Effective Liquidity Risk Measurement and Management

1Copyright 2003 The Kamakura Corporation – Confidential Information

Effective Liquidity Risk Measurement and Management

Leonard Matz


Effective Liquidity Risk Measurement

Common liquidity metrics: strengths and weaknesses

Cash flow projections

Scenarios


Loan to Deposit Ratio(South Africa)

110%

115%

120%

125%

130%

135%

140%

145%

1999 2000 2001 2002 2003


The Venerable, Oft Quoted and Almost Meaningless Loan to

Deposit Ratio

• Assumes that all sources of funding other than deposits are stable

• Assumes that all deposits are unstable

• Assumes that all assets other than loans are completely liquid

• Assumes that all loans are completely illiquid


Lots of Ratios Measure Relationships of Liquid,

Illiquid, Stable, and Volatile Balance Sheet Volumes

• Large liability dependence ratios

• Various ratios of liquid assets to

purchased funds


Net Liquid AssetsBalance Sheet Liquidity Model

Illiquid

Volatile

Stable

LiquidNet Liquid

Assets

ASSETS LIABILITIES


Traditional Liquidity Measures

Leave Much to Be Desired

Mainly retrospective – use historical data.

Large and growing off balance sheet commitments are too often excluded.

Fail to capture any of the dynamics. Liquidity needs are not all the same. Sources available to meet those needs are not all the same.


Off Balance Sheet Items(South Africa)

0%

10%

20%

30%

40%

50%

ABSA 1994

SA banks1994

ABSA2003

SA banks2003

Other

Credit Card

IrrevocableLetters ofCredit

Unutilizedfacilities

IndemnitiesandGuarantees


Off Balance Sheet Items

0

10

20

30

40

50

60

70

80

90

100

1992 1992 2002 2002

Loan Commitment Letters of Credit

All 11,462Commercial

Banks

2,790 Banks Assets

$100 Million to $1 Billion

3314 Banks Assets

$100 Million to $1 BillionAll 7888

Commercial Banks


FOUR IMPARATIVES FOR MEASURING LIQUIDITY

1. The quantity of liquidity you have or can get MUST be related to the quantity of liquidity that you think you may need.

2. The quantity of liquidity that you need is, mainly, the sum of current liabilities you may lose plus new assets you may have to fund.

3. Liquidity risk, the amount of liquidity you might need, is HIGHLY scenario specific. Liquidity cannot be intelligently measured without using scenario analysis. Scenarios are the language or risk measurement.

4. The quantity of liquidity available is scenario specific. Sources available in some scenarios are less available or unavailable in others.


Liquidity Cash Flow Projection Analysis

The essence of liquidity risk is cash flow. Therefore,

fundamentally, liquidity gap analysis is simply an evaluation

of the two requirements: "enough money"

and “when we need it".


Rate Risk vs. Liquidity Risk

Gap analysis is not very well suited for capturing interest rate risk.

Gap analysis works much better as a tool for capturing liquidity risk.


Week 1

Week 2

Week 3

Week 4

Month 2

Month 3

Months 4-6

Months 7-12

Customer Driven Volumes

Personal loans—closed end -49 -56 -51 -65 -211 -197 -657 -1,961

Personal loans—open end -16 -21 -17 -15 -7 -65 -149 -1,777

Business loans -904 673 125 346 -345 -804 2,812 5,709

Residential mortgage loans -87 98 81 -89 -361 -378 -1,033 -2,117

Other assets 0 0 0 0 0 0 0 0

Noninterest-bearing deposits

399 610 519 125 70 -184 -550 450

NOW accounts 529 525 472 266 50 -75 12 740

MMDAs 85 80 75 70 150 -235 600 1,200

Passbook savings 40 40 40 40 100 -50 0 200

Statement savings 50 55 60 50 150 -50 50 300

CDs under $100,000 220 270 230 335 -220 -300 425 1,800

J umbo CDs 5 200 -25 -55 0 -335 685 1,260

Net noninterest income -85 -85 -85 -85 -340 -340 -1,020 -1,940

Misc. and other liabilities 0 0 0 0 0 0 0 0

Sub-Total 187 2,389 1,424 923 -1,033 -3,013 1,175 3,864

Overnight 1,395 0 -1,345 -757 0 0 0 -1,100

Investment securities -1,582 -1,384 -79 34 733 313 1,052 -887

Federal funds purchased 0 0 0 0 300 2,200 -1,525 -1,077

Repos and other borrowings

0 -1,005 0 0 0 500 -502 0

Dividends 0 0 0 0 0 0 -200 -800

Sub-Total -187 -2,389 -1,424 -923 1,033 3,013 -1,175 -3,864

Net Cash Flows 0 0 0 0 0 0 0 0


Cash Flow Time Profile

-300

-250

-200

-150

-100

-50

0

50

100

150

200

1 2 3 4 5 6

Time periods

Do

llars

Assets

Liabilities

Marginal gaps


Problem: Both Cash Availability And Needs Are Highly

Correlated with Scenarios

Cash availability: asset liquidity unused funding capacity

Needs: deposit withdrawal undrawn credit facility drawdown collateral pledging


BIS Recommends Scenario Analysis

“A bank should analyze liquidity utilizing a variety of ‘what if’ scenarios.”

BIS: “Sound Practices For Managing Liquidity in Banking Organizations”, February 2000.


KEY ISSUE

Scenarios are far more important to liquidity risk measurement and management than for credit risk, rate risk or operational risk !!!!

The range of potential liquidity risk scenarios is far more varied than scenarios for other financial risks.

Tactics that work in some scenarios are unavailable or constrained in other scenarios.


Factors Behind 29 Failures


Systemic Crises – A Wide Variety

1987199019911992199419951997199819992000

20012002

U.S. stock market crashcollapse of U.S. high yield (junk) bond marketoil price surgeERM (European Exchange Rate Mechanism) crisisU.S. bond market crashMexican CrisisAsian crisisRussian default, Ruble collapse. LTCMgold pricesTMT (telecommunications, media & technology ) sector collapseSeptember 11 payments system disruptionArgentine crisis


IMF finds numerous problems

“A review of the experiences since 1980 of the 181 current Fund member countries reveals that 133 have experienced significant banking-sector problems at some stage during the past fifteen years (1980-1995)

Source: Lingren, G.J., Garcia, and N. Saal, Banks Soundness and Macroeconomic Policy, Washington DC, IMF, 1996


1. Normal course of business, including any seasonal fluctuations

2. Bank specific funding crisis

3. Systemic liquidity crisis

Use At Least Three Scenarios


Scenarios Monitored By A Large International Bank

Market Risk

Emerging Markets

Systemic Shock

Global Prolonged Recession

Operational Risk

Merger & Acquisition

Downgrade to A1/P1 & A1/A+

Downgrade to A2/P2 & A3/A-

Ext

erna

lIn

tern

al

Scenario analysis

“Stress”


Define Three Characteristics For

Each Scenario

Type: systemic or bank specific; local, national or international

Duration: short or long

Severity: mild or severe


Scenario Results

• Determine total Liquidity Mismatch for each scenario

Balance sheet +54 +30 -22 -44Credit lines 0 0 -10 -10Collateral +30 +27 +26 +15

Gap -6 -39

Going Squeeze Specific General

Additional measures needed

Source: Bruce McLean, Forrest, UBS


Effective Liquidity Risk Management

Management tactics

Limits, management and reporting

Stress testing


Adding Liquid Assets – A Right Way and a Wrong Way

Core Assets

Liquid Assets

Volatile Liabilities

Core Funding

+ Equity

Structural Liquidity

Deficit

Core Assets

Liquid Assets

Volatile Liabilities

Core Funding

+ Equity

Structural Liquidity

Deficit


Beyond Liquid Assets

• Loans can also provide liquidity value – Mortgages as collateral for borrowings– Salable and securitizable assets where bonds have not

yet been issued

• A $1 reduction in liquidity risk is just as good as a $1 increase in liquid assets holdings.– Do not have to hold liquid assets, therefore saves the

cost

In practice, it depends on the scenario and stress level. When is an asset liquid? When is a liability volatile?


Asset Management: The Three Ss

• Syndication– Early warning system

– Pricing & participation %

– Recent credit concerns

• Securitization– All tangible bank assets can be securitized

– What about residuals & equity pieces?

• Sales

Source: Fred Poorman, BNK Analytics


Asset Securitizations

““Picking only the low-Picking only the low-hanging fruit leaves a hanging fruit leaves a very illiquid balance very illiquid balance sheet remaining!”sheet remaining!”

Source: Carl Tannenbaum, ABN Ambro


Planned Responses to A Crisis:

Asset Management

Rank all assets by how quickly and easily they can be sold

Start preparations for loan sales or securitizations

Maintain primary and secondary liquidity from assets warehouses

Manage pledging to free up excess collateral

Manage pledging to use the least readily salable assets


By Far The Most Common Answer:

OKAY, BUT … Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.” Walter Bagehot

THE WELL PREPARED NEED BETTER PLANS

“Our Plan is Draw Down Our Committed Lines”


Balance Sheet Trends(South Africa)

-50

50

150

250Mill

ion

s

Total Equity Retail DepositsGrowth in Loans Growth in InvestmentsGrowth in Other Assets

2000 2001 2002 2003

Change in Capital and Deposits

Change in Assets


Balance Sheet Trends

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Total Equity Capital Retail Deposits Growth in Investments

Growth in Loans Growth in Other Assets

1996 1997 1998 1999 2000

Change in Assets

Change in Capital

and Deposits

2001 2002 2003


Sometimes We Can Borrow. Sometimes Not.

Wholesale Funds Providers Are Brutal Arbiters of

Creditworthiness

• Quickly recognize potential problems

• Respond rapidly


Managing Funding Sources

Rank, measure, manage for both current needs and for contingent needs.

Encourage funding from more sticky sources.

Monitor borrowing spreads – not unused borrowing commitments.

Take advantage of market conditions to lengthen maturities when possible.

Maintain an appropriate amount of time deposits and borrowing with remaining lives greater than 90 days, 180 days and one year.


Estimating Stickiness

Fiduciary

Agent or

Owner

Insured

or Secur

ed

DepositorReliance

onInformati

on

Depositor’s

Relationship

with theBank

Stickiness

Estimate

consumers owner yes low high high

small business

owner in part low high medium

LargeCommercial

owner no medium medium low

Banks agent no high medium medium

Municipalities

agent in part high medium medium

money market

mutual funds

quasifiduciary

no high low low


Very Sensitive to Perceived

Deterioration in Credit Quality or

Safety

money market mutual funds

rating sensitive providers

pension funds

insurance companies

other funds providers with fiduciary responsibility

broker/dealers

regional and money center banks in your country

foreign banks

large corporations

community banks in your market area

Only sensitive to credit quality and

liquidity when problems are very

bad and highly publicized.

local, uninsured, unsecured depositors

customers who are net borrowers (their loan balances exceed their deposit balances)

local, secured funds providers

insured depositors

Sensitivity of Funds Providers By Type


Managing Funding Sources

Few, if any, liquidity risk management tactics are more vital than managing the time profile of maturing liabilities.

Un-matured time deposits and borrowings are one of the most stable sources of funding in the event of a funding problem.

Key Issue:


Four Essential Liquidity Management Tools

1. Always keep some asset liquidity reserves. This is the insurance cost of liquidity management. But recognize that you cannot and do not want to hold enough for a catastrophe.

2. Extend liability terms to reduce liquidity risk.

3. Be prepared to enhance liquidity quickly at the first signs of increased potential need.

4. Manage cash flow profiles.


Key Considerations for Setting Limits

1. Not so big as to be meaningless.

2. Within the bank’s risk tolerance: the cost of put test.

3. Adjusted for the “path to the exit”.

4. Must include a “cushion”.


Setting Limits – What Target?

For all scenarios?

For all stress levels?

For the “worst case” of all scenarios and stress levels you evaluate?

For the “most likely” crisis and stress level?


Liquidity Risk Limits Should Apply to Stress Scenarios

Banks should analyze the likely impact of different stress scenarios on their liquidity position and set their limits accordingly. Limits should be appropriate to the size, complexity and financial condition of the bank. Management should define the specific procedures and approvals necessary for exceptions to policies and limits.

Source: Paragraph 19, Sound Practices for Managing Liquidity in Banking OrganizationsBasel Committee on Banking Supervision, Basel February 2000


Limits, Guidance and Observation Ratios

• Your bank may wish to address all three of these problems by adopting a system that combines a few “hard limits” with “guidance limits” and “observation ratios”.

• The hard limits are board approved minimum liquidity coverage ratios. Hard limits may only apply to the time periods in a single scenario at a single level of stress.

• Guidance limits can be minimum liquidity coverage ratios for each time period in the scenarios and stress levels not covered by hard limits. The guidance limits may be established by ALCO rather than by the board. Violations of guidance limits may merely require closer monitoring, more frequent reporting and/or additional analysis.

• Observation ratios may be for ancillary measures of liquidity risk such as maturity distributions.


Regulatory Approaches

Quantitative Mix Qualitative

Germany Austria Belgium Spain

Iceland Denmark Sweden

Finland

France

Greece

Ireland

Italy

Liechtenstein

Luxembourg

Netherlands

Norway

Portugal

UK

Source: Dr. Paul Baneke, De Nederlandsche Bank


Management Report Requirements

• Manage the quantity of information. Always use three levels of detail.

• Focus on key metrics: cash flow coverage by time bucket and scenario

– compared to limits. other variables, such as marketable securities,

that highlight important needs and sources for your bank.

Periodically supplement with reports for special situations or topics

• Always monitor potential key triggers. LIQIDITY IS A CONSUQUENCIAL RISK


A Reporting Dashboard (ratio of projected in-flows to out-flows)

Projected Net Cash Flows

Liquidity Scenario

0 - 30 days

31 - 60 days

61 - 90 days

91 - 180 days

Ordinary course of business 1.37

minimum 1.25

Bank specific crisis – level 1 1.21

minimum 1.20

Bank specific crisis – level 2 0.85

minimum 1.10

Systemic crisis – level 1

minimum


Why Stress Test?

“The liquidity strategy should set out the general approach the bank will have to liquidity, including various quantitative and qualitative targets. This strategy should address the bank's goal of protecting financial strength and the ability to withstand stressful events in the marketplace.”

Source: paragraph 7, Sound Practices for Managing Liquidity in Banking OrganizationsBasel Committee on Banking Supervision, Basel February 2000

BIS Guidelines Require Stress Testing


Why Stress Test?

Holding Liquidity is Not Free

– No bank can hold enough liquidity to survive anything close to a “worst case” liquidity crisis.

– The penalty for too little liquidity may be the failure of the bank but too much liquidity carries a penalty as well.

Optimal management of liquidity requires a delicate balance between

liquidity risk and income.


Volatility of Savings Deposits

The good news: The bank has not experienced a severe loss of deposits.

The bad news: The historical observations tell us NOTHING about a future stress environment.

-10,000

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

6,000

8,000

10,000

Red lines indicate 2 SD


Measurement and Quantification Conclusions

• Historical observation does not necessarily reflect what might happen (future events)

• Modelling a (fat tail) distribution does not solve the problem either:

–Outlying point or fat tail?

–Risk is not linear in extreme events

• The Question is not: ‘What Risk will we get if we push out the quantiles?’ – The answer to that question is only a matter of scaling and is therefore meaningless!

• Instead, the question is: ‘Is there a structural change that the bank should model?’

Adapted from material developed by Dr. Robert E Fiedler

Copyright 2003 The Kamakura Corporation – Confidential Information

Measurement and Quantification Processes

Pro

babili

ty

Severity of loss

Stress testing typically appliesstatistical tools to provide moreinformation about the tail.

VaRExtreme Value TheoryOther tools

14


Liquidity risk

is highly

idiosyncratic,

arbitrary and

inconsistent.


For More Information

LIQUIDITY RISK LIQUIDITY RISK MANAGEMENTMANAGEMENT

and

SELF PACED A/L SELF PACED A/L MANAGEMENTMANAGEMENT

published by: Sheshunoff Information Services, Inc.

1-800-456-2340www.sheshunoff.com

written by: Leonard Matz, [email protected]

Effective Liquidity Risk Measurement and Management

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