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Assessing and Pricing Liquidity Risk: An Economic Perspective of Asset and Liability Dynamics

October, 2011

Amnon Levy, Managing Director, Head of Portfolio Research

Yashan Wang, Senior Director, Portfolio Research

Assessing and Pricing Liquidity Risk October, 2011

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Bank Funding Costs Continue to be a Major Concern

Lehman Brothers Bankruptcy

European Sovereign Debt Crisis

Bear Stearns Hedge Funds’ Collapse


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Variation in Secured Lending

For a complete description and interpretation of the data, please see

Krishnamurthy, Arvind, Stefan Nagel and Dmitry Orlov. Sizing up Repo, working paper, 2011.

0

200

400

600

800

06Q4 07Q2 07Q4 08Q2 08Q4 09Q2 09Q4

Repo Investment by Money Market Funds

Repo Investment by Securities Lenders

Investments in Repo by US MMFs and Securities Lenders ($billions)


Basel: “… the maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs.”

FSA: “A Contingency Funding Plan should set out a firm’s strategy for addressing liquidity shortfalls in stressed conditions.”

Fed: “…a cushion of liquid assets, and a formal well-developed contingency funding plan (CFP) as primary tools for measuring and managing liquidity risk.”

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Regulatory Emphasis on Contingent Liquidity


5

Economic Guidance Mostly in the form of motivating relationships:

» Banks’ assets and liabilities are often maturity-mismatched, with long-term assets funded through short-term liabilities

» In periods of distressed liquidity conditions, the bank may face elevated funding costs, and more stringent haircuts as it refinances its short-term funding

» At the same time, the bank’s borrowers may increase their use of bank funds, forcing the bank to raise additional funds.

But a formal framework and quantitative guidance are limited:

» What amount of liquid assets should a financial institution hold in order to absorb potential losses due to adverse funding conditions?

» To which extent should more liquid/fungible assets receive liquidity offsets?

» How should a financial institution account for these dynamics when originating loans or when calculating a transfer price?


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Some Funding Sources: Benefits, Drawbacks, and Risks

Long term borrowing – Typically costlier » Long term debt

» Preferred stock

» Equity

» Demand deposits (can be uncertain)

Short Term Borrowing - Generally cheap but uncertain availability and cost » Collateralized borrowing (e.g., Repo, ABCP)

» Money Market

» Fed Funds

» Discount window

Asset Sale » Often at a loss

» Affects bank’s strategy


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Measuring Contingent Liquidity Risk in a Stylized Economic Setting

Consider a simplified two-period setting:

» A bank invests in a variety of assets – Extends backup lines of credit to a pool of borrowers

» Borrowers’ future demand for liquidity (line utilization) is uncertain

– Fully funded instruments with varying degrees of liquidity » The degree to which assets can be collateralized is uncertain

» The market price of the assets is uncertain

» The bank funds the credit lines using a combination of long-term funds (a liquidity buffer), short-term collateralized debt, and possibly asset sales

» The bank’s funding cost, in part due to the value of collateral, and the borrowers’ line usage are correlated

» Availability of short-term funds is limited in severe market conditions

What amount of liquid assets should the bank hold in order to absorb potential losses due to adverse funding conditions?


Basel III characterizes an acute short-term stress scenario for determining the resilience of the balance sheet:

» A significant downgrade of the institution’s public credit rating

» A partial loss of deposits

» A loss of unsecured wholesale funding

» A significant increase in secured funding haircuts

» Increases in derivative collateral calls and substantial calls on contractual and non-contractual off-balance sheet exposures, including committed credit and liquidity facilities

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Characterizing the “Perfect Storm”


Case Study: Countrywide Taps Backup Lines as a Source of Funding Liquidity

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Aug 16, 2007 Countrywide draws on $11.5bn syndicated credit facility

Jul 1, 2008 Bank of America completes acquisition of Countrywide

Aaa

Aa

A

Baa

Ba

B

Caa-C


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Characterization of the Funding Environment

Bank invests in assets of varying liquidity, and extends lines of credit. It funds operations with long-term borrowing

Bank uses liquidity reserve to fund draw-downs

Bank uses a combination of reserve funds, short-term borrowing, and asset sales to fund draw-downs

0t 1t 2t

Borrowers pay back lines and bank unwinds


Access to capital markets may be limited

» A systemic event may result in access to funding to be severely hampered

11

( )( ) 1 2 11 1

1, 2 1

2 1

1 log 1 ( )BankBank Bankt t tt tr N N PD RSQ t t LGD

t tλ− ≈ − − + ⋅ − ⋅ −

Short Term Cost of Collateralized Funding

Probability of bank default between t1 and t2 Market risk premium

Markets Functioning1 1Shutdownλ λ≤=

1 1 2, Bank

Default

Colateral Colateralt t tLGD QPD LGD≈ ⋅

Risk adjusted collateral default probability given that the bank defaults


20% 40% 60% 80%%

%

%

%

20% 40% 60% 80%%

%

%

%

20% 40% 60% 80%%

%

%

%

1bps 10bps 100bps 1000bps

Modeling the Joint Dynamics

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Borrower Usage

-12% -8% -4% 0% 4% 8%

Bank Gains/Losses

Borrower Credit

Migration

Collateral Asset Credit Migration

Market Risk Premium

Haircut/Asset Sale

Ban

k

Line of credit borrower

Ban

k

Market Risk Premium

Ban

k

Collateralizable Asset Borrower Bank

borrowing cost

Bank Funding Decision - Borrow or Sell


13

Bank Asset Value and Credit Market Risk Premium

0.2

0.4

0.6

0.8

1

1.2

0.8

0.9

1

1.1

1.2

Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11

Banking Index Asset Value Market Price of Risk

-0.4

-0.2

0

0.2

0.4

0.6 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11


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Market Risk Premium Significantly Higher in Crisis Periods

The crisis period is characterized as the 95-percentile of the empirical density estimate:

0.9Shutdownλ =

Credit Market Risk Premium


15

Other Empirical Specifications

» Asset Correlations: Estimated using GCorr™ global correlation model

» Credit Migration: Obtained from the Moody’s Analytics Distance-to-Default Dynamics model

» Credit Line Utilization: A credit quality contingent PD-usage mapping is estimated using Moody’s Analytics Credit Research Database (CRD™)

» Haircut data from European Central Bank

0 0.25 0.5 0.75 1.0

20%

40%

60%

80%

100%

Annual Default Probability

Line

Usa

ge

Haircut on Collateral Assets, source ECB

Credit Rating Haircut

Aaa to A3 3%

Baa1 to Baa3 18%

Below Baa3 Not eligible


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Case Study: Liquidity Provisioning for a Portfolio of Homogeneous Borrowers Bank Characteristics

Cost of long-term debt: 1.5%

Maturity of short-term debt: 1 year

1 year default probability: 50 bps

RSQ: 60%

Revolver Borrower Characteristics

No. of Homogeneous Borrowers: 80

Maturity of credit line: 2 years

Contractual Usage Fee: 3%

1 year default probability: 2%

RSQ: 25% Collateral Asset Characteristics

No. of Homogeneous assets: 40

Maturity of assets: 2 years

1 year default probability: 80 bps

Coupon rate: 3%

RSQ: 40%


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Quantifying the Value of Asset Liquidity » Callateralizable assets can be used as collateral in secured borrowing or asset sale

(as well as being sold)

» Banks often avoid asset sale under stressed market condition

» Liquid assets can be sold at market prices but not eligible as collateral in borrowing

» Illiquid asset are not eligible for borrowing or selling

» Funding needs are met by liquidity buffer only

» Coupon Rate for Collateralizable Assets = 3%

» To achieve the same solvency probability for the bank » Additional coupon required if assets are not collateralizable but liquid = 47 pbs

» Additional liquidity buffer cost if assets are not collateralizable and illiquid = 96 bps


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Liquidity Buffer Size as a Fraction of Total Asset Value

0% 20% 40% 60% 80% 100%

corr(bank, revolver) = 36%, assets collateralizable

corr(bank, revolver) = 36%, assets liquid

corr(bank, revolver) = 36%, assets illiquid

corr(bank, revolver) = 56%, assets illquid


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Credit Spread 180 bps

Contingent Liquidity Spread 94 bps

Reference Rate

Assumptions: Corr(Bank, Revolver) = 36%, w/ Collaterizable Assets

FTP

= 2

74 b

ps

Incorporating Contingent Liquidity Costs in Funds Transfer Pricing

Contr

actu

al F

ee =

300bps


20 20

A Practical Approach for FTP and Spread Decomposition

Fu

nd

s Tra

nsf

er

Pri

ce

Commercial Margin

Credit Spread

Option Spread

Funding Liquidity Spread

Contingent Liquidity Spread

Reference Rate

135 bps

23 bps

78 bps

64 bps


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Summary » Economic framework introduced that describes:

» the level of liquid assets a financial institution should hold in order to absorb potential losses due to adverse funding conditions

» how a financial institution should account for the cost of holding liquidity reserves when originating loans or when calculating a transfer price

» how a financial institution should quantify the benefit of assets that provide liquidity offsets

» In understanding liquidity risks it is imperative to account for the correlation between » borrowers’ funding needs

» the values of bank’s investment assets and their liquidity characteristics – to what extent they can be used in collateralized borrowing or selling

» liability dynamics – in particular funding sources and costs

» the market price for risk

» The economic framework is flexible and allows for integration with credit and other risks, calculation Funds Transfer Price, and decomposition of FTP into Credit Spread, Option Spread, Funding Liquidity Spread, and Contingent Liquidity Spread

moodys.com

Amnon Levy Managing Director Head of Portfolio Research Moody’s Analytics San Francisco Tel: +1 (415) 874 6279 Email: [email protected]

Yashan Wang Senior Director Portfolio Research Moody’s Analytics San Francisco Tel: +1 (415) 874 6238 Email: [email protected]


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