Balance-Sheet Liquidity and Approaches to Its Stress Testing

Koncepce likvidity

Několik základních definicí (např. BdF, FSR, 02/2008):

Bilanční likvidita (banky): schopnost banky dostát svým okamžitým závazkům nebo Likvidita při financování se („funding“): jednoduchost, s jakou je banka schopna získat zdroje k úhradě závazků např. z externích zdrojů; Tržní likvidita: schopnost trhu zobchodovat daný objem aktiv (cenných papírů) bez významné změny jejich cen;Měnová likvidita: se týká množství plně likvidních aktiv v bankovním systému nebo množství peněz dodávaných centrální bankou komerčním bankám….

Různé definice, úzký vzájemný vztah

„Liquidity is an elusive notion. It is easier to recognize than to define.“ (Crockett, 2008)

3

Příklad: The crisis hit the Czech financial markets too

• The market liquidity has rapidly fallen ….• The CNB introduced liquidity-providing repo operations aimed at

fostering the functioning of the government bond and money market.

Market liquidity indicators for individual markets

Source: Bloomberg, CNB

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

FX market Stock marketMoney market Gov'ment bond market

OMO and currency in circulation

(in bil. CZK)

Source: CNB

100

150

200

250

300

350

400

450

04/08 08/08 12/08 04/09 08/09 12/09 04/10 08/10

0

5

10

15

20

25

30

35

Liquidity-absorbing repo operations

Currency in circulation

Liquidity-providing repo operations (rhs)

4

Příklad: Funding liquidity of the Czech banks still good

Ratio of deposits to loans granted in selected EU countries(2009; %, deposits/loans to residents)

Source: ECB

Note: EA = euro area; EU = average for all EU countries.

0

20

40

60

80

100

120

140

160

CZ SK PL ROBGHU SI LT EE LV BE AT FR IT UK SE DK EA EU

Basic liquidity indicators of Czech banks(in %)

Source: CNB

0

5

10

15

20

25

30

35

40

45

50

55

60

2004 2005 2006 2007 2008 2009 2010

120

130

140

150

160

170

180

190

200

Liabilities on demand/total liabilities Liquid assets/total assetsLiquid assets/clients' deposits Growth of primary deposits (yoy)Deposits/Loans (rhs)

• Full coverage of the credit portfolio from client deposits that keep on growing (deposits exceed loans by 40%).

• Excess deposits invested in liquid assets amounting to almost 30% of overall assets.

5

Regulatory standards: • Liquidity coverage ratio (LRC): • Stock of high quality liquid assets / Net cashoutflows over

a 30-day time period ≥ 100%• Net stable funding ratio (NSFR) : • Available amount of stable funding / Required amount of

stable funding > 100%

Funding liquidity in Basel III

6

Liquidity coverage ratio (LRC) - builds on traditional liquidity “coverage ratio” methodologies used internally by banks to assess exposure to contingent liquidity events:

• Net cumulative cash outflows for the scenario are to be calculated for 30 calendar days into the future. The value of the ratio should be no lower than 100% (i.e. the stock of liquid assets should at least equal the estimated net cash outflows).

• Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high quality assets as a defense against the potential onset of severe liquidity stress.

• Banks and supervisors are also expected to be aware of any potential mismatches within the 30-day period and ensure that sufficient liquid assets are available to meet any cash-flow gaps throughout the month.

• In order to qualify as a „high-quality liquid asset“, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible.

Funding liquidity in Basel III

7

Net stable funding ratio (NSFR): : • “Stable funding” is defined as those types and amounts of equity and liability

financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.

• The amount of such funding required of a specific institution is a function of the liquidity characteristics of various types of assets held, off-balance sheet contingent exposures incurred, and/or the activities pursued by the institution.

• The NSFR aims to limit over-reliance on wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all on and off-balance sheet items.

• In addition, the NSF approach would help to counterbalance the cliff-effects of the liquidity coverage ratio and offset incentives for institutions to fund their stock of liquid assets with short-term funds that mature just outside the supervisory defined horizon for that metric.

Liquid enough even according to the BCBS‘ QIS

8

Despite the existing favorable position we test banks for liquidity-associated risks

Main objective: to investigate liquidity risk not only as a source of bank funding risk (the ability to raise cash to fund assets), but also as strong link to market liquidity (the ability to convert assets into cash at a given price).

9

Assets = usage of funds Liabilities = funds

LIQUIDITY SHORTFALL

Promises from the past Uncertainty

about the future

=

A bank must solve:A bank promised to lend (credit lines)

butmay not have enough funding sources (even more impaired financial markets, withdrawals)

… a simple illustration of the lack of liquidity ...

10

Banks` liquidity buffer vs. stressed cash outflows

Banks normally have liquidity reserves consisting of liquid securities or cash to cope with unexpected cash outflows.Unexpected cash outflows (some examples):• Loss of confidence in a bank,• Frozen money markets,• Withdrawals of deposits, or/and• Drawdowns of credit lines.

The question is: Are banks` liquidity reserves sufficient and liquid enough?

11

• The difference between funding (liabilities) and illiquid assets (the blue rectangle) is the funds invested in liquid assets (the red rectangle).• Liquidity tension: (a) impossible banks‘ securities issuance, (b) withdrawals from private individuals and (c) higher credit facilities usage.• A bank with a larger liquidity reserves, a larger proportion of deposits and a smaller proportion of securities that will mature over shorter notice…

…survives and its liquidity buffer is ample and liquid enough.

(1) A liquidity buffer is ample and liquid enough

Source: Riksbank, CNB

Cash outflows according to scenarios The simple balance-sheet after shocksAssets Liabilities LiabilitiesAssetsAssets Liabilities

The simple balance-sheet in the baseline

Liquid assets

Illiquid assets

Deposits

Market funding

Equity

Illiquid assets

Equity

Deposits

Market funding

Liquid assets

Illiquid assets

Deposits

Market funding

Equity

12

• The difference between funding (liabilities) and illiquid assets (the blue rectangle) is the funds invested in liquid assets (the red rectangle).• Liquidity tension: (a) impossible banks‘ securities issuance, (b) withdrawals from private individuals and (c) higher credit facilities usage.• A bank with a smaller proportion of deposits and higher dependence on market funding (a large proportion of securities that will mature over shorter notice)…

… fully exhausts its liquidity reserves.

(2) The liquidity buffer is not sufficiently ample and liquid

Source: Riksbank, CNB

Liabilities Assets Liabilities

The simple balance-sheet in the baseline The simple balance-sheet after shocks

Assets Liabilities AssetsCash outflows according to scenarios

Liquid assets

Illiquid assets

Deposits

Market funding

Equity

Illiquid assets

Equity

Deposits

Liquid assets

Illiquid assets

Deposits

Market funding

Equity

Market funding

13

The current LST for the Czech banking system examine…

• Top-down approach originally developed by De Nederlandsche Bank with some CNB`s modifications.

• The 3-Phase Test captures the impact of both bank-specific and market wide scenarios and considers both the first- and second-round effects of shocks with a survival period of one month.

• 1st phase (first-round effects): two dimensions: (a) a liquidity shortfall,(b) drying up of market liquidity,

• 2nd phase: reactions by banks to mitigate shocks and restore LB,

• 3rd phase: negative reputational impacts and collective behavior (second-round effects) – the feedback effects of shocks – some additional impact on LB.

pressures on the initial liquidity buffer (LB)

14

Liquidity shortfallLiquidity buffer (LB1)

Liquidity buffer (LB2) Mitigation Reaction by banks

Collective behavior

Liquidity buffer (LB3)

Source: Modified from Van den End, J. W. (2008)

Liquidity buffer (LB0)

Flow chart for liquidity stress test

Reputation risk

2nd round effect

1st round effectsScenario

… whether Czech banks are being able to survive arisen liquidity tension.

3rd

2nd

1st

15

Initial liquidity buffer

Starting point - liquidity buffer (LB0) as the first line of defense

LIQUID ASSETS (LB)

1. CASH

2. CLAIMS on CEBs

3.CLAIMS on other clients (non-financial, financial) on demand and due within 1 month

4. BONDS (bills) issued by government

5. BONDS (bills) issued by CEBs

Liquidity buffer (LB):

• Banks` holdings of liquid assets in case of unexpected tensions in its balance-sheet;

• Definition: sum of unweighted liquid assets (initial level of banking system assets under normal conditions).

16

Scenarios‘ impact

Scenario ==> 1st round effect ==> LIQUIDITY SHORTFALL, ↓ LB

Scenario type and shock size in banks' liquidity stress testScenario type (in %) Scenario1 (2)Outflow of deposits according to ROA after credit and market shocks

(banks' avrg) 5 (10)

Autonomous credit growth 2 (0)Drawdown of credit lines 20 (10)Reduction in value of assets sold before maturity according to risk costs (PD x LGD)

(banks' avrg) 30 (50)

Share of short-term claims on banks that will become unavailable

50 (100)

Share of short-term claims on non-banks that will become unavailabe

20 (30)

Reduction in value of government bonds eligible as collateral in CNB liquidity-providing operations

20 (30)

Reduction in value of other securities 20 (40)No additional interbank fundsNo additional securities issuance is availableSource: CNB, CNB calculation

source of liquidity shortfall

conditions under which

banks reacted

1st round of shocks:• first three items above are affected at once;• two premises are linked to credit and market shocks.

Liquidity shortfall: difference between the amount of the aftershock assets and liabilities;

Banks` reaction: sales of assets under restrictive conditions.

17

Dependence on macro stress testing

Asymmetric Developments Renewed Recession

< -2% 10% 15% -2% – -1% 8% 13% -1% – 0% 6% 11% 0% – 1% 4% 9%1% – 2% 2% 7%

> 2% 0% 5%

Asymmetric Developments Renewed Recession

< 1% 10% 25%1% – 2% 30% 45%2% – 3% 40% 55%

> 3% 50% 65%

Source: CNB, CNB calculation

Dependence of selected liquidity shocks on estimated bank balance-sheet indicators in the stress tests

Estimated RoA in 2011 (%)Bank run

Estimated risk costs 2011 (%)

Reduction in value of assets sold before maturity

LST takes into account the results of the credit and market risk stress testing:• The higher losses the greater outflow of liquidity,• The less quality the higher haircuts.

18

Liquidity shortfall

A. Deposit outflows: not all deposits are guaranteed, fixed costs to extracting deposits from banks, an insufficiency of the insurance funds…

B. The increase of the banks` loan portfolio: the drawdown on credit lines, the loss of confidence.

19

Mitigate the impact of shocks

LIQUIDITY SHORTFALL ==> Reactions by banks ==> Mitigate 1st round effects ==> ↓Liquidity buffer (LB1)

Reaction: banks can reduce assets only due to constrains on funding (the liability side can not be increased):

(a) banks first liquidate the initial liquidity buffer (the most liquid assets) reflecting market liquidity, their specialization and their strength of presence in financial markets – cash, claims on CEBs, sovereign bonds…),

(b) and then the other items (run out of liquidity buffer) – high haircuts.

20

… a simple illustration of banks‘ reactions...

Assets

Selling more for lower

price

PRICE DECLINE

NO PRICE

Market dilemma: (a) Reputation risk: …Why is that

bank selling? Stigma(b) Systemic risk: …too many

banks are selling, the same assets…

21

Impact of the 2nd round of shocks

Reactions by banks ==> Loss of reputation and collective behavior ==> 2nd round effects (feedback) ==> ↓Liquidity buffer (LB3 )

The behavioural reactions have wider disturbing effects on markets and feeding back on the banks additional haircuts on assets and withdrawals of liabilities. The feedback effect is stronger for reacting banks.

• Loss of reputation: signalling effect;• Systemic risk (collective reaction) depends on:

(i) the number of reacting banks, (ii) the similarity of the banks‘ reaction, and (iii) the size of reacting banks;

• Market conditions: reaction on liquid and developed versus illiquid and shallow markets.

22

ScenariosCNB‘s FSR 2010/2011 (data at the end of 2010)

Scenario type and shock size in the bank liquidity test

Scenario typeAsymmetric

DevelopmentsRenewed

Recession

Bank run (average for banks, %) 5 10Drawdown of credit facilities (credit lines, % of volume)

20 10

Share of short-term claims on banks that will become unavailable (%)

50 100

Share of short-term claims on other clients that will become unavailable (%)

20 30

Reduction in value of government bonds eligible as collateral in CNB liquidity-providing operations (%)

20 30

Reduction in value of other securities (%) 20 40Reduction in value of assets sold before maturity (average for banks, %)

30 50

Source: CNB, CNB calculation

• The same scenarios as for macro stress testing (Asymmetric Developments, Renewed Recession).• The Renewed Recession scenario would cause liquidity problems, but these would not be systemic in nature.

23

ResultsCNB‘s FSR 2010/2011 (data at the end of 2010)

• The tested banks withstood the simulated stress and would be able to close the potential liquidity gap within one month even under worsened market conditions.

• Only a few banks would fully exhaust their liquidity buffers by their response to the liquidity shock.

Results of the liquidity test(%; share in original total assets)

Source: CNB, CNB calculation

Note: The first column of each pair of identically coloured columns expresses the value for the Asymetric Developments scenario and the second expresses that for the Renewed Recession scenario. Gap = liquidity gap. Feedback effect = additional stress caused by banks reactions in markets. LB0 = initial liquidity buffer; LB2 = buffer after first round of shocks; LB3 = final liquidity buffer.

-15

-5

5

15

25

35

45

Large banks Medium-sizedbanks

Small banks Buildingsocieties

LB0 Gap LB2 Feedback effect LB3

24

Zátěžové testy likvidity dopadly rovněž uspokojivě

• Metodologie shodná jako v minulém období (dvě kola šoků, šoky navázány na výsledky bank v testech solvence), nově však provedeny separátně pro jednoměsíční a tříměsíční horizont.

• Likviditní polštář by se v průměru snížil o dvě třetiny, v segmentu stavebních spořitelen by v případě tříměsíčního horizontu klesl o více než 80 %.

• Jedna banka (v případě 3M horizontu dvě banky) by zcela vyčerpala likviditní polštář.

Výsledky testu likvidity(%, podíl na celkových aktivech)

Pramen: ČNB, výpočet ČNBPozn.: LB = likviditní polštář; 1M = jednoměsíční; 3M = tříměsíční.

35,5

7

28,2

2

34,5

7

20,4

1

11,5

0

8,96 13

,79

7,42

37,4

5

22,1

3

12,3

5

10,2

1

14,6

7

3,81

32,4

4

38,2

80

5

10

15

20

25

30

35

40

Velké banky Střední banky Malé banky Stavebníspořitelny

Počáteční LB_1M LB po zátěži_1MPočáteční LB_3M LB po zátěži_3M

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• V oblasti likvidity je patrný významný rozdíl vyplývající ze specifického obchodního modelu stavebních spořitelen.

Riziko likvidity – banky vs. stavební spořitelny

(v poměru k bilanci, v %, březen 2012)

Pramen: ČNBPozn.: Graf obsahuje i pobočky zahraničních bank.

Nesoulad splatností úvěrů a vkladů: netto rozvahová pozice bank a stavebních spořitelen

-60

-50

-40

-30

-20

-10

0

10

20

30

40

Banky bezstavebníchspořitelen

Stavební spořitelny Bankovní sektorjako celek

Do 3 měsíců Nad 3 měsíce do 5 let Nad 5 let

• U stavebních spořitelen je nesoulad splatností úvěrů a vkladů výraznější než ve zbytku bankovního sektoru – platí to zejména z pohledu dlouhodobých pohledávek se splatností nad 5 let.

• Podíl rychle likvidních aktiv na aktivech se u stavebních spořitelen v roce 2011 dále snížil na úroveň kolem 15 % a zůstává tak významně nižší než u ostatních bank.

26

…for potential uses

Main formulas:1) An initial liquidity buffer:2) A liquidity shortfall:3) An available liquidity buffer:4) Banks` reactions:

For non-reacting banks1) The second round of shocks:2) Haircuts:

For reacting banks1) The second round of shocks:2) Haircuts:

4

10

iiILB

5

101 *

iiB hILB

1,11

, RpI j

n

jjB

01 R

BB BjB

jBjBjj qsLILIqpp //1 ,,,1,2

jjj

n

jjB ppRpIR ,1,21,1

1,2

spp jj ,2,3

jjj

n

jjB ppRpIR ,1,31,1

1,3

rDdrCpLR **1

LB 0 Initial liquidity buffer

I Liquid balance-sheet assetsi ItemsR 1 Liquidity shortfall

L Banks' loan portfoliop Autonomous credit growthC Credit linesdr Drawdown rate of committed credit linesD Depositsr Deposit withdrawal rateLB 1 Available liquidity buffer

h Haircuts for liquid assetsj Number of assets liquidated R 2 Second round of shocks

LI Amount of particular asset liquidatedq Number of reacting bankss Market conditions

Variables

27

Relevant literature

• Van Den End, J. W. (2008): Liquidity Stress-Tester: A macro model for stress-testing banks‘ liquidity risk, Dutch National Bank, WP No. 175 (May).

• IMF (2011): Global Financial Stability Report, Chapters 2 – Liquidity Risk: How to Address the “Systemic” Part (March).

• Barnhill, T., Schumacher, L. (forthcoming): Modeling Correlated Systemic Liquidity and Solvency Risks in a Volatile Environment with Incomplete Information, IMF WP.

• Wong, e., Hui, C.H. (2009): A Liquidity Risk Stress-Testing Framework with Interaction between Market and Crecit Risks, Hong Kong Monetary Authority, WP 06/2009 (March).

• Aikmen, D., Piergiorgio, A., Eklund, B., Gai, P., Kapadia, S., Martin, E., Mora, N., Sterne G., Willison, M. (2009): Funding Liquidity Risk in a Quantitative Model of Systemic Stability, Bank of England, WP No. 372 (June).

• Riskbank (2010): Financial Stability Report, 2/2010.• Van Den End, J. W. (2010): Liquidity Stress-Tester: Do Basel III and Unconventional

MP Work?, Dutch National Bank, WP No. 269 (December).…• Adrian, T., Shin, H. S. (2009): Money, Liquidity, and MP, FED of NY, Staff Reports No. 360

(January).• Cifuentes, R., Shin, H. s., Ferrucci, G. (2005): Liquidity Risk and contagion, Journal of the European

economic association, (April-May).• Brunnermeier, M., Pedersen, L. H. (2009): Market Liquidity and Funding Liquidity, Review of

Financial Studies, 22(6), p. 2201-2238.• Praet, P., Herzberg, V. (2008): Market liquidity and banking liquidity: linkages, vulnerabilities and the

role of disclosure, FSR – Special issue on liquidity, Banque de France, No. 11.• Adrian, T., Shin, H. S. (2008): Liquidity and financial contagion, FSR – Special issue on liquidity,

Banque de France, No. 11. • Nikolaou, K. (2009): Liquidity (risk) concepts: definitions and interactions, ECB WP No. 1008 (Feb.). …