayment risk.

9. Inflation risk• Investing institutions must be alert to the possibility that the purchasing power of interest income and repaid

principal from a security or loan will be eroded by rising prices for goods and services.10. Pledging requirements

• Depository institutions in the United States cannot accept deposits from federal, state, and local governments unless they post collateral acceptable to these governmental units in order to safeguard public funds. At least the first $100,000 of these public deposits is covered by federal deposit insurance; the rest must be backed up by holdings of Treasury and federal agency securities valued at par.

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Investment Maturity Strategies

1. The Ladder, or Spaced-Maturity, Policy (阶梯期限策略)• Choose some maximum acceptable maturity and then invest in an equal proportion of securities in each of

several maturity intervals until the maximum acceptable maturity is reached.2. The front-end load maturity policy

• Purchase only short-term securities and place all investments within a brief interval of time.3. The back-end load maturity policy

• Invest only in bonds in the 5- to 10- year maturity range.4. The Barbell Strategy

• A combination of front-end and back-end loan approaches.5. The Rate Expectations Approach (利率预期法)

• Most aggressive used by the largest financial firms.• Continually shifts maturities of securities in line with current forecasts or interest rates and the economy.

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65


Maturity Management Tools

1. The Yield Curve• Forecasting interest Rates and the Economy

✦ Yield curve shapes have critical implications for the decisions an investments officer must make.

• Risk-Return Trade-Offs✦ The yield is also useful because it tells the investments officer something important about

the current trades-offs between greater returns and greater risks.• Pursuing the Carry Trade

✦ Yield curves provide the investments officer with a measure of how much may be earned at the moment by pursuing the carry trade. For example, the officer may borrow funds for 30 days at 4 percent and use that money to invest in five-year government bonds yielding 6 percent. The difference between these two rates of return is called carry income and tends to be greatest when the yield curve has a steep upward slope.

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• Riding the Yield Curve✦The investments officer looks for a situation in which some securities are soon to

approach maturity and their prices have risen significantly while their yields to maturity have fallen.

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2. Duration• Immunization

✦ A way to minimize damage to an investing institution's earnings that changes in market Interest rates may cause.

✦ A formula for minimizing Interest rate risk:


Duration of an individual security or a security portfolio

Length of the investor’s planned holding period for a security or a security portfolio

• Duration works to immunize a security or portfolio of securities against interest rate changes because tow key forms of risk - interest rate risk and reinvestment risk- offset each other when duration is set equal to the investing institution’s planned holding period.

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69

LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES

The Demand for and Supply of Liquidity

‣ For most financial institutions , the most pressing demands for spendable funds (可动用资金) generally come from two sources: (1) customers withdrawing money from their accounts, and (2) credit requests from customers the institution wishes to keep, either in the form of new loan requests or drawings upon existing credit lines. Other source s of liquidity demand include paying off previous borrowings, such as loans the institution may have received from other financial firms or from the central bank. Similarity, payment of income taxes or cash dividends to stockholders periodically gives rise to a demand for immediately spendable cash.

‣ To meet the foregoing demands for liquidity, financial firms can draw upon several potential sources of supply. The most important source for a depository institution normally is receipt of new customer deposits. These deposit inflows tend to be heavy the first of each month as business payrolls (工资单) are dispensed, and they may reach a secondary peak toward the middle of each month as bills are paid.

‣ Another important element in the supply of liquidity comes from customers repaying their loans and from sales of assets, especially marketable securities, from the investment portfolio.

‣ Liquidity also flows in from revenues (fee income) generated by selling nondeposit services and from borrowings in the money market.

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‣These various sources of liquidity demand and supply come together to determine each financial firm' s net liquidity position at any moment in time. That net liquidity position (L) at time t is:

‣ When Lt < 0, prepare for a liquidity deficit, deciding when and where to raise additional funds.‣ When Lt > 0, prepare for a liquidity surplus, deciding when and where to profitably invest surplus

liquid funds until they are needed to cover future cash needs.

A financial firm's net liquidity position(Lt)

Incoming deposits (inflows)

Revenues from the sale of nondeposit

services

Customer loan repayments

Sales of assets

Borrowings form the

money market

Deposit withdrawals (outflows)

Volume of acceptable loan

requests

Repayments of borrowing

Other operating expenses

Dividend payments to stockholders

= + + + +

- - - --

Supplies of Liquidity Flowing into the Financial Firm

- Demands on the Financial Firm for Liquidity

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‣ Liquidity has a critical time dimension. Some liquidity needs are immediate or nearly so. • For example, in the case of a depository institution several large CDs may be due to mature

tomorrow, and the customers may have indicated they plan to withdraw these deposits rather than simply rolling them over into new deposit.

‣ Longer-term liquidity demands arise from seasonal, cyclical, and trend factors. • For example, liquid funds are generally in greater demand during the fall and summer coincident

with school, holidays and travel plans.‣ The essence of liquidity management problems for financial institutions may be described in two

succinct statements (简洁的陈述):1. Rarely are demands for liquidity equal to the supply of liquidity at any particular moment in time. The

financial firm must continually deal with either a liquidity deficit or a liquidity surplus.2. There is a trade-off between liquidity and profitability. The more resources are tied up in readiness to

meet demands for liquidity, the lower is that financial firm’s expected profitability.

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Estimating Liquidity Needs

1. The Sources and Uses of Funds Approach‣ The sources and uses of funds method for estimating liquidity needs begins with two simple facts

① In the case of a bank, for example, liquidity rises as deposits increase and loans decrease.

② Alternatively, liquidity declines when deposits decrease and loans increase.

‣ The key steps in the sources and uses of funds approach, using bank as an example, are:

① Loans and deposits must be forecast for a given planning period.

② The estimated change in loans and deposits must be calculated for that same period.

③ The liquidity manager must estimate the net liquid funds’ surplus or deficit for the planning period by comparing the estimated change in loans to the estimated change in deposits.

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Estimated liquidity deficit (−) or surplus (+) for the coming period

Estimated change in deposits Estimated change in loans= −

Using the forecasts of loans and deposits generated by the foregoing relationships, management could then estimate the bank's need for liquidity by calculating

Estimated change in total loans for the

coming period

is a function

of

projected growth in the economy (for example, the growth of gross domesticproduct [GDP]or business

sales)

projectedquarterlycorporate earnings

current rate ofgrowth in the money supply

projected prime loan rate minus the

commercial paper rate or CD rate

andestimated

rate of inflation

Estimated change in total

deposits for the coming

period

is a function

of

projected growth in personal income in the

economy

estimatedincrease in retail

sales

current rate ofgrowth of the money supply

projected yield on money market

depositsand

estimated rate of

inflation

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2. The Structure of Funds ApproachØ First, we might divide a bank's deposit and nondeposit liabilities into three categories:

1. “Hot money” liabilities (often called volatile liabilities) — deposits and other borrowed funds (such as federal funds borrowings) that are very interest sensitive or that management is sure will be withdrawn during the current period.

2. Vulnerable funds — customer deposits of which a substantial portion, perhaps 25 to 30 percent, will probably be withdrawn sometime during the current time period.

3. Stable funds (often called core deposits or core liabilities) — funds that management considers unlikely to be removed (except for a minor percentage of the total).

Ø Second, the liquidity manager must set aside liquid funds according to some desired operating rule for each of these funds sources. For example, the manager may decide to set up a 95 percent liquid reserve behind all hot money funds (less any required legal reserves held behind hot money deposits).

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‣ The liquidity reserve behind deposit and nondeposit liabilities would be:

‣ The institution's total liquidity requirement would be:

Liabilityliquidity reserve

0.95 × (Hot money deposits and nondeposit funds − Legal reserves held) + 0.30 × (Vulnerable deposit and nondeposit funds − Legal reserves held) + 0.15 × (Stable deposits and nondeposit funds − Legal reserves held)

=

Total liquidity requirement = Deposit and nondeposit liability liquidity requirement and loan liquidity requirement

0.95 × (Hot money funds − Required legal reserves held behind hot money deposits) + 0.30 × (Vulnerable deposits and nondeposit funds − Required legal reserves) + 0.15 × (Stable deposits and nondeposit funds − Required legal reserves) + 1.00 × (Potential loans outstanding − Actual loans outstanding)

=

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Example: Estimating Liquidity Needs with the Structure of Funds Method

A. First National Bank finds that its current deposits and nondeposit liabilities break down as follows:Hot money $ 25 million Vulnerable funds (including the largest deposit and nondeposit liability accounts)Stable (core) funds $ 100 million

• First National's management wants to keep a 95% reserve behind its hot money deposits (less the 3% legal reserve requirement imposed by the central bank behind many of these deposits) and nondeposit liabilities, a 30% liquidity reserve in back of its vulnerable deposits and other borrowings (less required reserves), and a 15% liquidity reserve behind its core deposit and nondeposit funds (less required reserves) .

B. First National Bank's loans total $135 million but recently have been as high as $140 million, with a trend growth rate of about 10 percent a year. This financial firm wishes to be ready at all times to honor customer demands for all loans that meet its quality standards.

C. The bank's total liquidity requirement is:

$ 24 million

Deposit / Nondeposit Funds plus Loans0.95 ($25 million − 0.03 × $25 million)

+0.30 ($24 million − 0.03 × $24 million)+0.15 ($100 million − 0.03 × $100 million)

+$140 million × 0.10 + ($140 − $135 million)= $23.04 million + $6.98 million + $14.55 million + $19 million

= $63.57 million (Held in liquid assets and additional borrowing capacity) 78第39页,共148页




3. Liquidity Indicator Approach‣ Many financial-service institutions estimate their liquidity needs based upon experience and industry

averages. This often means using certain liquidity indicators. For example, for depository institutions the following liquidity indicator ratios are often useful:① Cash position indicator: Cash and deposits due from depository institutions / total assets. ② Liquid securities indicator: U.S. government securities / total assets.③ Net federal funds and repurchase agreements position: (Federal funds sold and reverse repurchase

agreements – Federal funds purchased and repurchase agreements) / total assets.④ Capacity ratio: Net loans and leases / total assets. Which is a really a negative liquidity indicator.⑤ Pledged securities ratio: Pledged securities / total security holdings. Also a negative liquidity

indicator because the greater the proportion of securities pledged to back government deposits, the fewer securities are available to sell when liquidity needs arise.

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3. Liquidity Indicator Approach⑥ Hot money ratio: Money market (short-term) assets / volatile liabilities.

⑦ Deposit brokerage index: Brokered deposits / total deposits.

⑧ Core deposit ratio: Core deposits / total assets. Core deposits are primarily small-denomination checking and savings accounts that are considered unlikely to be withdrawn on short notice and so carry lower liquidity requirements.

⑨ Deposit composition ratio: Demand deposits / time deposits. This ratio measures how stable a funding base each institution possesses, a decline suggests greater deposit stability and a lesser need for liquidity.

⑩ Loan commitments ratio: Unused loan commitments / total assets.

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Example

Which of the following indicators would create concern for a liquidity manager looking

to stabilize liquidity and create confidence in the bank's position?

A. An increasing hot money ratio.

B. An increasing deposit composition ratio.

C. Increases in reverse repurchase agreements.

D. An excess of federal funds sold over federal funds purchased.

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4. Signals from marketplace‣ For example, liquidity managers should closely monitor the following market signals:

① Public confidence② Stock price behavior③ Risk premiums on CDs and other borrowings④ Loss sales of assets⑤ Meeting commitments to credit customers⑥ Borrowings from the central bank

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Regulations on Calculating Legal Reserve Requirements

‣ The largest depository institutions must hold the largest percentage of legal reserves, reflecting their great importance as funds managers for themselves and for hundreds of smaller financial institutions. However, whether large or small, the total required legal reserves of each depository institution are figured by the same method. Each reservable liability item is multiplied by the stipulated (明确要求的) reserve requirement percentage to derive each depository’s total legal reserve requirement. Thus；

Total required legal reserves

Reserve requirement on transaction deposits × Daily average amount of net transaction deposits over the computation period + Reserve requirement on nontransaction reservable liabilities × Daily average amount of nontransaction reservable liabilities over the computation period.

=

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Regulations on Calculating Legal Reserve Requirements

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Example: Sample Calculation of Legal Reserve Requirements in the United States

• The first $10.7 million of net transaction deposits are subject to a 0 percent legal reserve requirement (known as the “exemption amount”). The volume of net transaction deposits over $10.7 million up to $58. 8 million carries a 3 percent reserve requirement (known as the “low reserve tranche"). while the amount over $58.8 million is subject to a 10 percent reserve requirement (the “high reserve tranche"). Nontransaction reservable liabilities (including nonpersonal time deposits and Eurocurrency liabilities) are subject to a 0 percent reserve requirement.

• First National's net transaction deposits averaged $100 million over the 14-day reserve computation period, while its nontransaction reservable liabilities had a daily average of $200 million over the same period. Then First National's daily average required legal reserve level = 0.0 × $10.7 million + 0.03 × ($58.8 million - $10.7 million) + 0.10 × ($100 million - $58. 8 million) = $5.563 million.

• First National held a daily average of $5 million in vault cash (库存现金) over the required two-week reserve computation period. Therefore, it must hold an additional amount of legal reserves over its two-week reserve maintenance period as follows:

= $5.563 million - $5.000 million = $0.563 million Daily average level of additional legal reserves First National Bank must raise

= Total required legal reserves

Daily average vault cash holdings

-

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Factors in Choosing among the Different Sources of Reserves

‣ In choosing which source of reserve to draw upon to cover a legal reserve deficit, money position managers must carefully consider several aspects of their institution’s need for liquid funds:1. Immediacy of need2. Duration of need3. Access to the market for liquid funds4. Relative costs and risks of alternative sources of funds5. The interest rate outlook6. Outlook for central bank monetary policy7. Rules and regulations applicable to a liquidity source

‣ Liquidity manager must carefully weigh each of these factors in order to make a rational choice among alternative sources of reserves.

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Strategies for Liquidity Managers

1. Asset Liquidity Management (or Asset Conversion) Strategies• This strategy calls for storing liquidity in assets, predominantly in cash and

marketable securities. When liquidity is needed, selected assets are converted into cash until all demands for cash are met.

‣ Characteristics of liquid asset① A liquid asset has a ready market so it can be converted into cash without delay.② It has a reasonably stable price so that, no matter how quickly the asset must be

sold or how large the sale is, the market is deep enough to absorb the sale without a significant decline in price.

③ It is reversible (可恢复原状的), meaning the seller can recover (收回) his or her original investment (principal) with little risk of loss.

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2. Borrowed Liquidity (Liability) Management Strategies• Calls for borrowing immediately spendable funds to cover all anticipated demands for liquidity.

‣ Advantages• Can choose to borrow only when it actually needs funds.• Permits to leave the volume and composition of its asset portfolio unchanged.• Liability management comes with its own control lever - the interest rate offered to borrow

funds.‣ Disadvantages

• The volatility of interest rates and the rapidity with which the availability of credit can change.• Purchase liquidity is difficult, both in cost and available.• Other financial firms become less willing to lend to the troubled institution due to the risk

involved.

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3. Balanced Liquidity Management Strategies• Due to the risks inherent in relying on borrowed liquidity and the costs of storing liquidity in

assets, most financial firms compromise by using both asset and liability management.‣ Guidelines for Liquidity Managers

• First, the liquidity manager must keep track of the activities of all departments using and/or supplying funds.

• Second, those responsible for liquidity management should know in advance when the biggest credit or funds-supplying customers plan to withdraw or add funds to their accounts.

• Third, the liquidity manager must make sure the financial firm's priorities (优先事项) for liquidity management are clear.

• Fourth, liquidity needs must be analyzed on a continuing basis to avoid both excess and deficit liquidity positions.

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Uses and Sources of Intraday Liquidity

Ø Following are common uses of intraday liquidity:1. Outgoing wire transfers. Outgoing wire payments, on behalf of clients or the bank’s own account, are

typically the largest use of intraday liquidity.2. Settlements, at PCS systems. Most PCS systems have one settlement per day, with many occurring in

the late afternoon timeframe. This may serve as either a source or use of funds depending on the net position of a participant on any given day.

3. Funding of nostro accounts (往账: 我行去其他行开户). Banks manage the cash they place in correspondent bank (代理银行或关系银行) accounts to a target average monthly balance as part of the compensation provided to the correspondent for its bank services. On any given day, the account funding position may act as a source or use of funds to the bank’s overall liquidity profile, depending on the net position of the activity flowing through the account that day.

4. Collateral pledging. Some banking activities, such as over-the-counter capital markets trading and deposits of certain public funds, require a bank to earmark and set aside collateral.

5. Asset purchases/funding. Funding other balance sheet assets, such as securities purchases for investment portfolio, client loans, and fixed asset purchases, is another common use of intraday liquidity.

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INTRADAY LIQUIDITY RISK MANAGEMENT

Uses and Sources of Intraday Liquidity ‣ Uses of Intraday Liquidity

Funding Requirement Description Impacted by Client

Activity Impacted by Bank Activity Abillty to Forecast

Outgoing Wire Transfers (对外电汇)

Payments on LVPS such as Fedwire (联邦电子资金转

账系统) and CHIPS

Yes, clients provide bank instructions

Yes, Bank Treasury and lines of business have payment needs

Bank activity can usually be forecasted with 1 to 2 days’ notice; client payment activity is more difficult to predict

Settlements at Payment, Clearing and Settlement (PCS) Systems

Net cash settlements at payments systems, clearinghouses

Not directly initiated by clients, but includes client activity

Yes, position monitored by operations groups

Can be forecast for securities that have multi-day settlements (e.g., T+3); more difficult for same day settlement activity

Funding of Nostro Accounts (往账资金)

Cash transfer to a crrespondent bank for services provided

Not directly initiated by clients, but includes client activity

Yes, position monitored by operations groups

Securities settlements are generally predictable; client payment activity flowing through correspondents is less predictable

Collateral Pledging Obtaining and earmarking (预先安排) of collateral required by an outside beneficiary

Yes, some clients require collateral to cover bank trading liabilities or deposits

Yes, banks are required to post collateral for margin at FMUs or other trading counter-Parties

Dependent on trading volumes and asset price changes, generally known one day in advance

Asset Purchases / Funding

Exchange of bank cash for another asset such as a client loan

Yes, clients can draw down on lines of credit or letters of credit

Yes, assets may be securities for the bank's investment portfolio or fixed assets

Bank fixed asset activity should be known in advance; securities purchases may be same day settlement; client loans are more difficult to predict

Most large value payment systems

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INTRADAY LIQUIDITY RISK MANAGEMENT

Uses and Sources of Intraday Liquidity ‣ Sources of Intraday Liquidity

Funding Requirement Description Client Activity Bank Activity Ability to Forecast

Cash Balances Deposits at the central bank and at correspondent bank nostro accounts

No, clients do not directly impact closing/start of day cash balances

Yes, Bank Treasury determines level of closing/start of day cash balances

Bank activity can usually be forecasted with 1 to 2 days’ notice; client payment activity is more difficult to predict

Incoming Funds Flow (资金流入)

Incoming cash payments and cash credits from FMU (financialmarket utilities)

Yes, incoming client payments are credited to the bank's accounts at the central bank and correspondents

Yes, activities conducted for the bank's business can impact cash balances

Bank activity can usually be forecasted with 1 to 2 days’ notice; client payment activity is more difficult to predict. FMU credit can be forecast for securities that have multi-day settlements (e.g., T+3); more difficult for same day settlement activity

Intraday Credit Credit line or overdraft (透支额) permitted during business hours and covered by close of business. Lines are often uncommitted and provided without interest charges.

No, client activity does not directly impact the amount of intraday credit extended to a bank

Yes, counterparties will often adjust intraday credit extensions to reflect business activity from other areas of the bank (e.g., OTC trading)

Some intraday credit facilities are disclosed and well known to a bank (e.g., FRB net debit cap). Others are not disclosed but can often be inferred from historical data

Liquid Assets Cash, money market deposits, and short term government debt (e.g., T-Bills) which can be quickly converted to cash

Yes, client may be sources of liquidity in converting liquid assets to cash(e.g., repo transaction)

Yes, bank trading and investment portfolio activity can impact the amount of liquid assets available.

Liquid assets held in the investment portfolio and in other money market investments tend to have low volatility and as a result are predictable

Overnight Borrowings

Fed Funds, Eurodollar borrowings. overnight deposits

Yes, clients may be direct sources of liquidity for overnight borrowing (e.g., repo transaction)

No. other Bank lines of business do not regularly supply overnight funding

Client supply of overnight borrowing tends to be fairly predictable, but with moderate volatility

Other Term Funding

Other term deposits, repos from FHLB, money market funds, etc.

Yes, clients may be direct sources of liquidity for term funding

No, other Bank lines of business do not regularly supply term funding

Client supply of term funding tends to be fairly predictable, with low volatility

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Governance of Intraday Liquidity Risk Management ‣ All risk management frameworks start with a governance structure that defines the roles and responsibilities of various

bank employees and committees in overseeing risk-related activities. The following list provides characteristics of an effective governance structure for overseeing intraday liquidity risk:

1. Active risk management. In many institutions, intraday liquidity risk is accepted as a cost of doing business and is not as actively managed with the same level of rigor as other types of enterprise risk or even other liquidity risks.

2. Integration with risk Governance. Oversight of intraday liquidity risk management is integrated into the bank’s overall risk oversight structure. This ensures that:• The intraday liquidity risk management framework follows the industry’s three lines of defense model, with

particular emphasis on expertise in the second line of defense to coordinate across the institution.① Treasury is the first line of defense. Actively managing the intraday and end-of-day funding positions of the

bank as well as the risk management programs related to funding activities.② Corporate Risk Management is the second line of defense.③ Internal Audit is the third line of defense.

3. Risk assessment. At leading institutions, intraday liquidity risk is incorporated into the risk taxonomy and is a component of risk self-assessments.

4. Risk measurement and monitoring. There are two perspectives from which leading institutions monitor their intraday liquidity risk: (1) the amount of intraday credit the institution is extending to clients, and (2) the amount of intraday credit the institution utilizes.

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Measures for Understanding Intraday Flows

1. Total Payments• A bank and its intraday risk management teams should maintain statistics concerning the amount of

payments it makes on all electronic payments systems in which it participates. 2. Other Cash Transactions

• A bank should also track its intraday and end-of-day settlement positions at all financial market utilities in which it participates.

3. Settlement Positions• If complete data to reconstruct account positions at any time of day is not available, at a minimum a bank

should maintain data on its settlement positions with all its FMUs. These critical, deadline specific payments, often with large transaction amounts, are critical to managing intraday liquidity and systemic risk. A bank should monitor patterns in settlement positions and correlate them with external market factors to improve its ability to predict upcoming liquidity requirements earlier in the day.

4. Time Sensitive Obligations• Similar to settlement positions, these transactions require completion at a specific time during the day.

Examples include transactions concerning market activates (such as the return of borrowings), margin payments, and other payments critical to a bank's business or reputation.

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Measures for Understanding Intraday Flows

5. Total Intraday Credit Lines to Clients and Counterparties• A bank risk manager looking after the bank's own intraday liquidity risk needs to understand

the potential and actual amounts of intraday credit the bank is extending to clients and counterparties.

• In some cases, these intraday credit lines could be committed and disclosed to the client, but most are uncommitted and undisclosed. In addition to the credit lines, the bank should have data regarding average and peak usage. and the ability to model activity at the client and portfolio levels.

6. Total Bank Intraday Credit Lines Available and Usage• As demonstrated through the requirements for preparing resolution plans, regulators

increasingly expect financial institutions to understand and manage the a mount of systemic risk they pose to the overall financial system.

• A key component of that analysis is the amount of intraday credit that a bank relies on in business- as -usual conditions and the maximum amount of intraday borrowing it can draw down.

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Measures for Quantifying and Monitoring Risk Levels

1. Daily Maximum Intraday Liquidity Usage• This is a measure of the bank’s usage of an intraday credit extension.

2. Intraday Credit Relative to Tier 1 Capital• This measure is a broad representation of the intraday settlement risk posed by a bank.

3. Client Intraday Credit Usage• This measure is derived by comparing a client’s peak daily intraday overdraft (透支额) to the

established (committed or uncommitted) credit line. 4. Payment Throughput (支付吞吐量)

• These measures track the percentage of outgoing payment activity relative to time of day.• A bank can track its peak intraday credit usage relative to total volumes with an FMU to

provide an indicator of the efficiency of the FMU’s usage of daylight credit.

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MONITORING LIQUIDITY

A Taxonomy of Cash Flows

‣ The identification and taxonomy of the cash flows that can occur during the business activity of a financial institution is crucial to building effective tools to monitor and manage liquidity risk.

‣ Focus on Time and Amount‣ Time: Cash flows may occur at future instants (未来瞬间) that are known with certainty at the

reference time (deterministic), or they may manifest (显现) themselves at some random instants (随机瞬间) in the future (stochastic).

‣ Amount: Cash flows may occur in an amount that is known with certainty at the reference time (deterministic), or alternatively their amount cannot be fully determined (stochastic).

‣ Based on the classification we have introduced, we can provide some examples of cash flow, with the corresponding category they belong to, according to the time/amount criterion. The examples are also shown in Figure 7.1.

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Taxonomy of Cash Flows

Fixed

CreditRelated

Indexed/ Contingent

Behavioural/ 行为相关的

NewBusiness

Det

erm

inis

ticSt

ocha

stic

Am

ount

Time

Deterministic Stochastic

• Withdrawals from deposits• Withdrawals of credit lines to client• Prepayment of mortgages• Prepayment of deposits

• New deposits• New loans• New assets

• Pay-out (大额支出) of a one touch option when barrier is hit

• Withdrawals by the Bank from credit lines received

• Recovery of NPV on client's default

• Missing cash-flow after client's default

• Pay-out on American option's exercise

• Risk-free Fixed Rate Bonds Coupons

• Capital Amortization of Risk-free Fixed Rate Mortgage

• Risk-free Floating-Rate Bond Coupons

• Pay-out of European Option's Exercise

• New Debt Issuance by the Bank

• Renewal of Expiring Contracts

银行从收到的信贷额度中提款

客户违约后现金流缺失

到期合同的续签

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Liquidity Options (流动性期权)

‣ A liquidity option can be defined as the right of a holder to receive cash from, or to give cash to, the bank at predefined times and terms. Exercising a liquidity option does not directly entail a profit or a loss in financial terms, rather it is as a result of a need for or a surplus of liquidity of the holder.

‣ A liquidity option is exercised because of the cash flows produced after exercise, even if it is sometimes not convenient to exercise it from a financial perspective.

‣ For example 1: Consider the liquidity option that a bank sells to a customer when the bank opens a committed credit line (承诺信用额度): The obligor has the right to withdraw whatever amount up to the notional of the line whenever she wants under specified market conditions, typically a floating rate (say, 3-month Libor) plus a spread, that for the moment we consider determined only by the obligor’s default risk. The option to withdraw can be exercised when it also makes sense under a financial perspective (财务层面); for example, if the spread widened due to worsening of the obligor's credit standing (信用状况): in this case funds can be received under the contract’s conditions (which are kept fixed until expiry) and hence there is a clear saving of costs in terms of fewer paid interests on the line's usage rather than opening a new line. On the other hand, the line can be used even if the credit spread shrinks (利差收缩), so that it would be cheaper for the obligor to get new funds in the market with a new loan, but for reasons other than financial convenience it chooses to withdraw the needed amounts from the credit line.

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Liquidity Options

‣ Example 2: Another example of a liquidity option is given by sight and saving deposits

(活期存款和储蓄存款): the bank's clients can typically withdraw all or part of the deposited amount with no or short notice. The withdrawal might be the possibility to invest in assets with higher yields more than compensating for higher risk, or it might be due to the need of liquidity for transaction purposes. So, even in this case there may exist some financial rationale behind exercising a liquidity option, But it can also be triggered by many other different reasons that are hardly predictable, or can be forecast on a statistical basis.

‣ Exercising a liquidity option can work the other way round (行使流动性选择权可以起到相反的作用): The bank's client has the right to repay the funds before the contract ends. Although the bank would benefit in the case from the greater amount of liquidity available, but if the interest rate falls, the bank would suffer negative economic effects and cause a loss.

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Liquidity Options

‣ The effect of liquidity options on the bank.

1. A liquidity impact on the balance sheet, given by the amount withdrawn or repaid.

2. A (positive or negative) financial impact, given by the difference between the contract's interest rates and credit spread and the market level of the same variables at the time the liquidity option is exercised, applied on the withdrawn or repaid amount.

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Liquidity Risk

‣ Definition of liquidity risk: The event that in the future the bank receives smaller than expected amounts of cash flows to meet its payment obligations.

‣ Definition of funding cost risk: The event that in the future the bank has to pay greater than expected cost (spread) above the risk-free rate to receive funds from sources of liquidity that are available.

‣ Definition of liquidity risk (comprehensive): The amount of economic losses due to the factor that on a given date the algebraic sum of positive and negative cash flows and of existing cash available at that date, is different from some (desired) expected level.

‣ This definition includes a manifestation of liquidity risk as:1. Inability to raise enough funds to meet payment obligations, so that the bank is forced to sell its

assets. Thus causing costs related to the non-fair level at which they are sold or to suboptimal asset allocation.

2. Ability to raise funds only at costs above those expected. These costs refer to the cost dimension of liquidity risk.

3. Ability to invest excess liquidity only at rates below those expected.

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Quantitative Liquidity Risk

‣ we can formally define the positive and negative cash flows as:

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‣ The term structure of expected cash flows:

‣ The term structure of cumulated expected cash flows:

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Liquidity Generation Capacity

‣ Definition: the ability of a bank to generate positive cash flows, beyond contractual ones, from the sources of liquidity available in the balance sheet and off the balance sheet at a given date.

‣ The LGC manifests itself in two ways:1. Balance sheet expansion with secured or unsecured funding.2. Balance sheet shrinkage (资产负债表收缩) by selling assets.

‣ Balance sheet expansion can be achieved via:1. Borrowing through an increase of deposits, typically in the interbank market (retail or

wholesale unsecured funding);2. Withdrawal of credit lines the financial institution has been granted by other financial

counterparties (wholesale unsecured funding);3. Issuance of new bonds (wholesale and retail unsecured funding).

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Liquidity Generation Capacity

‣ To sum up, we can identify three types of sources of liquidity that can be included in the classifications above:

1. Selling of assets, AS 2. Secured funding using assets as collateral and via repo transactions, RP 3. Unsecured funding via withdrawals of committed credit lines available from other financial institutions and via deposit transactions in the interbank market, USF‣ The term structure of LGC:

‣ The term structure of cumulated LGC

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Term Structure of Available Asset

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Term Structure of Expected Liquidity

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Cash Flow at Risk

‣ Cash flow at risk (CFaR) is the maximum likely cash outflow over the horizon period at a specified confidence level. A positive (negative) value for LaR means the worst outcome will be associated with an outflow (inflow) of cash. LaR is similar in concept to VaR, but instead of a change in value, it deals with a cash flow. LaR is also distinct from liquidity-related losses, but they are related.

‣ As an example, an investor has a large market risk position that is hedged with a futures position. If the hedge is a good one, the basis risk is small, and the VaR should be small. There is the possibility of margin calls on the futures position, however, and this means there is the possibility of a cash outflow equal to the size of that position. In summary, the hedged position has a small VaR but a large LaR. At the other extreme, European options have zero LaR until expiration, but potentially large VaR prior to maturity.

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Example

ØA risk analyst at a fund management company is discussing with the risk team the gaps in the company’s risk measurement system. Among the issues they have identified is the understanding that failing to anticipate cash flow needs is one of the most serious errors that a firm can make. Addressing such a problem demands that a good liquidity-at-risk (LaR) measurement system be an essential part of the bank's risk management framework. Which of the following statements concerning LaR is correct?

A. A firm's LaR tends to decrease as its credit quality declines.B. For a hedged portfolio, the LaR can differ significantly from the VaR.C. Hedging using futures has the same impact on LaR as hedging using long option

positions.D. Reducing the basis risk through hedging decreases LaR.

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THE FAILURE MECHANICS OF DEALER BANKS

The major lines of business in which dealer banks operate and the risk factors they face in each line of business

Ø Large dealer banks provide a variety of intermediary functions in the markets.1. Large dealer banks play an important function in the OTC derivatives market.

• Dealer banks transfer the risk of the derivatives positions requested by counterparties by creating new derivatives contracts with other counterparties. Counterparty risk in the OTC market refers to the risk that one or more of the counterparties will default on their contractual obligations. If the dealer bank does not have the liquidity to function, they will become insolvent.

• The failure of a large dealer bank would result in increased systemic risk for the OTC market. For example, the default of Lehman Brothers in September of 2008 not only disrupted the OTC derivatives markets, but the repercussions (影响，反响) were also felt by other financial markets and institutions.

2. Another important function of large dealer banks is in the short-term repurchase or repo market.• Large dealer banks finance significant fractions of another dealer bank’s assets through repos.• Some large dealer banks had very high leverage due to the lack of capital requirements for these repos.

The high leverage caused significant solvency risk when the use of subprime mortgages as collateral was questioned.

• The systemic and firm specific risk is significantly increased if a repo counterparty questions the solvency of a dealer bank. Counterparties are unlikely to renew repos, and the repo creditors may be legally required to sell collateral immediately.

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3. Dealer banks provide investment banking functions through the management and underwriting of securities issuances.• An additional strain on liquidity is caused by the lack of cash inflows when issuers question

the solvency of the dealer bank and take their business elsewhere.• This can lead to systemic risk as new issues and the liquidity of existing issues are halted, as

few institutions are able or willing to fill the void when a large dealer bank’s solvency or liquidity are questioned.

4. Large dealer banks act as a prime broker to large investors such as hedge funds.• In this context, the services provided by the dealer banks include custody of securities,

clearing, securities lending, cash management, and reporting. • When the solvency of a prime broker is questionable, a hedge fund could demand cash margin

loans from the dealer that are backed by securities. The prime broker may not be able to use those same securities as collateral with other lenders who may also question their solvency. Thus, the dealer bank’s liquidity position is weakened if large clients reduce their exposure by exiting their positions or entering new positions to offset their risk.

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• In addition, if prime broker clients leave, then their cash and securities are no longer in the pool of funds to meet the dealer bank’s liquidity needs for other clients. A systemic shortage of collateral and a liquidity crisis can result from the reduction of collateral securities caused by the flight of prime brokerage clients. Systemic risk is even greater when hedge funds do not mitigate their exposure through diversification. Prior to the recent financial crisis, hedge funds had significant positions with only a few dealer banks.

5. Dealer banks also provide an important function as a counterparty for derivatives for brokerage clients. • Dealer banks sometimes operate “internal hedge funds” and private equity partnerships. Off-balance

sheet entity functions such as internal hedge funds, structured investment vehicles, and money market funds can have substantial losses.

• The dealer banks have an incentive to voluntarily support these entities to protect their reputation and franchise value. When a dealer bank shows signs of distress, counterparties and others may begin to exit their relationships, which severely increases the dealer bank’s liquidity risk.

6. In addition, large dealer banks provide traditional commercial banking functions, such as gathering deposits for corporate and consumer lending.• The risks for a dealer bank are similar to a traditional bank with respect to these functions.

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Liquidity Concerns For Dealer Banks

1. A liquidity crisis for a dealer bank is accelerated if counterparties try to reduce their exposure by restructuring existing OTC derivatives with the dealer or by requesting a novation (更新、转移). • Another means that a counterparty has of reducing their exposure to a dealer is through a

novation to another dealer. For example, a hedge fund may use a credit default swap from a dealer to protect themselves from a loss on a borrower. If the hedge fund was concerned about the solvency of the dealer bank, they could request a novation from another dealer bank to protect themselves from default arising from the original dealer bank. Although these novations are often granted (准许) by dealer banks, in the case of Bear Stearns, the request was denied, which raised additional concerns regarding the solvency of Bear Stearns. In addition to decreasing the reputation capital (信誉资本) and franchise value (特许权价值) of this dealer bank, the liquidity position was also under increased stress.

2. The flight of repo creditors (债权人) and prime brokerage clients can also accelerate a liquidity crisis. 3. Lastly, the loss of cash settlement privileges is the final collapse of a dealer bank’s liquidity.

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Example

ØA dealer bank’s liquidity crisis is least likely to be accelerated by:

A. The refusal of repurchase agreement creditors to renew their positions.

B. The flight of prime brokerage clients.

C. A counterparty’s request for a novation through another dealer bank.

D. Depositors removing their savings from the dealer bank.

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Policies to Alleviate Dealer Bank Risks

‣ The 2009 Public Private Investment Partnership (PPIP) (公私投资合作组织) was instituted by the U.S. Treasury Department’s 2008 Troubled Asset Relief Program (不良资产救助计划) (TARP) to help dealer banks and the financial industry recover from the crisis at hand. One of the policy objectives was to mitigate the effect of adverse selection (逆向选择) in the market for “toxic” assets, such as the CDOs backed by subprime mortgages. Adverse selection is the principle that buyers are only willing to buy the assets at a deep discount due to the information asymmetries that exist regarding the asset’s true value. A dealer bank may be forced to sell illiquid assets in order to meet liquidity needs. This results in additional losses due to the lack of demand for those assets. The PPIP subsidizes bidders (资助投标人) of “toxic assets (有毒资产)” by offering below-market financing rates and absorbing losses beyond a predetermined level.

‣ The United States Federal Reserve System and the Bank of England provided new secured lending facilities to large dealer banks when they were no longer able to obtain credit from traditional counterparties or the repo market. When the dealer bank’s solvency is questioned, tri-party clearing banks (三方清算银行) are likely to limit their exposure to the dealer bank.

‣ Another potential approach is the creation of an “emergency bank” that could manage the orderly unwinds (有序展

开) of repo positions of dealer banks with liquidity difficulties.‣ Capital requirements will most likely be increased and include off-balance sheet positions in an effort to reduce the

leverage positions of dealer banks.‣ Central clearing will reduce the threat of OTC derivatives counterparties fleeing (逃离) a questionable dealer bank.

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Example

ØOne potential solution for mitigating the liquidity risk caused by derivatives counterparties exiting their large dealer bank exposures is most likely the:

A. use of central clearing.

B. use of a novation through another dealer bank.

C. requirement of dealer banks to pay out cash to reduce counterparty exposure.

D. creation of new contracts by counterparties.

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Example

ØWhich of the following items is not a policy objective of the U.S. Treasury Department’s 2008 Troubled Asset Relief Program to help dealer banks recover from the subprime market crisis?

A. Provide below-market financing rates for bidders of “toxic” assets.B. Absorb losses beyond a pre-specified level.C. Force the sale of illiquid assets in order to better determine the “true” value.D. Mitigate the effect of adverse selection.

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Example

Ø Large dealer banks have often financed significant fractions of their assets using short-term (overnight) repurchase agreements in which creditors hold bank securities as collateral against default losses. The table below shows the quarter-end financing of four broker-dealer financial instruments. All value are in USD billions.

• In the event that repo creditors become equally nervous about each bank’s solvency, which bank is most vulnerable to a liquidity crisis?

A. Bank PB. Bank QC. Bank RD. Bank S

Bank P Bank Q Bank R Bank SFinancial Instruments Owned 656 750 339 835

Pledged as collateral 258 472 139 209Not pledged 398 278 200 626

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Liquidity Stress Testing

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LIQUIDITY STRESS TESTING

Measuring Contingent Liquidity Requirements

‣ Funding liquidity risk: The risk that the institution will not have adequate capacity to fund its obligations without incurring unacceptable economic losses.• Operational liquidity : The cash that is needed to fund the business on a daily basis

and it is required to ensure orderly clearing of payment transactions.• Restricted liquidity : Liquid assets that are available to be used only for specifically

defined purposes (用于特殊目的，不能用于日常运营活动).• Strategic liquidity : The cash that is held by the institution to meet future business

need that may arise outside the course of normal operations. This is the funds that the firm maintains to satisfy potential investment opportunities such as fixed asset purchases or mergers/acquisitions.

• Contingent liquidity : The liquidity that is available to meet general financial obligations under a stress scenario.

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Liquidity Taxonomy

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Overview of The Model

‣ If the objective of the liquidity stress test is to measure the amount of required contingent liquidity, then the institution must construct a cash flow model that accurately and precisely measures the following components:• (normal) Liquidity asset buffer: Represents the contingent liquidity that is currently in place.

• Stressed outflows: Are those assumed to occur under stress scenarios.• Stressed inflows: Are assumed to partially offset the stressed outflows.• Stressed liquid asset buffer: Liquidity asset buffer, net of stress outflows and stress

inflows, indicates the adequacy of the current liquidity asset buffer given the stress scenario assumptions.

Stressed liquid asset buffer = (Normal) liquidity asset buffer - Stressed outflows + Stressed inflows

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Firm A has $1 billion in highly liquid assets. In a sudden stressed scenario, it estimates that retail customers will withdraw $150 million in deposits, and retail customers will be able to make $80 million of loan repayments. Firm A must deal with $60 million of margin and collateral calls on its derivatives transactions due to falling collateral values and greater volatility of the underlying assets. In addition, it has utilized $10 million of a total $100 million liquidity facility. What is the estimate of Firm A's stressed liquidity asset buffer?

A. $0.80 billion.

B. $0.88 billion.

C. $0.90 billion.

D. $0.96 billion.

Example

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Overview of The Model

Normal Liquid Asset Buffer (Less): Stressed Cash Outflow$0

$10

$20

$30

$40

$50

$60

Plus: Stressed Cash Inflows

Net Cash Outflow

Yields: Stressed Liquid Asset Buffer

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Example

Ø firm A has $1 billion in highly liquid assets. In a sudden stressed scenario, it estimates that retail customers will withdraw $150 million in deposits, and retail customers will be able to make $80 million of loan repayments. Firm A must deal with $60 million of margin and collateral calls on its derivatives transactions due to falling collateral values and greater volatility of the underlying assets. In addition, it has utilized $10 million of total of $100 million liquidity facility (流动性融通). What is the estimate of Firm A’s stressed liquidity asset buffer?

A. $0.80 billionB. $0.88 billionC. $0.90 billionD. $0.96 billion

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Design of the Model

‣ Organizational scope‣ Scenario development‣ Development of assumptions‣ Outputs‣ Governance ‣ Integration of other risk models

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Design of the Model

‣ Organizational scope:• Liquidity transfer restrictions. Liquidity may be trapped in certain legal entities,

potentially creating a distorted view of the consolidated liquidity position of the institution.

• Currency. While the liquidity stress test should be performed in the currency of the entity being tested （the home country for the consolidated test）， careful consideration should be taken for the liquidity impact of currency conversion requirements.

• Regulatory jurisdiction. For institutions operating in multiple foreign jurisdictions under various regulatory oversight regimes, the need to conduct individual stress tests for foreign subsidiaries or groups may arise.

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Design of the Model

Contingent Funding Plan

触发

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Scenario Development‣ Liquidity failure is a high-impact, low-frequency event. there is little data to build reliable,

predictive models.‣ Types of liquidity stress scenarios

• Historical Scenarios✦Based on actual liquidity failures and attempt to translate those events to the financial

institution performing the stress test.• Hypothetical Scenarios

✦Based on a forward-looking view in which the financial institution experiences severe liquidity stress.

‣ Liquidity stress should exhibit the following characteristics• Distinguish between systemic and idiosyncratic risk.• Distinguish between levels of severity.• Clearly define the scenarios.

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Development of Assumptions

‣ The following assumptions can have an outsized impact on the results of the stress test, and should be considered carefully in developing the model :1. Investment portfolio haircuts 2. Deposit outflows3. Unsecured wholesale funding4. Collateral requirement

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Outputs of the Model‣ The liquidity stress test should enable the production of a regular reporting package that contains

the following for each of the entities being tested:1. Stress testing assumptions• general stress level; systemic, idiosyncratic, or combined scenario.2. Current liquidity position metrics• main objective is to determine how much liquidity is available compared to the net cash

outflows.3. Prospective liquidity position metrics• Available liquidity in the future, level of wholesale funding dependence, and level of

concentration in certain funding channels.4. Capital and performance metrics• Banks are required to maintain regulatory capital. Therefore, regarding the investment of

that capital, there is a cost-benefit decision between lower yield but more liquid investments or higher yield but less liquid investments.

• Analyzing capital measures helps determine the impact on capital when capital is needed to support liquidity in stressed times.

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Governance and Controls

‣ As an integral part of the institution’s liquidity risk governance framework, the liquidity stress test should be the subject of, while at the same time supporting, effective oversight in order to help ensure the liquidity risk profile is aligned to the bank’s risk appetite and capacity. The specific roles should consist of the following:• Asset-liability committee (ALCO): Ensuring the establishment, review, and approval of a

liquidity stress testing policy; Suggesting and approving liquidity risk scenarios, including major changes to liquidity scenarios and/or assumptions; Setting liquidity risk policy limits dependent on stress test outcomes and escalating exceptions.

• Treasury Unit: as the first line of defense. Maintenance of liquidity stress testing procedures; Recommending stress test scenarios; Reviewing and monitoring the liquidity characteristics of the institution's assets and liabilities and making recommendations to the ALCO concerning stress testing assumptions; Producing stress test-backed liquidity risk reporting

• Risk management: the independent risk management function, as the second line of defense.• Internal audit: as the third line of defense.• Model risk management

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Integration of Liquidity Stress Testing with Related Risk Models

‣ Liquidity Stress Testing should not be performed in a silo without consideration of other related risk frameworks.

‣ Consider the correlations between risk types that are likely to surface in a systemic or idiosyncratic stress scenario.

‣ Consider the interdependencies and connection points between the liquidity stress model and other risk models.• Liquidity stress testing and capital stress testing.• Liquidity stress testing and asset liability management.• Liquidity stress testing and funds transfer pricing.

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Liquidity Risk Reporting and Stress Testing

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LIQUIDITY RISK REPORTING AND STRESS TESTING

Liquidity Risk Reporting

1. Deposit Tracker Report (存款追踪报告)

• A simple report of the current size of deposits, together with a forecast of what the level of deposits are expected to be going forward. This report is tracked weekly and monthly because it provides an idea of the LTD (loan to deposit) ratio in the immediate short term.

2. Daily liquidity Report

• Is a straightforward spreadsheet detailing the bank's liquid and marketable assets, together with liabilities, up to 1-year maturity and beyond. It provides an end-of-day of the bank's liquidity position for the Treasury and Finance departments.

3. Funding Maturity Gap (缺口) ("Mismatch") Report

• The funding gap report shows the maturity gap (also known as the maturity mismatch) per time bucket, for all assets and liabilities, with an adjustment for liquid securities.

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Example for “Deposit Tracker Report ”

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Example for “Deposit Tracker Report ”

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Example for “Daily Liquidity Report”SECURITIES AND CDs

Classification Marketable00s

Input dataSecurities CDs

Bank CDs: non-ECB eligible, liquid at maturity date (breakdown below) 231,645Bank CDs: ECB (欧洲中央银行) eligible (合格的), liquid same day 0ECB eligible securities, liquid in 1 week tender 649,967Non-ECB eligible securities, can be sold over 4 weeks 277,589Government securities 9,640TOTAL MARKETABLE SECURIMES AND CDs 937,196 231,645Non-marketableNon-ECB eligible CD summaryAverage remaining tenor Amount1 day2 days1 week2 weeks 6,6451 month 25,0002 months 50,0003 months 35,0006 months 115,00012 months

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Example for “Funding Maturity Gap Report”

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4. Funding Concentration Report

• Funding source concentration reports is key for senior Treasury and relationship managers. A central principle of liquidity management is funding diversity, and its emphasis that a bank should not become over-reliant on a single source, or sector, of funds.

5. Undrawn Commitment Report (未提取承诺报告)

• Off-balance sheet products such as liquidity lines, revolving credit facilities, letters of credit and guarantees are potential stress points for a bank's funding requirement. The existence of undrawn commitments can exacerbate funding shortages at exactly the wrong time, which is why liquidity metrics include such undrawn commitments.

6. Liability Profile

• This is a simple breakdown of the share of each type of liability at the bank.

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Example for “Funding Concentration Report”

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Example for “Undrawn Commitment Report ”

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Example for “Liability Profile”

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7. Wholesale Pricing and Volume• In addition to cash flow measures previously discussed, a bank’s funding cost and the

breakdown of funding by product are key metrics that can impact a bank’s liquidity position. By comparing firm-specific yield curves with peers, regulatory authorities can identify specific banks that may be areas of concerns if their yield curves raise significantly above other banks. Bank managers may be able to obtain benchmark information from the regulator to help senior managers monitor their own position. Figure 72.13 illustrates an example of a bank’s firm-specific yield curves by type. Figure 72.14 provides a graph based on funding volume and product type. These reports are typically run on a quarterly basis, unless requested more frequently by regulatory authorities.

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• Summary and Qualitative Reports:

• Liquidity report MI for senior management should be presented as a 1-page summary of the key liquidity metrics. This can be distributed on a monthly basis or as directed by ALCO, although the distribution frequency may be increased during a stress period.

• For banking groups that operate across country jurisdictions and multiple subsidiaries, a qualitative report should be completed for Head Office Group Treasury, on a monthly basis. This will assist the group to better understand the liquidity position in each country。

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Frequency of Reporting

• In general, the main liquidity reports are required by the regulator, who stipulates their frequency. ALCO should view this obligation as a minimum requirement, and supplement it with additional MI as desired.

• In the UK, quantitative liquidity reporting is an integral part of the regulatory regime. The full requirement applies to individual liquidity adequacy standards (ILAS) firms. Some smaller institutions and foreign branches are not ILAS firms and where reporting requirements are waived or modified the regulatory authority will agree the format and frequency of liquidity reporting on a case-by-case basis.

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Stress Test Reports

‣ Senior management of the bank must be able to understand what the bank’s liquidity position will be in the event of idiosyncratic (firm-specific) or market-wide stress. The liquidity stress tests examine the funding difficulties that could arise in the event of extreme scenarios. Stress test reports help senior bank managers understand the liquidity position of the bank in the event of a market or bank-specific crisis. Understanding the bank’s liquidity enables management to take actions to mitigate the liquidity risk. The daily cash flow survival report is due weekly for firm-specific stress events and daily for market-wide stress events.

‣ The cash flow survival report is the most important stress test for liquidity. The report examines the bank’s liquidity under business as usual (BAU) conditions and after mitigating actions are used. Examples of mitigating actions of senior management include liquidating securities and acquiring contingent funding sources.

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Cash Flow Survival Report

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Cash Flow Survival Report

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Example

Ø One of the most important stress tests for senior bank managers is the cash flow survival report. It is common for banks to forecast two types of cumulative cash inflows and outflows to measure the liquidity risk of the bank. Which of the following best describes the two types of cumulative cash flows and how often is the report typically run for firm-specific and market-wide stress tests?

A. The two types of cash flows are business as usual and cash flows with adjustments for derivatives and nonmaturing deposits. All stress tests are required weekly.

B. The two types of cash flows are business as usual and cash flows with adjustments for off-balance-sheet items and contingent funding. All stress tests are required daily.

C. The two types of cash flows are business as usual and cash flows with adjustments for retail banking deposits and contingent funding. Firm-specific stress tests are required daily and market-wide stress tests are required weekly.

D. The two types of cash flows are business as usual and cash flows with adjustments for liquidated marketable securities and contingent funding. Firm-specific stress tests are required weekly and market-wide stress tests are required daily.

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Contingency Funding Planning或有融资计划

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Actions in a Liquidity Crisis

‣ The relationship between contingency funding plan and liquidity stress testing:• Contingency funding plans (CFPs) use the results of liquidity stress testing and

other relevant data as inputs within the context of governance, available contingent liquidity actions, and making decisions. Contingent liquidity events can range from low-severity, high-frequency to high-severity, low-frequency; and CFPs are used for the high-severity, low-frequency events. Thus, CFPs provide a way to control for contingent liquidity events in times of extreme stress.

• The relationship between contingency funding plans and liquidity stress testing is further established in terms of limits and escalation levels. In that regard, liquidity risk measures used during normal circumstances are a baseline for developing early warning indicators (EWIs).

CONTINGENCY FUNDING PLANNING

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Example

ØWhich of the following statements regarding contingent funding plans• (CFPs) is correct?

A. CFPs are linked to liquidity stress tests through their limit structures.B. CFPs are used for high-severity, high-frequency contingent liquidity events.C. CFPs allow for a means to control contingent liquidity events in normal times.D. Liquidity risk measures used during stressed times are a baseline for

developing early warning indicators (EWIs) for CFPs.

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Design Considerations

‣ While no universal CFP exist that can cover all types of institutions and situations, there are several CFP key design considerations that firms should be mindful of in designing their CFPs. These considerations include the following:1. Alignment to Business and Risk Profiles• Consider the range of business activities, products, asset classes, geographic

coverage (地理覆盖), and foreign exchange.• Align the risk appetite statement to the CFP by using EWIs, limits, and escalation

levels that are quantitative in nature.• Add the CFP to the firm’s strategic planning process so that the CFP is more

future-oriented and adaptable.2. Integrate with Broader Risk Management Frameworks• The CFP is included in the firm’s liquidity risk management, enterprise risk

management (ERM), capital management, and business continuity and crisis management programs; such integration makes the CFP more effective because the CFP is able to work within the firm’s internal control system.


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Design Considerations

3. Operational, Actionable, but Flexible Playbook (可操作、可执行但灵活的行动手册)

• The CFP should be ready to be placed into action quickly should a crisis occur suddenly. In that regard, numerous stress scenarios should be presented, each with potential contingency actions that will vary depending on severity levels.

• The severity levels should be tied to EWIs, triggers, and contingency actions.4. Inclusive of Appropriate Stakeholder Groups• Groups such as management committees, business units, corporate treasury, risk

management, and technology, should be involved to ensure that the CFP is operationally ready.

5. Supported by a Communication Plan• A communication plan provides a structured and efficient dissemination of

information (信息传递) to stakeholders during a crisis.• Doing so, especially to external stakeholders, helps to maintain the firm’s reputation

and functions as a form of damage control to contain any negative financial impact to the firm. (这样做，特别是对外部利益相关者，有助于保持公司的声誉和作为一种损害控制形式的职能，以遏制对公司的任何负面财务影响。)


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Example

ØWhat is a key design consideration in developing a contingency funding plan (CFP)?

A. Aligned to business profile.B. Supported by a backup plan.C. Inclusive of all shareholder groups.D. Can be used in both normal and stressed states.

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Framework and Building Blocks

‣ Key components of a CFP framework include the following:1. Governance and oversight2. Scenarios and liquidity gap analysis 3. Contingent actions4. Monitoring and escalation5. Data and reporting


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1.Governance and oversight 1. Stakeholder Involvement, Roles, and ResponsibilitiesØ Four key roles exist in a firm with regard to the development and use of CFPs: corporate

treasury, liquidity crisis team, management committee, and board of directors.a) Corporate treasury• In normal circumstances, corporate treasury has an oversight role for the firm’s risk, funding,

and liquidity. Based on an analysis of micro- and macroeconomic conditions and results from liquidity stress testing, the corporate treasurer may need to activate the CFP and involve the liquidity crisis team.

b) Liquidity crisis team (LCT)• The LCT has a general coordination and communication role (with internal and external

stakeholders) in addition to the ongoing responsibility to monitor the firm’s liquidity.• Members of the LCT should include executives, business unit leaders, and other senior

management.


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1. Governance and oversight 1. Stakeholder Involvement, Roles, and ResponsibilitiesØ Four key roles exist in a firm with regard to the development and use of CFPs: corporate treasury,

liquidity crisis team, management committee, and board of directors.c) Management committee.• It consists of senior management and manages the LCT in periods of crisis. • Other roles include liaising with the board of directors, analyzing the firm’s liquidity, and

approval of any recommendations pertaining to the CFP implementation.d) Board of directors.• It provides leadership to the LCT and management committee during a crisis.• Board members who are well-versed (精通的) with the CFP are in the best position to advise the

management committee in terms of implementing the CFP.


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Example

ØIn the context of governance and oversight of a contingency funding plan (CFP), which role has direct oversight of the liquidity crisis team (LCT)?

A. Board of directors.B. Risk management.C. Corporate treasury.D. Management committee.

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1.Governance and oversight 2. Communication and Coordination• The various business units should be coordinated and be interdependent so as to

produce data in a timely manner for decision-making purposes. A robust communication plan builds confidence within the firm; confidence and control are important to maintain in a crisis. All stakeholders want to know that management has clear plans to deal with the crisis and related post-crisis issues.

• Ideally, a proper communication plan is managed centrally to ensure absolute consistency. However, some groups (e.g., investor relations, legal, and compliance) should be allowed to maintain the communication aspect with those stakeholders with whom they already have established relationships.


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1.Governance and oversight 3. Policies and Procedures• Documentation should include all aspects of the CFP, including the governance

structure, processes, data, and reporting activities. 4.Testing and readiness assessment• On a periodic basis, institutions should evaluate their CFP operational readiness and

test targeted elements of their cfps to ensure relevance and execution effectiveness in times of stress particularly given changing market dynamics and the institutions business and risk profiles


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2. Scenarios and Liquidity Gap Analysis• There should be consistency between the CFP stress scenarios and the liquidity stress

testing ones. Furthermore, the CFP stress scenarios should link to the recovery provisions. Liquidity stress testing encompasses systemic and idiosyncratic risks, together with market liquidity and funding liquidity for stress periods in both the short-term and long-term. The CFP’s role is to have a means of making management aware of an upcoming crisis situation along with feasible methods of remedying the situation.

• The CFP considers the results of liquidity stress testing but might also examine other relevant liquidity stress scenarios beyond the firm’s normal scope of analysis. The additional scenarios help to strengthen the contingency plans to consider possible (but perhaps less likely) events that could negatively affect liquidity.


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3. Contingent actions• Once a liquidity gap analysis has been performed, a firm can determine the appropriate

contingent and capital actions to pursue. Such actions should be consistent with the amount of the capital shortfall, when the capital shortfall will occur, and the capital inflow associated with the contingent action.

Examples of contingent actions include:• Keeping credit lines that do not have significant borrowing restrictions and offer attractive

rates.• Reducing the amount of lending activity (e.g., imposing stricter underwriting standards).• Offering higher rates on deposits to increase the level of deposit activity by customers.• Choosing not to reinvest securities when they mature.• Moving from having less shorter-term funding and more longer-term funding sources.• Increasing securitization activities.• Disposing of liquid assets (处置流动资产).• Issuing subordinated debt.


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Example

ØWhich of the following items is an example of a contingent action that could be taken by a bank during a stress situation?

A. Securitizing assets.B. Decreasing lending rates.C. Increasing capital distributions.D. Shifting from longer-term to shorter-term funding sources.

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4. Monitoring and escalation• The CFP should leverage the institution’s liquidity risk monitoring and measurement

framework. This framework should include a portfolio of measures to monitor both the current liquidity profile and the anticipated effects of potential liquidity events.

• These measures can be organized as market and business measures (external and internal) and liquidity health measures (internal), and represent factors that affect — directly or indirectly — the institution’s liquidity position.

• Escalation levels: Level1: Triggered by stress test results indicating a greater decline in liquidity than the institution s risk appetite targets and or a shift in the markets perception of the institution. Level2 : Triggered when institution experiences noticeable markets and or idiosyncratic events that are adversely impacting its business and liquidity risk profile. Focus more on immediate and short-term horizon. Level3: Dramatic steps should be taken to stabilize the liquidity position. Focus on survival.


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5. Data and Reporting• Reports should convey the methods used to determine liquidity coverage for upcoming

liabilities and funding needs and elaborate (详尽阐述) on the level of coverage predicted by these measures. In addition, institutions should ensure that existing reports capture intraday liquidity positions, track exposure to contingent liabilities, and monitor capacity usage in funding sources.


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Managing and Pricing Deposit Services

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Transaction and Non-Transaction Deposit Types

ØThe largest source of funds at most depository institutions (i.e., commercial banks, savings and loans (S&Ls) and credit unions) is deposits. In the broadest sense, a commercial bank is defined as an institution that accepts deposits and makes loans. As such, deposits are a source of profitability and growth potential for the institution. The difference between the yield banks earn on assets such as loans and securities, versus the cost of funds on deposits and other sources of funding, is a key driver of commercial bank profitability.

ØBank managers and staff are concerned with two broad issues surrounding deposits:

• What are the lowest cost funding sources available?

• How can the bank raise sufficient deposits to fund loans and other activities?

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Transaction (Payment or Demand) Deposits

Ø Transaction (demand) deposits are used by depositors to make payments and are one of the oldest funding sources of banks. Banks must honor withdrawals immediately, without prior notice, either in person (i.e., the customer withdraws cash) or to a third party designated by the customer to receive funds. Withdrawals were historically done using checks (支票), and more recently through debit cards (借记卡) and electronic fund transfers via internet (electronic) banking. Transactional accounts represent the least predictable deposits because they can be withdrawn without notice. This means their maturities are, at least potentially, the shortest of all bank sources of funds. (交易

存款是企业利用银行管理其日常开支而存入银行的可随时支取的货币，是银行提供的代客户进行支付的一种服务，此类存款

属于活期存款。)

Ø Transaction deposits include noninterest-bearing (i.e., deposits do not earn explicit interest payments) and interest-bearing demand deposits. Both noninterest-bearing and interest-bearing accounts provide account holders with:

• Payment services.• A secure place to hold funds (提供一个资金的安全存放点).• Records of transactions.

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ØNoninterest-bearing demand deposits. Since the passage of the Glass-Steagall Act (格拉斯-斯蒂格尔法案) of 1933, banks were not allowed to pay interest on deposits. Historically, business deposit accounts made up the greatest proportion of noninterest-bearing deposits. Congress passed the Wall Street Reform and Consumer Protection Act (华尔街改革和消费者保护法案) in 2009, allowing banks to pay interest on corporate deposit accounts.

• noninterest-bearing demand deposits that do not earn an explicit interest payment but provide the customer with payment services, safekeeping of funds, and recordkeeping for any transactions carried out by check, card, or via an electronic network.

Ø Interest-bearing demand deposits that provide all of the foregoing services and pay interest to the depositor as well. (NOWs, MMDAs, SNOWs)

ØMobile Apps

Transaction (Payment orDemand) Deposits

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Non-Transaction (Savings or Thrift) Deposits‣ Savings or thrift deposits (储蓄存款) are designed to attract funds from customers who wish to set

aside money in anticipation of future expenditures or for financial emergencies (财务上的突发事件). These deposits normally pay significantly higher interest rates than transaction deposits do. While their interest cost is higher, thrift deposits are generally less costly to process and manage on the part of offering institutions. There are several types of savings accounts, including:①Passbook savings deposits (存折储蓄存款): sold to household customers in small denominations

(frequently a passbook deposit could be opened for as little as $5), and withdrawal privileges (特权) were unlimited.

② Time deposits (定期存款): Often called certificates of deposit (CDs). Offered to wealthier individuals and businesses, which carry fixed maturity dates (30, 60, 90, 180 or 360 days and 1 through 5 years or more) with fixed and sometimes fluctuating interest rates. Some time deposits have interest rates that adjust periodically. This adjustment period is called the roll period or leg period. Innovations in CD accounts include:

• Bump-up CDs. The depositor can switch to a higher rate if interest rates rise.• Step-up CDs. The interest rate periodically adjusts upward.• Liquid CDs. The depositor is permitted to withdraw some funds without penalty.• Index CDs. CD returns are linked to a stock market index such as the S&P 500.

MANAGING AND PRICING DEPOSIT SERVICES

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Example

ØWhich of the following describes a certificate of deposit (CD) that carries an interest rate that periodically adjusts upward?

A. Liquidity CD.B. Bump-up CD.C. Step-up CD.D. Index CD.

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Retirement Savings Deposits‣ Today depository institutions in the United States hold about a quarter of all IRA and

Keogh retirement accounts outstanding, ranking second only to mutual funds. ‣ The great appeal for the managers of depository institutions is the high degree of stability

of IRA and Keogh deposits--financial managers can general rely on having these funds around for several years. Moreover, many IRAs and Keoghs carry fixed interest rates--an advantage if market interest rates are rising-allowing depository institutions to earn higher returns on their loans and investments that more than cover the interest costs associated with IRAs and Keoghs.


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Pricing Deposit Services

1.Cost Plus Profit Deposit Pricing


Unit price charged the customer for each deposit

service

Operatingexpense per unit

of deposit service

Estimated overhead expense (管理费用) allocated

to the deposit-service function

Planned profit margin from each service

unit sold

= + +

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Example: Cost-plus pricing of deposit services

Ø Bank of the Bluegrass offers a demand deposit account that has a $500 minimum deposit. The cost to service the account, including labor and computer time, is $2.50 per month. The allocated overhead expense is $1.25 per month, and the bank would like to build in a $0.25 profit margin per account. Calculate the monthly fee the bank should charge the customer using the cost-plus pricing method.

• Answer:

• Monthly fee per account = $2.50 + $1.25 + $0.25 = $4.00 per month

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2. Using Marginal Cost to Set Interest Rates on Deposits

• Marginal cost = Change in total cost = New interest rate × Total funds raised at new

rate − Old interest rate × Total funds raised at old rate


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Using Marginal Cost to Set Interest Rates on Deposits

Table 12.2 Using Marginal cost to Choose the Interest Rate to Offer Customers on DepositsExample of a Bank Attempting to Raise New Deposit Funds

Expected Amounts of New

Deposits That Will Flow In

Average Interest

the Bank Will Pay on New Funds

Total Interest Cost of

New funds Raised

Marginal Cost of New

Deposit Money

Marginal Cost as a Percentage of New Funds

Attracted (marginal cost rate)

Expected Marginal Revenue

(return) fromInvesting the New Funds

Difference betweenMarginal

Revenue and Marginal Cost

Rate

Total Profits Earned (after interest cost)

$25 7.0% $1.75 $1.75 7.0% 10.0% +3% $0.7550 7.5 3.75 2.00 8.0 10.0 +2% 1.2575 8.0 6.00 2.25 9.0 10.0 +1% 1.50100 8.5 8.50 2.50 10.0 10.0 +0 1.50125 9.0 11.25 2.75 11.0 10.0 -1% 1.25

Note: Figures in millions except percentages.


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Example: Marginal cost method

Ø A bank currently has $100 million of deposits earning an average rate of 2%. It would like to raise an additional $50 million, but to do so, will have to raise the deposit rate to 3% on both the old and new accounts. What is the marginal cost rate of the additional $50 million in funds?

A. 3%.B. 5%.C. 7%.D. 9%.

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3. Conditional Pricing• Where a depository sets up a schedule of fees in which the customer pays a low fee or no

fee if the deposit balance remains above some minimum level, but faces a higher fee if the average balance falls below that minimum. Thus the customer pays a price conditional on how he or she uses deposit account. 条件定价法是指客户支付的费用主要取决

于账户余额和账户交易的次数.

• Conditional pricing techniques vary deposit prices based on one or more of these factors:

✦ The number of transactions passing through the account.

✦ The average balance held in the account over a designated period.

✦ The maturity of the deposit in days, weeks, months, or years.


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4. Relationship PricingØ Banks can also engage in relationship pricing. This means the bank prices

deposit services in conjunction with all the other services the customer uses and/or pays or.

• For example, a corporate customer with a large loan might get preferential pricing on deposit or treasury services. A wealthy family that keeps very large demand deposit and savings balances may receive lower pricing on trust department services (信托部门服务).



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Challenges to Offering Deposit Accounts

1. Deposit Insurance• The FDIC (联邦存款保险公司), established in 1934, insures deposits. Banks

can borrow funds at relatively low rates because deposits are insured (i.e., deposit insurance lowers the overall cost of funds). Current coverage is $250,000 per account holder.

2. FDIC Insurance Premiums• Insurance premiums are determined using a risk-based system. Riskier

depository institutions pay higher FDIC insurance premiums than do less risky institutions. Risk is determined by both the risk class of the institution and the capital adequacy of the insured institution.

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3. Bank Disclosures• The Truth in Savings Act (储蓄真相法案) of 1991 requires banks to make greater

disclosures of the terms on deposit accounts. Regulation specifies the rules for compliance with these laws. Depositors must be informed of terms before they open new accounts.

• Required disclosures include:ü Minimum balance required to open the account.ü Minimum balance that must be in the account to avoid fees.ü Amount that must be in an account to earn the promised yield.

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Challenges to Offering Deposit Accounts4. Overdraft Protection (透支保护)• Overdraft protection (bounce protection) is a service that protects a depositor in the

event he accidentally overdraws on his deposit account. The service can either be a line of credit set up to cover overdrafts, or a second account such as an MMDA (货币市

场存款账户), from which funds are transferred to cover overdrafts. However, the service is controversial (有争议的): both regulators and the public have expressed several concerns:

① The customer pays a fee to set up the account. Also, the credit line interest rate is high (e.g., 18%) and the loan must be paid off quickly, often within 30 days.

② Low income individuals who are more financially vulnerable may rely more heavily on the service. This again, to critics, looks like predatory lending to low income individuals (在批评者看来，这又像是对低收入者的掠夺性贷款).

③ Customers may be more likely to write bad checks if they know they will be covered. The result is that they will pay high interest costs to cover overdrafts, rather than building up savings.

④ People may not bother to balance their account statements (平衡他们的帐目报表) because they know they are protected from overdrafts.

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Example

Ø Which of the following is not a criticism of financial institutions providing credit lines to cover overdrafts?

A. It creates moral hazard. To prevent moral hazard, people who write bad checks should have to suffer the cost and embarrassment (困境) of dealing with the consequences so that they will not do it in the future.

B. It encourages people to write bad checks because they know they will be covered if there are insufficient funds in their accounts.

C. It leads to predatory lending. It preys on lower income individuals because they may be more likely to write bad checks and the interest rate on overdraft lines of credit tend to be high.

D. People who have overdraft protection may neglect to balance their monthly bank statements.

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5. Basic (Lifeline) Banking• A controversial (有争议) social issue facing financial institutions today is

whether access to financial services is a human right. It is difficult to live in our current society, to obtain shelter (居所; 住处), education, healthcare, and employment without access to bank accounts.

• For example, many employers will no longer write checks for payment of wages to employees; the employee must have a bank account and wages are directly deposited into that account. If a person does not have a bank account, then all of the jobs/employers that require direct deposit are inaccessible. As such, some government officials and human rights activists have asked the question of whether every adult should be guaranteed access to basic financial services. This is called basic or lifeline banking.

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Managing Nondeposit Liabilities

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Sources of Nondeposit LiabilitiesØ The largest source of funds at most depository institutions [i.e., commercial banks, savings and

loans (S&Ls), and credit unions] is deposits. However, depository institutions may not choose to, or be able to, fully fund assets (e.g., loans and securities) with deposits and owners’ equity.

Ø To fill a funding gap, banks use nondeposit liabilities, which are money and capital market sources of debt funding. These have maturities that can range from overnight to several years.

Ø Alternative sources of nondeposit funds include:① Federal funds. 联邦基金（Fed Funds）指美国的商业银行存放在联邦储备银行的准备金，包括法定准备金及

超过准备金要求的资金。这些资金可以借给其他成员银行，以满足他们对短期准备金的需求，拆借的利率称为联邦基金利率。

② Repurchase agreements (repos).③ Discount window borrowing (贴现窗口借款). 贴现窗口是中央银行向商业银行提供的满足其短期的、非永

久性的流动性需求的业务。商业银行用国库券、银行承兑票据等短期的高质量的票据作抵押从央行借入资金。

④ FHLB. The Federal Home Loan Bank (FHLB) system historically has made loans to mortgage lenders.

⑤ Negotiable CDs.⑥ Eurocurrency deposit market.⑦ Commercial paper market.⑧ Long-term nondeposit funds.

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Example

ØWhich of the following types of nondeposit funding was created to provide liquidity to mortgage lenders?

A. Fed funds.B. Repurchase agreements.C. Federal Home Loan Bank (FHLB) borrowing.D. Discount window borrowing.

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Liability Management

MANAGING NONDEPOSIT LIABILITIES

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Example

ØWhich of the following nondeposit funding sources requires collateral?

A. Fed funds and commercial paper.

B. Commercial paper and discount window borrowing.

C. Fed funds and repurchase agreements.

D. Discount window borrowing and repurchase agreements.

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Available Funds Gap

‣ The difference between current and projected outflows and inflows of funds yields an estimate of each institution’s available funds gap. Thus • Available funds gap (AFG, 可用资金缺口) = Current and projected loans and

investments the lending institution desires to make − Current and expected deposit inflows and other available funds.

‣ For example, suppose a commercial bank has new loan requests that meet its qualify standards of $150 million; it wishes to purchase $75million in new Treasury securities being issued this week and expects drawing on credit lines from its best corporate customers of $135 million. Deposits and other customer funds received today total $185 million, and those expected in the coming week will bring in another $100 million. This bank’s estimated available funds gap (AFG) for the coming week will be as follows:• AFG = ($150 + $75 + $135) – ($185 + $100) = $360 - $285 = $75


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Example

ØBarbara Friedman, a bank manager on the asset-liability committee, must estimate the amount of money market funding she expects the bank to need in the coming week. Friedman estimates that the bank will make $60 million of new loans in the coming week. The bank does not plan to make any security investments but does expect additional drawdowns on credit lines to equal $10 million. The bank is in a highly competitive deposit market and only expects $15 million in new deposits in the coming week. However, based on previous years’ experience, she expects that two of the bank’s largest customers will withdraw $1 million each in the coming week. Friedman should estimate the available funds gap for the coming week to be:

A. $43 million.B. $45 million.C. $53 million.D. $57 million.

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Nondeposit Funding Sources: Factors to Consider

‣ Which nondeposit sources will management use to cover a projected available funds gap? The answer to that question depends largely upon five factors:1. The relative costs of raising funds from each source.2. The risk (volatility and dependability) of each funding source.3. The length of time (maturity or term) for which funds are needed.4. The size of the institution that requires more funds.5. Regulations limiting the use of alternative funds sources.


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Nondeposit Funding Sources: Factors to Consider


203

Calculate Overall Cost of Funds1. Historical average cost approach


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Calculate Overall Cost of Funds

1. Historical average cost approach


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Calculate Overall Cost of Funds2. The pooled-Funds ApproachThis method of costing borrowed funds looks at the future:


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2. The pooled-Funds Approach• The overall cost of new deposits and other borrowing sources must be:

• But because only two-thirds of these expected new funds ($200 million out of $300 million raised) will actually be available to acquire earning assets.

• Thus, the borrowing financial firm in the example above must earn at least 15 percent, on average, on all the new funds it invests to fully meet its expected fund-raising costs.


Pooled deposit and nondeposit funds expense

Hurdle rate of return over all earning assets

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Example

ØBlue Star Bank expects to raise $300 million, $250 million of which will be invested in earning assets. The total expected interest and overhead costs on the newly raised funds is forecasted to be $22.00. The pooled deposit and nondeposit funds expense and hurdle rate over all earning assets are, respectively:

A. 7.33%; 7.33%.

B. 7.33%; 8.80%.

C. 8.80%; 7.33%.

D. 8.80%; 8.80%.

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Repurchase Agreements and Financing

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Mechanics of Repurchase Agreements

‣ Economically, a repurchase agreement (i.e., repo) is a short-term loan secured by collateral.‣ Repo Initiation

REPURCHASE AGREEMENTS AND FINANCING

‣ Repo Termination (Settlement)

Reverse Repo: 借出方B叫做逆回购

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Example


Ø Pasquini Investments (Pasquini) is a private brokerage looking for 30-day financing of $25 million of its accounts payable but is unsure whether the appropriate investment is a term repurchase agreement (repo) or a term reverse repo agreement. Pasquini is willing to post AAA-rated government bonds as collateral. The bonds have a face value of $27 million and a market value of $25 million. The firm is quoted a rate of 0.5% for the transaction. Which of the following choices most accurately reflects the contract type and the contract price needed by Pasquini?

Contract type Contract price

A. Repo $27,011,250

B. Reverse repo $25,010,417

C. Repo $25,010,417

D. Reverse repo $27,011,250

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Common Motivations for Entering Into Repos

1. Borrowers in Repos Bond Financing Liquidity Management2. Lender in Repos Cash Management (Repos as Investment Vehicles) Short Position Financing (Repos as Financing Vehicles)


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Example


ØRepurchase (repo) agreements are popular financing vehicles for financial institutions. Which scenario best reflects a motivation for the given institution to enter into a reverse repo transaction?

A. An insurance company seeks to increase the duration of its bond holdings to match its liability profile.

B. A municipality with large near-term cash requirements seeks to raise capital to finance public expenditures.

C. A hedge fund wants to borrow a bond to initiate a short position. D. A bank wants to reduce its regulatory capital requirements associated with higher

risk sovereign bond positions.

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Counterparty Risk and Liquidity Risk

‣ Repo transactions involve the exchange of cash as well as the exchange of collateral. As a result, both counterparty risk (credit risk) and liquidity risk are present:• Counterparty risk is the risk of borrower default or non-payment of its obligations,

and it arises because the lender is exposed to the risk of a failure by the borrower to repay the repo loan and interest

• Liquidity risk is the risk of an adverse change in the value of the collateral and can be of particular concern to the lender. This risk can be mitigated with the use of haircuts, margin calls, reducing the term of the repo, and accepting only higher quality collateral。

‣ Repo during the credit crisis• Lehman Brothers • Bear Stearns


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Example


Ø Posting collateral and requiring collateral haircuts are important risk mitigants in repo transactions with respect to which of the following risks?

Posting collateral Collateral haircuts

A. Market risk Interest rate risk B. Credit risk Interest rate riskC. Market risk Liquidity riskD. Credit risk Liquidity risk

215

Example


Dr. rosenfeld was a senior analyst at the firm with responsibility for its fixed income repo desk at the time of the Bear Stern went bankruptcy. about the repo market's role in the collapse of Bear Sterns, he said in testimony before the Financial Crisis Inquiry Commission that this loss of confidence was prompted by market rumors, which he believes were unsubstantiated and untrue about Bear Stearns liquidity position. Nevertheless, the loss of confidence had three related consequences Each of the following was one of his cited three consequences except which was not？

A. Prime brokerage clients withdrew their cash and unencumbered securities at a rapid and Increasing rate

B. Repo market lenders declined to roll over or renew repo loans even when the loans were supported by high-quality collateral such as agency securities

C. Counterpart to non-simultaneous settlements of foreign exchange trades refused to pay until Bear Stearns paid first

D. Short sellers seized on the panic and drove the stock price down which reduced equity capital available, and equity capital was already the least stable source of funds

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Collateral in Repo Transactions

1.General Collateral• Repo lenders are not concerned with receiving a particular security or class of

securities as collateral.• The repo rate for trades secured with general collateral is called the GC rate.• In the United States, the GC repo rate is typically slightly below the federal

funds rate.• The difference between the federal funds rate and the GC rate is measured

through the fed funds-GC spread. This spread widens when Treasuries become scarcer (the GC rate falls) or during times of financial stress, as was the case during the recent financial crisis.


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Collateral in Repo Transactions

2. Special Collateral• When lenders are concerned with receiving a particular security as collateral, the

collateral is referred to as special collateral, and the repo trade is called a specials trade.

• The repo rate for trades secured with special collateral is called the special rate.• Special rates are determined by market supply and demand; however, it is

important to note that the supply and demand of the underlying security is not the same as the supply and demand of the specials trade itself. In fact, a bond that is in high demand in the market may not be in great demand as collateral for a specials trade. The reverse could equally be true.


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Special Spreads and The Auction Cycle

‣ The difference between the GC rate and the special rate for a particular security and term is called a special spread. Special spreads are important because in the United States, they are tied closely to the U.S. government Treasury bond auctions, and the level and volatility of the spread can be an important gauge of market sentiment.

‣ In the United States, federal government bonds are sold at auction based on a predetermined, fixed schedule. The most recent issue is called the on-the-run (OTR) or current issue, while all other issues are called off-the-run (OFR).

‣ Current OTR issues tend to be the most liquid, with low bid-ask spreads, that can be liquidated quickly even in large sizes. This liquidity makes them desirable for both long positions and short positions• For example, a repo lender would favor these securities for short positions because the shorts

could be covered quickly and at a relatively low cost. The popularity of OTR issues as special collateral in repo trades historically resulted in lower repo rates and wider special spreads


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Special Spreads and The Auction Cycle


‣ Investors and traders who are long an OTR bond for liquidity reasons require compensation if they are to sacrifice that liquidity by lending that bond in the repo market.

‣ At the same time, investors and traders wanting to short the OTR securities are willing to pay for the liquidity of shorting these particular bonds when borrowing them in the repo market.

‣ As a result, OTR securities tend to trade special

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Special Spreads and The Auction Cycle‣ The auction cycle is an important determinant not only of which bonds trade special but also of how

special individual bonds trade over the course of the auction cycle.• First, special spreads are quite volatile on a daily basis, reflecting supply and demand for special

collateral each day.• Second, special spreads can be quite large spreads of hundreds of basis points are quite common.• Third special spreads do attain higher levels over some periods rather than others.• Fourth and the main theme of this subsection while the cycle of OTR special spreads is far from

regular, these spreads tend to be small immediately after auctions and to peak before auctions.• Immediately after an auction of a new OTR security, shorts can stay in the previous OTR security

or shift to the new OTR. This substitutability tends to depress special spreads. Also, the extra supply of the OTR security immediately following a re-opening auction tends to depress special spreads


221

Example


Ø Dora Melles is a portfolio manager who frequently uses repo and reverse repo agreements for short-term securities transactions. She has been using on-the-run (OTR)Treasury bonds for long positions for several years. Melles now expects that interest rates will rise, and based on her assessment, she believes these bonds are suitable securities as collateral for short positions given that they tend to trade at special rates. Is Melles’ assessment accurate?

A. Yes.B. No, because OTR Treasury bonds tend to trade at general collateral (GC) rates. C. No, because OTR Treasury bonds cannot be covered quickly in short trades. D. No, because OTR Treasury bonds are not suitable as short hedges against interest rate

rises.

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The Financing Value of a Bond Trading Special when Used in a Repo Transaction

‣ The premium trading value of OTR bonds is due both to their liquidity and financing advantage as we previously discussed. The liquidity advantage stems from the ability to sell these bonds quickly for cash. The financing value stems from the ability to lend the bonds at a cheap special rate and use the cash to lend out at higher GC rates. This financing value is dependent on the trader’s expectation of how long the bond will continue trading at its special rate before the rate moves higher toward the GC rate

‣ Let’s assume that an OTR bond is issued on January 1 and trades at a special spread of 0.18%. A trader expects the bond to trade at GC rates past March 31. The financing value of the OTR bond is therefore the value over 90 days. The value of $100 of cash at the spread of 0.18% is:


‣ Thus, the financing value is 4.5 cents per $100 market value of the bond.

223

Example


Ø It is March 1, and the 10-year on-the-run (OTR) Treasury bond is trading at a special rate of 0.80%. The general collateral (GC) rate is 0.95%. A trader is considering lending the bond at the special rate and using the cash to lend out at the higher GC rate. The trader expects the bond to trade at GC rates after July 31 (i. e., in 153 days from today). Given this information, the value of lending $100 of cash is closest to:

A. $0.0638.

B. $0.1500.

C. $0.3400.

D. $0.6375.

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Example


In a presentation to management, a bond trader makes the following statements about repo collateral: I. Statement 1: The difference between the federal funds rate and the general collateral rate

is the special spread. III. Statement 2: During times of financial crises, the spread between the federal funds rate

and the general collateral rate widens. Which of the trader’s statements are accurate? A. Both statements are incorrect.B. Only statement 1 is correct. C. Only statement 2 is correct. D. Both statements are correct.

225

Liquidity Transfer Pricing: A Guide to Better Practice

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Introduction

‣ Internal transfer pricing is an extremely important management tool for banks. This paper observes that until the global financial crisis (GFC), many banks treated liquidity as a free good for transfer pricing purposes, and this was one cause for the very poor liquidity outcomes experienced during the GFC.

‣ Liquidity transfer pricing (LTP) is a process that attributes the cost, benefits and risks of liquidity to respective business units within a bank. LTP has gained considerable attention since the onset of the GFC with some reports linking poor LTP practices to the funding and liquidity issues witnessed at several banks.

‣ The purpose of LTP is to transfer liquidity costs and benefits from units to a centrally managed pool. To achieve this, LTP charges users of funds (assets/loans) for the cost of liquidity, and credits provider of funds (liabilities/deposits) for the benefit of liquidity.

LIQUIDITY TRANSFER PRICING: A GUIDE TO BETTER PRACTICE

227

什么是资金转移定价？

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Governing LTP

Ø Broadly speaking, all policies, processes and practices require governing. This is normally achieved through a combination of external control factors, such as regulation and competition, and internal control factors, such as board oversight and risk management.

1. Management of the LTP ProcessBroadly speaking, there were severe deficiencies in how the LTP process was managed.

① LTP Policies

• Few banks in the survey had an effective LTP policy. As a result, LTP was not defined, nor were there any principles and/or rules in place to assist businesses understand how LTP should operate.

② Internal Funding Structure — Centralized vs Decentralized (集中还是分散)

• There is substantial debate surrounding the optimal internal structure of banks — is it better to have a centralized funding center, whereby wholesale funding is restricted to a group or subsidiary treasury or, alternatively, decentralized funding centers, whereby certain business units are able to raise funding themselves from their own sources to cover their own liquidity needs?


229

Governing LTP③ Trading Book Funding Policies and Identifying Funding Requirements• Probably the worst LTP practices identified in the survey were in relation to trading and

investment banking activities. A combination of poorly designed trading book policies, inadequate risk controls and limits, as well as a lack of oversight were to blame. For example, some banks that took part in the survey lacked trading book funding policies and procedures, which allowed for over-aggressive trading behavior and the accumulation of illiquid assets in search of revenues, not risk adjusted profit.

④ Oversight• Ineffective oversight of the LTP process contributed to many of the problems that were identified

at banks that took part in the survey. For example, the accrual of long-term illiquid assets and short-term volatile liabilities created a large and poorly understood mismatch between the maturities of assets and liabilities, and therefore exposed banks to greater structural liquidity risk.

⑤ Towards Better LTP Practice• In one form or another, all of the banks included in the survey are enhancing the way LTP is

managed. A large portion of the banks surveyed, for example, are creating LTP policies for the first time to outline the purpose of LTP and, to provide some principles and/or rules to ensure business units understand the reasoning behind charges relating to the use of liquidity.


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Governing LTP

2. Liquidity Management Information Systems (LMIS)• LMIS are widely used by management as a primary source of measuring and

monitoring the performance of businesses. LMIS provide information that assists management in liquidity strategic decision-making.

• One application of LMIS is to support internal pricing mechanisms. In relation to LTP, LMIS enable the costs, benefits and risks of liquidity to be attributed to appropriate business activities.

3. Remuneration Practices (薪酬实践)• If designed well, incentive pay can have enormous benefits. It encourages behaviour that is

consistent with the culture of an institution and assists management in achieving group-wide objectives. On the other hand, poorly designed remuneration can promote perverse (任性的) behaviours such as excessive risk-taking, which could severely impact the performance of an institution.

• In 2009, the Financial Stability Board (金融稳定理事会,FSB) reported that poor remuneration practices were one of the factors that contributed to the GFC.


231

Challenges of Implementing the LTP Process

1. A major challenge in implementing the LTP process is maintaining proper oversight to manage and monitor the process.

2. A major challenge is properly accounting for the cost of liquidity in funding illiquid assets and crediting business units that provide liquidity through deposits. A centralized treasury center is recommended to overcome challenges that arise from decentralized funding centers. Arbitrage opportunities are less likely in a centralized LTP process.

3. Another challenge is developing trading book policies and implementing best practices to account for potential liquidity costs of derivatives and contingent collateral calls and margin calls.

4. A further challenge in implementing the LTP process is ensuring the LMIS infrastructure is sufficient to produce useful high-quality reports of liquidity in a timely manner.

5. A challenge in implementing the LMIS infrastructure is ensuring that the remuneration policy for executives of business units properly account for liquidity. The LMIS should create monthly reports.

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Example

ØWhich of the following best describes one of the major challenges for banks in implementing an effective LTP process?

A. A decentralized LTP process is recommended to mitigate arbitrage opportunities for different business units.

B. Illiquid long-term assets should be penalized for increasing liquidity risk.

C. Performance evaluations of business unit managers should be separate from the LTP process.

D. A liquidity management information system (LMIS) should produce and monitor high-quality reports on a quarterly basis.

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Liquidity Transfer Pricing Approach

1. “Zero” Cost of Funds Approach — Liquidity as a “Free” Good• Probably the most striking example of poor practice identified in the survey was

that some banks failed to account for the costs, benefits and risks of liquidity in all or some aspects of their business activities.

• These banks came to view funding liquidity as essentially free, and funding liquidity risk as essentially zero. As a result, there was simply no charge attributed to some assets for the cost of using funding liquidity, and conversely no credit attributed to some liabilities for the benefit of providing funding liquidity. In practice, the rate charged to users of funds was simply derived from the swap curve with no additional spread added.


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Liquidity Transfer Pricing Approach1. “Zero” Cost of Funds Approach — Liquidity as a “Free” Good


235


2. Pooled “Average” Cost of Funds Approach to LTP• Some banks recognized the need to charge users and credit providers of funding

liquidity and employed a pooled approach to LTP, where an average rate was calculated based on the interest expense (cost of funds) across all existing funding sources.

• For example, if the average rate across all funding sources was 10bps, all loans would receive a charge of $1,000 on principal amount of $1 million, irrespective of their maturity. Assuming this rate was also used to reward fund providers, then all deposits would receive a credit of $1,000 on a principal amount of $1 million, irrespective of their maturity.


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Liquidity Transfer Pricing Approach2. Pooled “Average” Cost of Funds Approach to LTP single average cost


237

Liquidity Transfer Pricing Approach Separate Average Costs of Funds Approach• Figure illustrates the average cost of funds curve for assets and the average benefit of funds

curve for liabilities, assuming different liquidity spreads for assets and liabilities.


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4. Matched-Maturity Marginal Cost of Funds Approach to LTP• A matched-maturity marginal cost of funds approach to LTP is current best

practice for assets and liabilities on the balance sheet• Under the matched-maturity marginal cost of funds approach, rates charged for

the use of funds and, conversely, rates credited for the benefit of funds are based on the term liquidity premiums corresponding to the maturity of the transaction

• Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds (in basis points)


239

Liquidity Transfer Pricing Approach4. Matched-Maturity Marginal Cost of Funds Approach to LTP


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Pricing Contingent Liquidity Risk

241



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‣ At the most basic level of what is considered to be better practice, all banks should be charging contingent commitments based on their likelihood of drawdown.

‣ For example, suppose a line of credit with a limit of $10 million has $4 million already drawn. The rate charged for contingent liquidity risk should be derived as:

‣ In the example above, assume there is a 60 per cent chance the customer will draw on the remaining credit and that the cost of term funding assets in the liquidity cushion is 18 bps. The rate charged for the cost of contingent liquidity risk should be equal to :

243

Example

ØA bank supplies a line of credit of $10 million that currently has $6 million already drawn. The bank determines that there is a 65% probability the customer will use the remaining line of credit. The bank’s cost of funding for the liquidity cushion is 16 bps. If the bank charges contingent commitments based on the probability of a drawdown, what should the charge for liquidity be for this line of credit?

A. $1,664.

B. $2,496.

C. $4,160.

D. $5,850.

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The US Dollar Shortage in Global Banking and the International Policy

Response

245

Global Balance Sheets and Funding RiskØDuring the decade leading up to 2007, banks had significantly expanded their investment

portfolios globally through diversifying internationally, increasing their investment holdings of U.S. dollar loans and structured products. Banks could finance these positions in three ways:

① Borrow in their domestic currency, convert to U.S. dollars in the spot market, and buy the asset.

① Convert their domestic currency liabilities into U.S. dollars using foreign exchange (FX) swaps, and buy the asset.

② Borrow U.S. dollars directly in the interbank markets from other participants or from the central bank.

ØRegardless of the funding choices, banks are exposed to funding risk, or the risk that they will be unable to roll over their maturing liabilities. The level of this risk depends on the assets’ maturity transformation on the balance sheets, creating a foreign currency mismatch—referred to as a funding gap—if the investment horizon of the foreign currency assets exceeds the time to maturity of the foreign currency liabilities (funding or FX swaps).

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Global Balance Sheets and Funding Risk

As a result, the maturity-mismatch and funding risk in foreign currencies is of critical importance. Banks are exposed to funding risk in their domestic currencies if the domestic currency asset investment horizon exceeds the liability maturity. However, banks can receive emergency liquidity funding from central banks, which can act as lenders of last resort, significantly minimizing domestic funding risk. On the other hand, central banks cannot create foreign currencies and, therefore, banks would need to meet any foreign currency requirements directly in the international markets.The foreign currency funding risk has to be measured across banks’ global consolidated balance sheets (合并资产负债表) by looking at mismatches between the maturity, currency, and counterparty in order to identify any vulnerabilities and stresses.

247

Example

ØThe funding gap can be best defined as:A.a mismatch between banks’ domestic and foreign currency

obligations.B. the difference between banks’ foreign currency and domestic

currency reserves.C.the difference between a bank’s collateralized and

noncollateralized foreign borrowings.D.a foreign currency mismatch if the investment horizon of the

foreign currency assets exceeds the time to maturity of the foreign currency liabilities.

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Vulnerabilities in Balance SheetsØ Large banks operate internationally, which can create mismatches in

currency and maturity positions on their balance sheets. Vulnerabilities are best seen when looking at the global balance sheet of a consolidated bank entity.

Ø As banks’ global asset purchases increased, foreign currency assets often exceeded funding in these currencies, leading to a U.S. dollar funding gap.

Ø Banks need to finance their U.S. dollar investments through short-term U.S. dollar borrowing in the interbank market, borrowing through FX swaps, or obtaining U.S. dollar funding from nonbanks.

Ø If the maturity of U.S. dollar liabilities to nonbanks is longer term, a lower bound of the U.S. dollar funding gap can be established as the net U.S. dollar position to nonbanks.

Ø If the maturity of U.S. dollar liabilities to nonbanks is shorter-term, an upper bound of the U.S. dollar funding gap can be established as the gross U.S. dollar position to nonbanks.

249

Example

ØIf the maturity of a bank’s U.S. dollar liabilities to nonbanks is longer-term:

A. a lower bound of the U.S. dollar funding gap can be established as the net U.S. dollar position to nonbanks.

B. an upper bound of the U.S. dollar funding gap can be established as the net U.S. dollar position to nonbanks.

C. a lower bound of the U.S. dollar funding gap can be established as the gross U.S. dollar position to nonbanks.

D. an upper bound of the U.S. dollar funding gap can be established as the gross U.S. dollar position to nonbanks.

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Causes of the 2007–2009 U.S. Dollar Shortage

Ø The maturity mismatch between banks’ U.S. dollar assets and liabilities and rise in the funding gap created short-term funding disruptions and made it difficult to obtain U.S. dollars through currency swaps. This was compounded by a withdrawal of money markets from bank-issued paper, and central banks withdrew a sizable portion of their U.S. dollar foreign exchange reserves.

Ø As U.S. dollar assets matured, banks needed to roll over these assets. Until mid-2008 banks accessed U.S. dollars directly in U.S. markets through their U.S. offices, including borrowing from the Fed (直到2008年年中，银行通过其美国办事处直接进入美国市场获得美元，包括向美

联储借款). However, banks encountered difficulty in selling their less liquid U.S. dollar assets, including structured products, without incurring significant losses. As a result, the holding period of assets lengthened while the funding maturity shortened, creating a U.S. dollar funding gap.

Ø Estimating the true size of the funding gap is difficult and depends on whether banks actually unwound their funding positions or rolled them over. Under the assumption that banks rolled over their positions, the funding gap would be underestimated by the amount of the asset write-downs.

251

International Policy Response by Central BanksØCentral banks had insufficient U.S. dollar liquidity to alleviate their banks’ funding

shortages. Reciprocal swap arrangements (互惠互换协议) with the Fed helped central banks obtain U.S. dollars. This created a swap network where the Fed lent money collateralized by foreign currencies. In turn, central banks made these funds available to other banks through local U.S. dollar auctions.ØThe earliest swap agreements were between the Fed, the ECB (欧洲中央银行), and the Swiss

National Bank (瑞士央行; 瑞士国家银行). Later, these arrangements were extended to other central banks, creating a global central bank network of swap lines.ØAs the crisis widened in late 2008, the swap lines with several of the major European

banks were made unlimited, effectively making the Fed as an international lender of last resort.ØThe swap lines were effective and led to a significant reduction in interbank rate volatility

while they also reduced pressure for the U.S. dollar to appreciate. ØThe use of swap lines also have two broader institutional benefits:pThe success of the U.S. dollar swap network signals that the use of swap lines can also

serve to mitigate pressures in other currencies.pA central bank that lends through the swap network is protected against credit risk

(counterparty default) because the lines are collateralized.

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Central Bank Network of Swap Lines

THE US DOLLAR SHORTAGE IN GLOBAL BANKING AND THE INTERNATIONAL POLICY RESPONSE 253

Example

ØWhich of the following statements about the U.S. dollar swap lines extended by the Fed to global central banks during the 2007–2009 financial crisis is least accurate?

A. Swap lines could be unlimited.B. Swap lines were primarily uncollateralized.C. The Fed can be seen as a lender of last resort.D. Central banks typically made funds available locally through auctions.

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Covered Interest Rate Parity Lost: Understanding the Cross-Currency Basis

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FX Swap vs. Cross-currency Swap

Ø In an FX swap, one party borrows one currency from, and simultaneously lends another currency to, a second party. The borrowed amounts are exchanged at the spot rate and then repaid at the pre-agreed forward rate at maturity.

ØA cross-currency swap is a longer-term instrument, typically above one year, in which the two parties also simultaneously borrow and lend an equivalent amount of funds in two different currencies. At maturity, the borrowed amounts are exchanged back at the initial spot rate, but during the life of the swap the counterparties also periodically exchange interest payments.

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Covered Interest Parity (CIP)

COVERED INTEREST PARITY LOST: UNDERSTANDING THE CROSS-CURRENCY BASIS

ØCIP is represented as:

where:• S = spot exchange rate in U.S. dollars per unit of foreign currency (USD/FC)• F = forward exchange rate in U.S. dollars per unit of foreign currency (USD/FC)• r = U.S. dollar interest rate• r* = FC interest rate

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CIP violations

COVERED INTEREST PARITY LOST: UNDERSTANDING THE CROSS-CURRENCY BASIS

ØFX swap:

Øcross-currency swap:

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Cross-Currency Basis Swaps

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Ø There are two key factors that can cause deviations from CIP and, consequently, cause the cross-currency swap basis to change and not be equal to zero in times of financial crisis: (1) decline in market liquidity and (2) increases in the risk of the underlying instruments that gives rise to risk premia.

① The first factor is lack of market liquidity in the underlying forward and spot FX contracts resulting from an external financial crisis. The result of this lack of liquidity is wider bid-ask spreads that increase the transactions costs of executing the FX swap and eliminate the arbitrage opportunity.

② The second factor is risk premium that result from increases in counterparty credit risk in the underlying FX markets and increases in sovereign credit risk in the government bonds used in CIP arbitrage [measured using sovereign credit default swap (CDS) spreads. Even small increases in risk premia can have a significant impact on arbitrageurs’ ability to execute the underlying trades if the hedging demand for one of the currencies is sufficiently large.

Cross-Currency Basis Swaps

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The causes of covered interest rate parity violations after the financial crisis of 2008

1. Why the Basis Opens Up: Demand for Currency HedgesØ As mentioned previously, even small risk premium that are present during noncrisis

times can make it difficult to arbitrage violations of CIP if the hedging demand for the currency is large enough. There are three sources of hedging demand that have grown since the crisis:

① The first source of currency hedging demand is from banks managing currency mismatches on their balance sheets using FX swaps.

② The second source of currency hedging demand is from institutional investors (like insurance companies and banks) using FX swaps to hedge the foreign currency risk in their investment portfolios.

③ The third source of currency hedging demand is from U.S. nonfinancial firms issuing foreign-currency denominated debt when credit spreads narrow in foreign debt markets. These firms then swap the FC proceeds back to USD using FX swaps.

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the causes of covered interest rate parity violations after the financial crisis of 2008

2. Why the Basis Does Not Close: Limits to ArbitrageØ In the absence of additional market constraints, even if the basis does open up, it should

close very quickly as arbitrageurs exploit the opportunity. However, this type of arbitrage is both costly and risky and it requires an expansion of the arbitrageur’s balance sheet. With that expansion comes credit risk on both sides of the arbitrage trade (borrowing and lending) and capital and funding risk, as well as liquidity risk when faced with mark-to-market requirements.

Ø These risks have always been there, but post-crisis market participants have been managing their balance sheets—and the accompanying risks and exposures—much more carefully. This has resulted from pressure from regulators, shareholders, and creditors. The bottom line is that limits to arbitrage resulting from careful balance sheet management has limited the impact of arbitrage activities on the cross-currency basis, and as a result, violations of CIP persist.

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Example

Ø The cross-currency swap basis is the:

A. Interest rate differential in a cross-currency swap.

B. Price to the long position in a cross-currency swap.

C. Difference between the forward and spot exchange rates in a cross-currency swap.

D. Amount by which the interest rate of one currency must be adjusted in a cross-currency swap so that covered interest parity (CIP) holds.

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Example

Ø In an foreign exchange (FX) swap, the:A. Price is quoted in forward points.B. Term is typically more than one year.C. Counterparties swap currencies back at the end of the contract at the

original spot rate.D. Counterparties exchange net interest payments based on the reference

rate during the term of the swap.

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Example

Ø Since the financial crisis of 2007–2009, the cross-currency basis for most major currencies relative to the U.S. dollar (USD) has consistently been:

A. Equal to zero.B. Greater than the interest rate differential.C. Greater than zero for the USD interest rate.D. Greater than the forward premium on the USD.

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Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

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Asset-Liability Management Strategy

RISK MANAGEMENT FOR CHANGING INTEREST RATES: ASSET-LIABILITY MANAGEMENT AND DURATION TECHNIQUES

Asset - liability management in banking and financial services.

Managing a financial institution's response to changing market interest rates

Net interest margin

Net worth (equity)

A financial institution's investment value, probability, and risk exposure

Interest revenues

Interest costs

Market value of assets

Market value of liabilities

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Funds Management Strategy


‣ The maturity of liability management techniques, coupled with more volatile interest rates and greater risk, eventually gave birth to the funds management approach, which dominates today. This view is a more balanced approach to asset-liability management that stresses several key objectives:1. Management should exercise as much control as possible over the volume, mix, and return

or cost of both assets and liabilities in order to achieve the financial institution’s goals.2. Management’s control over assets must be coordinated with its control over liabilities so

that asset management and liability management are internally consistent and do not pull against each other (不相互抵触). Effective coordination in managing assets and liabilities will help to maximize the spread between revenues and costs and control risk exposure.

3. Revenues and costs arise from both sides of the balance sheet. Management polices need to be developed that maximize returns and effectively control costs from supplying services.

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Net Interest Margin (净利差,NIM)


• For example, suppose a large international bank records $4 billion in interest revenues from its loans and security investments and $2.6 billion in interest expenses paid out to attract borrowed funds. If this bank holds $40 billion in earning assets, its net interest margin is :

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RISK MANAGEMENT FOR CHANGING INTEREST RATES: ASSET-LIABILITY MANAGEMENT AND DURATION TECHNIQUES 270

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• For example, suppose the yields on rate-sensitive and fixed assets average 10 percent and 11 percent, respectively, while rate-sensitive and non-rate-sensitive liabilities cost an average of 8 percent and 9 percent, respectively. During the coming week the bank holds $1700 million in rate-sensitive assets (out of an asset total of $4， 100 million) and $1800 million in rate-sensitive liabilities. The net interest income will be:

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• If management feels its institution is excessively exposed to interest rate risk, it will try to match as closely as possible the volume of assets that can be repriced as interest rates change with the volume of liabilities whose rates can also be adjusted with market conditions during the same time period

• For example, a financial firm can hedge itself against interest rate changes—no matter which way rates move— by making sure for each time period that the

Dollar amount of repriceable (interest-sensitive) asset =

Dollar amount of repriceable (interest-sensitive) liabilities

Interest- Sensitive Gap

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‣ Interest–sensitive gap = Interest-sensitive assets – Interest-sensitive liabilities

‣ Asset–sensitive (positive) gap = Interest-sensitive assets – Interest-sensitive liabilities > 0

‣ Liabilities–sensitive (negative) gap = interest-sensitive assets – Interest-sensitive liabilities < 0

‣ Dollar IS gap = ISA-ISL


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• For example, suppose that a bank has $100 million in earning assets and $200 million in liabilities subject to an interest rate change each month over the next six months. Then its cumulative gap must be -$600 million.

• Suppose market interest rates suddenly rise by1 full percentage point. Then the bank in the example given above will suffer a net interest income loss of approximately:

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Interest- Sensitive Gap Management• Defensive gap management: set IS gap as close to zero as possible.• Aggressive gap management:

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1. Interest rates paid on liabilities (which often are predominantly short term) tend to move faster than interest rates earned on assets (many of which are long term). Then, too, changes in interest rates attached to assets and liabilities do not necessarily move at the same speed as do interest rates in the open market.

2. The point at which certain assets and liabilities can be repriced is not always easy to identify.

3. Interest-sensitive gap management does not consider the impact of changing interest rates on the owners’ (stockholders’) position in the financial firm as represented by the institution's net worth.

Problems with Interest-Sensitive GAP Management

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Duration Gap Management

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RISK MANAGEMENT FOR CHANGING INTEREST RATES: ASSET-LIABILITY MANAGEMENT AND DURATION TECHNIQUES 279



• Defensive gap management: set leverage adjusted duration gap to zero.• Aggressive gap management:

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Limitations of Duration Gap Management


‣ While duration is simple to interpret, it has limitations1. For one thing, finding assets and liabilities of the same duration that fit into a

financial-service institution's portfolio is often a frustrating task (令人沮丧的任务).2. Some accounts held by depository institutions, such as checkable deposits and

passbook savings accounts, may have a pattern of cash flows that is not well defined, making the calculation of duration difficult.

3. A related problem with duration analysis revolves around the concept of convexity. Duration gap analysis tends to be reasonably effective at handling interest rate risk problems if the yield curve changes by relatively small amounts and moves in parallel shift.

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Illiquid Assets

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Characteristics of Illiquid Markets

ILLIQUID ASSETS

‣ There are several characteristics that describe illiquid asset markets, including: 1. Most asset classes are illiquid, at least to some degree2. Markets for illiquid assets are large3. Illiquid assets comprise the bulk of most investors’ portfolios4. Liquidity dries up even in liquid asset markets

In stressed economic periods, such as during the 2007-2009 financial crisis, liquidity can dry up.

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Market Imperfections and Illiquidity

ILLIQUID ASSETS

‣ Many economic theories assume that markets are perfect. This means that:• Market participants are rational and pursue utility maximization• There are no transaction costs, regulation or taxes• Assets are perfectly divisible• There is perfect competition in markets• All market participants receive information simultaneously

‣ The reality, though, is that markets are imperfect.

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ILLIQUID ASSETS

‣ Imperfections that encourage illiquidity include: 1. Market participation costs. There are costs associated with entering markets, including the

time, money, and energy required to understand a new market. In many illiquid markets, only certain types of investors have the expertise, capital, and experience to participate. This is called a clientele effect (追随者效应).

2. Transaction costs. Transaction costs include taxes and commissions. For many illiquid assets, like private equity, there are additional costs, including costs associated with performing due diligence. Investors must pay attorneys (律师), accountants, and investment bankers. These costs can impede investment.

3. Difficulties finding a counterparty (i.e., search frictions). For example, it may be difficult to find someone to understand/purchase a complicated structured credit product. It may also be difficult to find buyers with sufficient capital to purchase an office tower or a skyscraper in a city like New York.

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ILLIQUID ASSETS

4. Asymmetric information. Some investors have more information than others. If an investor fears that the counterparty knows more than he does, he will be less willing to trade, which increasing illiquidity. When asymmetric information is extreme, people assume all products are lemons (次品). Because no one wants to buy a lemon, markets break down. Often liquidity freezes are the result of asymmetric information.

5. Price impacts. Large trades can move markets, which, in turn, can result in liquidity issues for the asset or asset class.

6. Funding constraints. Many illiquid assets are financed largely with debt. For example, even at the individual level, housing purchases are highly leveraged. As a result, if access to credit is compromised, investors cannot transact.

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Example

ØWhen an investor has difficulty finding a counterparty for a complicated credit product like a structured debt instrument, this is known as:

A. Market participation costs.

B. Agency costs.

C. Search frictions.

D. Selection bias.

ILLIQUID ASSETS

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Illiquid Assets Returns Biases

ILLIQUID ASSETS

‣ In general, investors should be skeptical of reported returns in illiquid asset markets as they are generally overstated. There are reporting biases that result in artificially inflated returns. The three main biases that impact reported illiquid asset returns are:1. Survivorship Bias:

• Poor performing funds often quit reporting results. Also, many poor performing funds ultimately fail. Finally, some poor performing funds never begin reporting returns because performance is weak. All of these factors lead to survivorship bias. Survivorship bias leads to an overstatement of stated returns relative to true returns.

2. Sample Selection Bias:• Asset values and returns tend to be reported when they are high. For example, houses and

office buildings typically are sold when values are high. These higher selling prices are used to calculate returns. This results in sample selection bias, which again leads to overstated returns.

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Example

ØBlue Sky Funds, a private equity fund, has suffered low returns for the last five years. As a result, the fund has decided to quit reporting returns. The fund did report returns each year for the last 10 years when performance was strong. This problem of reporting leads to:

A.Survivorship bias.B.Sample selection bias.C.Infrequent trading bias.D.Attrition bias.

ILLIQUID ASSETS

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ILLIQUID ASSETS

3. Infrequent trading: • Illiquid assets, by definition, trade infrequently. Infrequent trading results in underestimated

risk. Betas, return volatilities, and correlations are too low when they are computed using the reported returns of infrequently traded assets.

• Returns for these infrequently traded assets are smoothed. For example, if one compares quarterly returns to the daily returns of the same asset, quarterly returns will appear (and actually be) less volatile. Also, correlations with other asset classes (e.g., liquid assets such as large-cap stocks) will be artificially low because return volatility is muted by infrequent trades.

• It is possible to unsmooth or de-smooth returns using filtering algorithms. Filtering algorithms generally remove noise from signals. However, unsmoothing adds noise back to reported returns to uncover the true, noisier returns.

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ILLIQUID ASSETS

3. Infrequent trading: • The unsmoothing process has several important properties:1. Unsmoothing affects only risk estimates and not expected returns2. Unsmoothing has no effect if the observed returns are uncorrelated3. Unsmoothing is an art

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ILLIQUID ASSETS

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Illiquidity Risk Premiums

ILLIQUID ASSETS

‣ There is little evidence that there are large illiquidity risk premiums across asset classes. However, there are large illiquidity risk premiums within asset classes

‣ There are four primary ways that investors can harvest illiquidity premiums:1. Allocating a portion of the portfolio to illiquid asset classes like real estate. This is passive

allocation to illiquid asset classes2. Choosing more illiquid assets within an asset class. This means engaging in liquidity security

selection3. Acting as a market maker for individual securities. For example, Dimensional Funds

Advisors (DFA) is a liquidity provider that buys stock at a discount from those wanting to sell quickly and sells small-cap stocks at a premium to investors demanding shares

4. Engaging in dynamic factor strategies at the aggregate portfolio level. This means taking long positions in illiquid assets and short positions in liquid assets to harvest the illiquidity risk premium. Of the four ways investors can harvest illiquidity premiums, this is the easiest to implement and can have the greatest effect on portfolio returns.

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Illiquidity Risk Premiums

ILLIQUID ASSETS

‣ There is little evidence that there are large illiquidity risk premiums across asset classes. Because:

1. illiquidity biases 2. ignores risk 3. There is no “market index” for illiquid asset classes 4. You cannot separate factor risk from manager skill‣ However, there are large illiquidity risk premiums within asset classes. 1. U.S. Treasuries 2. Corporate Bond 3. Equity‣ Why Illiquidity Risk Premiums Manifest within but Not across Asset Classes？Perhaps the

reason is limited integration across asset classes

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Portfolio Choice with Illiquid Assets

ILLIQUID ASSETS

‣ Asset Allocation with Transactions Costs: a major shortcoming of the transaction costs models is that they assume trade is always possible by paying a cost. This is not true for private equity, real estate, timber, or infrastructure.

‣ Asset Allocation with Infrequent Trading: 1. Illiquidity Markedly Reduces Optimal Holdings 2. Rebalance Illiquid Assets to Positions below the Long-Run Average Holding 3. Consume Less with Illiquid Assets 4. There Are No illiquidity Arbitrages 5. Investors Must Demand High Illiquidity Hurdle Rates

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