Liquidity Risk Garp

Copyright 2011, SAS Institute Inc. All rights reserved.
A New Regulation for Liquidity Risk

GARP, 1st December 2011
Jimmy Skoglund, SAS Institute Inc.
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Agenda
A new regulation based on learnings in the recent crisis
New reporting and liquidity monitoring standards
Short-term stress testing of liquidity coverage ratios
Long-term structural liquidity mismatch measurement - net stable funding ratios
Liquidity risk monitoring tools
Modeling Cash Flows for Liquidity Risk
Traditional run-off liquidity gaps
Behavior modeling of net cash flows
Counterbalancing capacity of unencumbered assets
Stress testing and liquidity coverage ratios
Pricing Liquidity Risks
Mismatch (term) liquidity risk
Contingency liquidity risk
Market liquidity risk
Funds transfer pricing of liquidity risk
Preparing for Liquidity Crisis Contingency Funding Plans
A Note on Advanced Liquidity Risk Management Techniques
Probabilistic measures and limits on liquidity risk
Optimising the counterbalancing capacity portfolio
Wrap Up and Summary
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Agenda
Wrap Up and Summary
4

The recent credit crisis compounded itself quickly into a major liquidity crisis (or
funding problem), leading to insolvency of major financial institutions
Many banks did not have a dedicated liquidity buffer or liquidity portfolio that
was managed
A key characteristic of the financial crisis was the inaccurate and
ineffective management of liquidity risk in many banks
Learnings from the recent crisis..
The new [Basel III] liquidity risk regulation underscores the importance of
managing the liquidity contingency buffer in much the same way as capital

Focusing on maintaining a high quality liquidity portfolio that can hedge out
liquidity outflows under stress scenarios

And, integrate the liquidity pricing and hence incentive to raise liquidity as well as
price costly liquidity according to the opportunity cost of raising the needed buffer
Regulators response..
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Guiding Principles
Basel (2008) Principles for Sound Liquidity
Risk Management and Supervision
Minimum Reporting
Basel (2009) International Framework for Liquidity
Risk Measurement, Standards and Monitoring
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
Regulatory Reporting Standards Monitoring Standards
Contractual Maturity Mismatch
Funding Concentration
Unencumbered Assets
Market Monitoring
Guiding Principles
Basel (2009) Principles for Sound Stress Testing Practices and Supervision
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Guiding Principles
Minimum Reporting
Unencumbered Assets
Market Monitoring
Guiding Principles
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Net Fund Requirements Modeling (market and behavioral risk)
a. Contingent withdrawal of funds (liability side liquidity risk),
b. Liquidity outflow due to off-balance sheet commitments that
includes facilities, lines of credit, guarantees, letter of credit (asset
side liquidity risk), and
c. Contingent liquidity impact due to derivatives collateral.
Counterbalancing (hedging) Capacity Modeling
a. Liquid asset value (cash, government bonds etc)
b. Haircut securities e.g., corporate bonds
Stock of Counterbalancing Capacity Assets
Net Cash Outflow under Stress Scenarios
= > 100%
Short-term (30 day stress scenario)
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Guiding Principles
Minimum Reporting
Unencumbered Assets
Market Monitoring
Guiding Principles
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Available Stable Funding (ASF)
Required Stable Funding (RSF)
= > 100%
Structural liquidity mismatch (1 year)
Assets
Unencumbered assets
Liabilities
Consumer loans
Short term funding
Non-core deposits
Core deposits
Long term funding
Equity
Corporate loans
Interbank loans
The NSFR is closely
related to Moodys Cash
Capital Position (CCP)
100%
100%
85% 100%
70%
0% 50%%
0% - 50%
85% - 100%
50% - 100%
50% - 100%
RSF Factors
ASF Factors
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Basic Idea:
Banks should avoid
excessive amount of
long-term assets being
funded short-term in
order to not run into
potential liquidity
issues in re-funding
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Guiding Principles
Minimum Reporting
Unencumbered Assets
Market Monitoring
Guiding Principles
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Complementary to NSFR
reporting banks are
required to monitor:
Counterparty
concentration
Product concentration
Currency
concentration
NSFR ratio promotes banks
to steer part of their funding
towards long term stable
funding. However, the
funding is not necessarily
diversified
Contractual Maturity Mismatch Funding Concentration Unencumbered Assets Market Monitoring
Key Monitoring Items
Traditional run-off maturity
mismatch.
Contractual maturity
used as behavior
model
Measures time to
insolvency in
extreme case of
complete drying up
of funding i.e., no
short-term funding is
rolled over
Report on available
unencumbered assets that
are (i) eligible for collateral,
or, (ii) eligible for central
bank facilities
Amount
Currency
denomination
Estimated market
haircut when used as
collateral
Location/Business unit
Monitoring market wide
information
Equity prices, debt
markets, fx markets
etc
Monitoring general
information on the financial
sector
Monitoring bank specific
information
Banks equity, CDS
prices, funding costs
etc
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Agenda
Wrap Up and Summary
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Traditional Liquidity Risk Management:
Run-off Liquidity Gaps
Tracking Liquidity Ratios

Now, focus on going concern behavioral modeling under stress
scenarios!
a. Modeling Net Funding Requirements of Assets and Liabilities

b. Counterbalancing Capacity of Unencumbered Assets

Insolvency in run-off gap
Cumulative Net
Cash Flow Map
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Going Concern Liquidity Risk Stress Scenario: Cumulative Net Cash Flow Map Should Not Be Negative!
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Modeling Net Funding Requirements: Example Scenarios
Behavioral Modeling of Consumer Cash Flows
Consumer loans:
i. decreasing prepayment rates (cost of funds increase)
ii. Increased default rates
iii. Increase in loan stock (increased demand for funds)
Consumer deposits:
i. Increased withdrawal of funds (run on bank, need for funds)
Behavioral Modeling of Market Funding Sources
Unsecured funding:
i. committed lines of credit not available
ii. Wholesale funding rolled over with reduced term and only with counterparties that have a
strong relation with the bank
Difficulty maintaining secured funding. Repos are rolled over only if counterparty has strong
relation with bank
Behavioral Modeling of Derivatives Margin Requirements
Increased margin requirements for OTC derivatives (adverse market scenario)
Increased collateral posting due to reduced value of collateral (adverse market scenario)
Increased margin requirements due to downgrade i.e., rating triggers (bank-specific)

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Example: Deposit run-off stress scenarios
In both of the stress scenarios we see a marked increase in the withdrawal rate up to 1 month.
The depositors that are most sensitive to the stress scenario and rumors about the bank will withdraw
early.
After the most sensitive customers have withdrawn the less sensitive customers remain and hence
the withdrawal rate decreases significantly.
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Modeling Counterbalancing Capacity of Unencumbered Assets
A CBC scenario, for the unencumbered assets, is constructed by making
assumptions about salability, price (haircut), repoability etc
Eligible assets:
Cash, central bank
reserves, government
debt, corporate and
covered bonds with
minimum A rating
(haircuts), securities
with claims on
sovereigns etc with 0%
risk weight
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Retail deposit run-off at
a minimum of 7.5% or 15%
Unsecured wholesale deposit run-off
by small business at
a minimum of 7.5% or 15%
Unsecured wholesale funding run-off
Provided by other legal entity customers at
100%
By non-financial corporates at
75%
By non-financial customers, sovereigns, banks
and public sector enterprises (PSEs) at a minimum of
25%
Cash Outflows
100% of retail contractual inflows from performing assets
0% cash flows from reverse repos and 100% cash flows from
reverse repos of illuiqid securities
0% cash inflow from committed lines of credit
100% contractual inflows from derivatives
100% of wholesale contractual inflows from fully performing
assets
Cash Inflows
- -
Increased liquidity needs due to valuation changes on
derivative transactions
Increased liquidity needs related to downgrade triggers
Increases liquidity needs related to potential for valution
changes on collateral posted for securing derivative transactions
20%
Loss of funding on asset-backed securities, covered bonds and
other structured finance products
Draws on committed credit and liquidity lines and other contingent
funding liabilities
Additional Components of
Cash Outflows
+
CBC
Cash
Central bank reserves
Government debt
Sovereign securities
with 0% risk weight
Minimum A rated corporate bonds
(20%-40% haircuts)
Net Funding Requirements
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Cash Outflows Cash Inflows
- -
Additional Components of
Cash Outflows
+
CBC
Net Funding Requirements
Insolvency measurement period for LCR
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Agenda
Wrap Up and Summary
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Pricing Liquidity Risk
Term Liquidity Charge*
Liquidity is a scarce resource and liquidity pricing
should be instituted in a way that rewards
providers of liquidity and penalize its users

Contingency Liquidity Charge Market Liquidity Charge
Credit providers of long-term funds
with term funding spread
Charge long-term illiquid loans
with term funding spread
**Charge opportunity cost of stand-by
unsecured funded liquidity reserves
Term liquidity charge
Liquefiability / repoability credit
Assets and liabilities Unencumbered assets
Used in banks FTP system to provide
incentives to branches
Accounting for liquidity explicitly in MtM
promotes assets that have short-term
liquidity by maturity or liquefiability
*Term liquidity charge is
based on the funding
spread vs. swap rates
**Opportunity cost
charge is based on the
spread between
secured and unsecured
funding
Risk premium for offering contingency
liquidity at some pre-defined rate***
***Customer spread
guarantee is an option
on the funding spread
with strike the
guaranteed spread
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Treasury Investors
4% Coupon rate
Cash liquidity
Interbank
Market
Swap rate + 30 bps
4% Fixed
Swap deal 5 Y bond funding
Measuring banks term liquidity costs

Treasury Investors
4.5% Coupon rate
Cash liquidity
Interbank
Market
Swap rate + 45 bps
4.5 % Fixed
Swap deal 10 Y bond funding
5 Year 10 Year
Term funding
liquidity costs
curve
30 bps
45 bps
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Swap rate
Liquidity spread
Maturity 1 Year 2 Years 3 Years 4 Years
3.80% 3.90% 4.20% 4.40%
5 Years
4.50%
0 bps 13 bps 27 bps 35 bps 40 bps
Example: Term liquidity spread for a 5 year loan

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Loan maturity term
The loan cash flows are discounted with term liquidity spread.
Hence, pricing should account for the same spread
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Swap rate
Liquidity spread
Maturity 1 Year 2 Years 3 Years 4 Years
3.80% 3.90% 4.20% 4.40%
5 Years
4.50%
0 bps 13 bps 27 bps 35 bps 40 bps
Funds transfer pricing with liquidity risk

Credit spread 5 bps 19 bps 38 bps 47 bps 59 bps
Other spreads* 3 bps 7 bps 11 bps 17 bps 22 bps
Capital allocation 0.5% 0.5% 0.5% 0.5% 0.5%
Capital cost** 6% 6% 6% 6% 6%
FTP
*E.g., costs and charges
=
FTP (swap) Capital allocation 100% -
( )
+
*
Capital allocation
*
Capital cost
+ FTP (spread)
Note: Liquidity contingency (CBC) costs are not in capital. How account
for opportunity cost of holding CBC similar to capital?
** Cost is the opportunity
cost of holding capital
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Example: Contingency liquidity pricing of a facility

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= 40 bps x 25% = 10 bps
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(
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= 40 bps x 70% x 20% = 5.6 bps
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= 8 bps x 70% x 20% = 1.12 bps
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= 40 bps x 5% x 70% = 1.4 bps
= 18.12 bps (e.g., 18,120 in currency amount for a 10 million facility)
Liquidity spread
Unsecured funding spread
Current usage
Core part
Drawdown factor
Liquidity spread volatility
40 bps
5 bps
8 bps
30%
25 %
20 %
Market and facility information
Funding spread
Undrawn part 70%
x
Core part
Funding spread x Undrawn part x Drawdown factor
Unsecured funding spread x Undrawn part x Drawdown factor
Funding spread x x Funding spread volatility
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Simplified option risk premia calculation for fixed spread contingency funding*
Unsecured funding (Interbank)
Secured (repo) funding
Unsecured
funding spread
The opportunity cost for unsecured
funding measures the relative cost of
unsecured vs. unsecured funding.
That is the cost of not having a liquid
asset buffer (collateral) for
contingency. The contingency
funding costs is on par with capital
costs for other risks such as credit
risk. However, for liquidity the cost is
for holding liqudity contingency
(CBC) rather than capital
*ATM option approximation for a T
year option is approximately 0.4 x
funding spread x funding spread
volatility x sqrt(T)
Undrawn part
26

Agenda
Wrap Up and Summary
27

Preparing for Liquidity Crisis Contingency
Funding Plans
Contingency Funding Plan (CFP) helps banks strategize
its response to liquidity crises in advance.
Objective:
A CFP contains procedures for (i) counteracting cash flow
shortfalls and (ii) maintaining market goodwill of the bank
Content:
A CFP take into consideration how a funding crisis evolves in
different stages as a trigger (early warning actions)
Large increase in credit spreads, banks funding rates increase compared to peer
banks,..
A CFP specifies actions based on the triggers
Action for CBC (sell, repo), project plan for execution of liquidity portfolio
A CFP nominates crisis teams and committes
Market Monitoring
(Triggers)
Action Plans
Responsibility
Chen, W, and Skoglund, J, 2011. Building a Project
Plan for Liquidity Execution
28

Agenda
Wrap Up and Summary
29

A Note on Advanced Liquidity Risk
Management Techniques
Market models, behavior models
ALCO puts VaR limits on Maximum Cash Outflow (MCO) at cumulative horizon t=1,,n
t=1
t=2
t=3
t=4
VaR(t) < MCO(t) for all t, else the
limit has been breached
D (Net Funding Requirements) = D (CBC) D (Net Cash Flow Map)
+
VaR(t)
30

A Note on Advanced Liquidity Risk
Management Techniques
( )
( ) ( ) ( )
....
, 0 , , max ,
min
t
CBC a
s a
CBC a
s CBC a
S s
s
h
S s p s t NFR s t CBC h f
V h p
a
o s
(
e
|
|
.
|
\
|

e
e e Optimization of asset share
is conditional on CBC
liquidation, repo scenario for
the asset
- Cheapest CBC portfolio
- Absolute mismatch constraints
- other constratints e.g., tail
mismatch constraints
Optimizing the counterbalancing capacity portfolio*
Find the (cheapest) CBC portfolio holdings (cash flows) that best replicates the (negative) Net
Funding Requirements (NFR)
-max(-NFR,0)
Optimal CBC
31

Agenda
Wrap Up and Summary
32

Wrap Up and Summary
The new [Basel III] liquidity risk regulation impose
significant challenges to banks of enhancing existing
liquidity measurement and management methods
Compliance requires
banks to take a sophisticated scenario based approach to
liquidity risk measurement and management
The establishment of scenario and risk based limits on
liquidity risk
Continous management of the dedicated CBC portfolio
Cost efficient portfolio
Policies and procedures to be implemented/reviewed (e.g.,
monitoring, CFP)
Best liquidity portfolio execution plan
Implementation of a pricing system for liqudity risk that
decentralizes the incentives for raising liquidity

33

References
Books and papers
Chen, W, and Skoglund, J, 2011. Cash Flow Replication with Mismatch Constraints. Forthcoming, Journal of Risk
Chen, W and Skoglund, J, 2011. Optimal Portfolio Strategy with Liquidity Capacity, Working paper
Chen, W, and Skoglund, J, 2011. Building a Project Plan for Liquidity Execution. Working Paper
Dev, A. and R, Vandana, 2006. Performance Measurement in Financial Institutions in an ERM Framework. Risk Books.
Matz, L. and P, Neu, ed. 2007. Liquidity Risk Measurement and Management. John Wiley
Moodys . 2001. How Moodys Evaluates US Bank and Bank Holding Company Liquidity.
Skoglund, J and Mathur, S, 2011. Liquidity Risk Management After the Crisis, a SAS white paper.
Skoglund, J., 2010. Funds Transfer Pricing and Risk-Adjusted Performance Measurement, a SAS white paper
Basel Committee
2008 Principles for sound liquidity risk management and supervision
2009 Strengthening the resilience of the banking sector
2009 International framework for liquidity risk measurement, standards and monitoring
2009 Principles for sound stress testing practices and supervision
2011 Basel III: A global regulatory framework for more resilient banks and banking systems
Senior Supervisors Group
2008 Observations on risk management practices during the recent market turbulence
Financial Stability Forum
2008 Enhancing market and institutional resilience
Institute of International Finance
2008 Final report of the IIF committee on market best practices


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Copyright 2011, SAS Institute Inc. All rights reserved.

A New Regulation for Liquidity Risk

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