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Liquidity risk

Giampaolo Gabbi
Agenda
Liquidity risk: what it is and where it comes from
Funding liquidity risk
Stock-based approach
Cash flow based approach
Hybrid approach
Stress tests and contingency funding plans
The Basel Committee framework
Principles for liquidity risk management and supervision
Liquidity coverage ratio
Net stable funding ratio
Market liquidity risk
One of the main reasons the economic and financial crisis became so
severe was that the banking sectors of many countries had built up
excessive on- and off-balance sheet leverage.
This was accompanied by a gradual erosion of the level and quality of the
capital base.
At the same time, many banks were holding insufficient liquidity buffers.
The banking system therefore was not able to absorb the resulting systemic
trading and credit losses nor could it cope with the re-intermediation of
large off-balance sheet exposures that had built up in the shadow banking
system.
The crisis was further amplified by a procyclical deleveraging process and
by the interconnectedness of systemic institutions through an array of
complex transactions
Basel Committee, Strengthening the resilience of the banking sector - consultative
document
The Basel Committee December 2009
proposals
Some figures from the market:
Interbank Interest Rates
Interbank Interest Rates Volatility
Infra Day Interbank Interest Rates
Interbank Volumes
Interbank Trades
Interbank Market Active Banks
Liquidity
Asset and liability mismatch generates not only interest rate
risk liquidity risk
Different meaning of liquidity:
Security ease with which it can be cashed back or traded, even
in large amounts, on a secondary market
Market liquidity of the securities traded in the market different
proxies of liquidity (e.g. bid-ask spread, volume)
Affected by many factors: n. mkt participants, size & frequency of trades,
degree of informational asymmetry, time needed to carry out a trade
Function of tightness (markets ability to match supply and demand at low
cost) and depth (ability to absorb large trades without significant price impact)
Financial institution ability to fund increases in assets and meet
obligations as they come due, without incurring high losses
Generally proxied by the difference between the average liquidity of assets
and that of liabilities
Liquidity risk
Liquidity risk
risk that a financial institution may not be able to pay back its
liabilities in a timely manner because of an unexpectedly large
amount of claims
more realistically, it may be able to meet those requests only by
quickly selling (fire sale) large amounts of assets, at a price that is
below their current market value, thereby suffering a loss
The role of banks in the maturity transformation of short-
term deposits into long-term loans makes banks
inherently vulnerable to liquidity risk
Liquidity risk depends not only on the final maturity of
assets and liabilities, but also on the maturity of each
intermediate cash flow, including the early pre-payment
of loans or the unforeseen usage of credit lines
Liquidity risk
2 types of liquidity risk
Funding risk risk that a F.I. may not be able to face
efficiently (i.e. without jeopardising its orderly operations
and its financial balance) any expected or unexpected
cash outflows
Market liquidity risk risk that a F.I., to liquidate a sizable
amount of assets, will affect the price in a considerable
(and unfavourable) manner, because of the limited depth
of the market where the assets are traded

The two risk types are connected a F.I. wishing to face
unexpected cash outflows may need to sell a large
amount of securities potential sharp fall in price
Funding liquidity risk
Relevant factors
Contractual maturity of assets and liabilities
Optionality in bank products e.g. demand deposits,
guarantees issued, irrevocable loan commitments (e.g.
SPVs related to securitization or CP programs),
derivatives involving margin requirements

Two main type of events
Bank specific events events that distress the
confidence of third parties rating downgrades
(especially relevant when covenants or triggers
minimum rating required)
Systemic events e.g. market disruption, liquidity dry up
(e.g. recent financial crisis)
Funding liquidity risk
Three main measurement approaches
Stock based approach
Measures the stock of financial assets that can promptly be
liquidated to face a possible liquidity shock
Cash flow based approach
Compares expected cash inflows and outflows, grouping them in
homogeneous maturity buckets and checking that cash inflows
are large enough to cover cash outflows
Hybrid approach
Potential cash flows coming from the sale (or use as collateral) of
financial assets are added to actual expected cash flows
Actual cash flows - adjusted to take into account expected
counterparties behaviour are used in all approaches
(not contractual ones)
Stock based approach
Measures the stock of financial assets that can promptly
be liquidated to face a liquidity shock
Requires the banks BS be re-stated contribution each
item gives to creating/hedging funding risks
Cashable assets (CA) all assets that can quickly be
converted into cash
Volatile liabilities (VL) short term funds for which there is
a risk that they may not be rolled over (wholesale funding
and volatile portion of customer deposits)
Commitments to lend (CL) OBS items representing
irrevocable commitment to issue funds upon request
Steadily available credit lines (AL) irrevocable
commitments to lend issued to the bank by third parties
(usually, other F.I.s)
Stock based approach
Cashable assets (CA)
Short-term deposits
Loans short-term credit lines (e.g., o/n and other interbank
facilities) than can be easily and effectively claimed back
without endangering the customer relationships
Securities only unencumbered positions (not used as
collateral against loans or derivative contracts) may also
include long term bonds or shares. Does not include securities
not traded on a liquid market and not eligible not accepted
as collateral (e.g., shares in private companies held for
merchant banking purposes, unrated bonds, etc.)
Need of a haircut for:
possible loss relative to the market price
difference between current value and value of the short-term loans that
could be obtained by pledging them as collateral
Stock based approach
Assets Liabilities
Cash & equivalent 10 Sort termdeposits 100
Loans (cashable) Customer deposits
- O/n and similar int/bank fac.s, easily cashable 200 - volatile portion 600
Securities (unencumbered)
- Not used as collateral 1.000
- Less haircut -120
Total cashable assets (CA) 1,090 Total volatile liabilities (VL) 700
Loans (others) Customer deposits
- Credit lines not easily cashable 580 - Stable portion 1,600
- Maturity loans 1,500 Medium to long term funding 1,000
Securities (others) Other long termfunds 300
- used as collateral 400 Capital 400
- Not cashable nor accepted as collateral 20
- haircut 120
Fixed fin. assets (minorities, participations, etc.) 150
Fixed real assets 100
Goodwill 40
Total per cassa 4,000 Total 4,000
Commitments to lend (CL) 300 Steadily available credit lines (AL) 80
Assets Liabilities
Cash & equivalent 10 Sort termdeposits 100
Loans (cashable) Customer deposits
- O/n and similar int/bank fac.s, easily cashable 200 - volatile portion 600
Securities (unencumbered)
- Not used as collateral 1.000
- Less haircut -120
Total cashable assets (CA) 1,090 Total volatile liabilities (VL) 700
Loans (others) Customer deposits
- Credit lines not easily cashable 580 - Stable portion 1,600
- Maturity loans 1,500 Medium to long term funding 1,000
Securities (others) Other long termfunds 300
- used as collateral 400 Capital 400
- Not cashable nor accepted as collateral 20
- haircut 120
Fixed fin. assets (minorities, participations, etc.) 150
Fixed real assets 100
Goodwill 40
Total per cassa 4,000 Total 4,000
Commitments to lend (CL) 300 Steadily available credit lines (AL) 80
Example of a reclassified B/S
Stock based approach
Cash Capital Position (CCP)
Share of cashable assets not absorbed by volatile liabilities
Signals banks ability to withstand liquidity shortages due to:
greater-than-expected volatility in funding sources
unexpected difficulties in the mgmt of cashable assets
(e.g. increase haircuts due to unfavourable fin. markets)
To control for banks size, CCP sometimes scaled by total
assets

Example previous slide
CCP = CA VL = 390 = 9.75% TA
CCP = CA VL CL = 90 = 2.25% TA
CCP CA VL CL =
Stock based approach
Long term funding ratios (LTFR) alternative measure of
liquidity based on stocks
% of assets with a maturity > 5 years funded with
liabilities with maturity > 5 years or with capital
Portion of assets with a maturity greater than n years
which is being funded with liabilities having an equally
great maturity
Banks transform ST liabilities into MTL term loans
LTFR usually below 100%
Low values (or a deterioration over time) may indicate
unbalances/weaknesses in the maturity structure of
assets & liabilities
Cash flow based approach
CCP based on simplified approach assets and liabilities
are either stable or unstable (binary approach)
In reality many different degrees of stability/liquidity exist
Underlying logic of CF based approaches:
restate BS items going beyond a binary logic maturity ladder
also called mismatch based approach
Cash flows are sorted across the different maturities
based on:
contractual maturities (including intermediate cash flows)
banks expectations
past experience
Mismatch or liquidity gap (Gt) net unbalance inflows
and outflows
Cash flow based approach
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows
Net
flows
Net
cum.tive
flows
Loans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 10 -20 -20 -10 0 0
1 week 30 -50 -20 -15 -55 -55
2 weeks 80 -70 -15 -20 -25 -80
1 month 70 100 -200 -15 -50 -10 -105 -185
2 months 100 90 -330 -10 -50 -10 -210 -395
3 months 200 110 -300 -10 -100 -10 -110 -505
1 year 400 100 -400 -110 -100 -110 -615
3 years 400 200 -300 -200 -300 -200 -815
5 years 300 700 -650 -450 -100 -915
10 years 650 100 750 -165
Beyond 200 50 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows
Net
flows
Net
cum.tive
flows
Loans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 10 -20 -20 -10 0 0
1 week 30 -50 -20 -15 -55 -55
2 weeks 80 -70 -15 -20 -25 -80
1 month 70 100 -200 -15 -50 -10 -105 -185
2 months 100 90 -330 -10 -50 -10 -210 -395
3 months 200 110 -300 -10 -100 -10 -110 -505
1 year 400 100 -400 -110 -100 -110 -615
3 years 400 200 -300 -200 -300 -200 -815
5 years 300 700 -650 -450 -100 -915
10 years 650 100 750 -165
Beyond 200 50 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Example of expected cash flows
As in the stock-based approaches, demand deposits and loans are dealt with based on
their expected actual maturity
Cash flow based approach
Two type of indicators
Cumulative liquidity gap unbalance between flows
associated with a given band and all shorter maturities


Marginal liquidity gaps Gts related to one time band
Note that, when sorting assets and liabilities across time
bands, we are considering:
cash flows not stocks
their expected maturity, not their repricing period

<
=
t i
t t
G CG
Cash flow based approach
Negative cumulative liquidity gap bank cannot cover
foreseeable cash payments with expected inflows
severe warning of potential liquidity shortage
However, one weakness cash flows associated with
securities (including unencumbered assets) are based
on contractual maturities and coupons assets can be
used as collateral to get new loans, also at a very short
notice
re-write the maturity ladder taking into account role of
unencumbered assets in facing liquidity risks

Hybrid approach
Hybrid approach
CF based approach CFs from securities are sorted
into maturity buckets based on contractual maturity a
10-year ZC bond face value 10 mln entirely associated
with 10 year band
Banks treasurer can manage liquidity shortages by
selling the bond or using it to get funded through a
collateralised loan or repo
Haircut funds raised would only be a share (e.g.,
90%) of the bonds mkt value (which would be less than
face value) e.g. 7 million 70% can be cashed
quickly, rest (interest and haircut) available in 10 years
This only applies to unencumbered eligible assets
assets the bank can freely sell or pledge as collateral
Hybrid approach
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows
Net
flows
Net
cum.tive
flows
Loans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 600 10 -20 -20 -10 0 600
1 week 30 100 -50 -20 -15 -55 645
2 weeks 80 100 -70 -15 -20 -25 720
1 month 70 80 -200 -15 -50 -10 -105 595
2 months 100 -330 -10 -50 -10 -210 295
3 months 200 -300 -10 -100 -10 -110 75
1 year 400 -400 -110 -100 -110 -135
3 years 400 150 -300 -200 -300 -200 -385
5 years 300 300 -650 -450 -100 -885
10 years 650 120 750 -115
Beyond 200 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Maturity
bucket
(upper limit)
Expected cash inflows Expected cash outflows
Net
flows
Net
cum.tive
flows
Loans Securities
Cash &
equivalent
Customer
deposits
Other
funding Bonds
Comm.ts
to lend
Overnight 40 600 10 -20 -20 -10 0 600
1 week 30 100 -50 -20 -15 -55 645
2 weeks 80 100 -70 -15 -20 -25 720
1 month 70 80 -200 -15 -50 -10 -105 595
2 months 100 -330 -10 -50 -10 -210 295
3 months 200 -300 -10 -100 -10 -110 75
1 year 400 -400 -110 -100 -110 -135
3 years 400 150 -300 -200 -300 -200 -385
5 years 300 300 -650 -450 -100 -885
10 years 650 120 750 -115
Beyond 200 250 85
Total 2470 1450 10 -2320 -400 -1050 -75 85
Modified expected CFs taking into account unencumbered assets
Net cash flows look much better using this approach
Hybrid approach

-1500
-1000
-500
0
500
1000
Loans
Securities
Cash and short-term
Customer deposits
Other deposits
Bonds
Commitments lo lend
Cumulative net flows
Liquidity gaps
(marginal and
cumulative) for
shorter
maturities are
now positive


The bank looks
immune to
liquidity
shortages for
the shorter
maturities
Hybrid approach
Results achieved so far are affected by
assumptions on timing and amounts uncertainty
concerning:
Amount e.g. floating rate securities, IRS, European options
Timing e.g. long-term mortgages being pre-paid, demand
deposits left with the bank for years
Both amount and timing cash flows associated to open
credit lines or commitments to lend

It is important to consider not only an expected scenario, but
also check how the liquidity gaps would deteriorate in worst
case scenarios stress test
Stress test
Stress test simulation exercise aimed at quantifying the
effects of an especially adverse scenario
Three main approaches
Historical approach historical scenarios (e.g., % of demand deposits
unexpectedly withdrawn within 2 or 4 weeks)
Statistical approach historical data to infer probability distribution of risk
factors reasonable estimate of potential shocks (e.g., on deposits,
haircuts, interbank loans, etc.)
Judgement-based approach subjective appraisals by the banks
management (support of risk management, supervisors or consultants)
These approaches can be used to simulate individual risk
factors separately or jointly (worst case scenarios)
A. bank run on demand deposits
B. increase in market volatility increase haircuts on unencumbered assets
C. A+B jointly
Stress test
Stressed scenarios are rather intuitive in principle, but their
practical implementation can prove difficult:
1. A stress exercise is usually limited to a number of selected B/S
items (e.g. effect of an extreme scenario on the time profile of cash
flows associated only with securities, ignoring other assets and
liabilities) a market turmoil may be accompanied by an increase
in customer deposits as investors would postpone their asset
allocation choices indirect effects should also be included
2. When more risk factors are considered jointly (e.g., a bank run and
an increase in market volatility) a simple algebraic summation of
their effects may not be correct
pessimistic if risk factors are not strongly correlated (probability)
optimistic., if the two shocks are mutually reinforcing (impact) e.g.
confidence crisis hitting a bank in the midst of a market-wide currency
crisis the pressure on deposits might be stronger than it would be in
a quiet macroeconomic environment
Contingency funding plans (CFP)
Stressed scenarios can prove useful in building contingency
funding plans (CFP) to be triggered in case of extreme scenario
CFP surveys all possible sources of extra funds in the event of a
liquidity shock (e.g. temporary withdrawals of compulsory
reserves, repos with CB, secured or unsecured interbank loans)
CFP sets priority order (ranking) in which they should be tapped
cost and flexibility of the sources and type of liquidity shock
(e.g. interbank loans in case of an institution-specific shock vs.
intervention of Central Bank in case of a market-wide crisis
CFP describes people and structures responsible for
implementing emergency policies and actions to be taken
A credible CFP can quickly bring panic under control, limiting
the duration and breadth of the liquidity shortage
Funding liquidity risk
Some peculiarities of funding liquidity risk vs other risks
Liquidity risk not necessarily risk of losses
Assets & Liabilities mismatch does not need to be faced
by capital by high quality liquid (unencumbered)
assets more capital simply makes a liquidity crisis
less likely
If the bank is made up of different legal entities, in the
event of a liquidity crisis liquid funds cannot freely be
moved from one entity to the other due to the opposition
of some supervisory authorities
Organizational issues
Liquidity risk management requires systematic approach with clear
organizational rules systematic approach also required by Basel
E.g. Liquidity risk management (LRM)
LRM policy key role of board of directors
ensures liquidity risk is correctly identified, measured, monitored and
controlled
defines risk tolerance and strategy for liquidity risk management
identifies roles and responsibilities of the LRM Unit
receives periodic reports on the liquidity situation
Examples of periodic reports
analysis of the flow of funds
contingency funding plan
list of largest providers of funds
funding gap and maturity structure
structure and composition of the bank's balance sheet
size and cost of more recent very short term funding
Organizational issues
Limits are generally imposed to risk-taking units they may
refer to different measures examples:
Max absolute maturity gap
Max volume of overnight funding in relation to total assets
Max gap between liquid assets and ST liabilities
Min liquid assets net of expected erosion in case of stress
Max concentration of liabilities across counterparties
Key role internal audit in LRM process e.g. consistency
between policies set by senior mgmt and day-by-day risk mgmt,
adequacy of processes and soundness of measures
Often an ALM Committee (ALCO) representatives of all
business areas that affect liquidity risk
responsible for development of specific policies for LRM
ensuring adequacy of measurement system
Organizational issues
Liquidity Risk Management unit responsible for:
identifying liquidity risks incurred by the bank
monitoring evolution of liquidity profile
developing policies for controlling and mitigating liquidity risk
developing appropriate rules for liquidity risk management roles,
responsibilities and organizational structure; limits; policies and formats for
reporting to senior management
Developing liquidity contingency plan
Early warnings events signalling liquidity shortages in
advance
Internal early warnings e.g. increased concentration of assets or
liabilities, increase of assets funded by volatile funding
External indicators e.g. rating downgrades, decline in the banks stock
price; increase in the banks CDS spread; increase in the trading volume
of securities issued by the bank, increase in requests for guarantees,
increase in the cost of funding, request for (additional) collateral by
counterparties, reduction in the lines of credit by corresponding banks
Basel Committee: Principles for the
management and supervision of liquidity
risk
Key elements of a robust framework for liquidity risk mgmt:
board and senior management oversight
establishment of policies and risk tolerance
use of liquidity risk management tools such as
comprehensive cash flow forecasting, limits and liquidity
scenario stress testing
development of robust and multifaceted contingency
funding plans
maintenance of a sufficient cushion of high quality liquid
assets to meet contingent liquidity needs
Basel Committee: Principles for the
management and supervision of
liquidity risk
Fundamental principle for the mgmt and supervision of liquidity risk
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, including a cushion of
unencumbered, high quality liquid assets, to withstand a range of
stress events, including those involving the loss or impairment of both
unsecured and secured funding sources.
Governance of liquidity risk management
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 (both on- and off-balance
sheet)
Basel Committee: Principles for the
management and supervision of
liquidity risk
Measurement and management of liquidity risk
5: A bank should have a sound process for identifying, measuring, monitoring
and controlling liquidity risk projecting cash flows arising from assets,
liabilities and off-balance sheet items
6: A bank should actively monitor and control liquidity risk and funding needs
within and across legal entities, business lines and currencies
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
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 and use stress test
outcomes to adjust its liquidity risk management strategies, policies, and
positions
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 liquidity stress scenarios
Basel Committee: Principles for the
management and supervision of
liquidity risk
Public disclosure
13: A bank should publicly disclose information on a regular basis that
enables market participants to make an informed judgement about
the soundness of its liquidity risk management framework and liquidity
position
The role of supervisors
14: Supervisors should regularly perform a comprehensive
assessment of a banks overall liquidity risk management framework
and liquidity position
15: Supervisors should supplement their regular assessments of a
banks 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, to facilitate effective cooperation regarding the
supervision and oversight of liquidity risk management
Basel Committee recent proposals
(Dec. 2009)
Two internationally consistent regulatory standards
Liquidity coverage ratio
Aimed at ensuring that a bank maintains an adequate level of high
quality assets that can be converted into cash to meet its liquidity
needs for a 30-day horizon under a liquidity stress scenario
Stock of high quality liquid assets/Net cash outflows over a 30-day
time period 100%
Net stable funding ratio
Aimed at promoting more medium and long-term funding of the
assets and activities of banking organisations
Minimum acceptable amount of stable funding based on the
liquidity of a banks assets and activities over a 1 year horizon
Available amount of stable funding/Required amount of stable
funding > 100%
Liquidity coverage ratio
High quality assets
Net cash outflows over
30 days
Andrea Resti
Liquidity coverage ratio
High quality assets
Unencumbered not pledged either explicitly or implicitly in any way to
secure, collateralise or credit enhance any transaction (e.g. covered bonds)
and not held as a hedge for any other exposure
Liquid during a time of stress and, ideally, central bank eligible
Fundamental characteristics
Low credit and market risk
Ease and certainty of valuation
Low correlation with risky assets
Listed on a developed and recognised exchange market
Market-related characteristics
Active and sizable market
Presence of committed market makers
Low market concentration
Flight to quality
High quality assets unencumbered, high quality liquid assets
(ununcumbered: not pledged either explicitly or implicitly in any way to
secure, collateralise or credit enhance any transaction and not held as
a hedge for any other exposure) examples:
a) Cash
b) CB reserves
c) Marketable securities representing claims guaranteed by sovereigns,
CBs, non-central gov.t public sector entities (PSEs), BIS, IMF, or
multilateral dev.t banks as long as all the following criteria are met:
i. 0% risk-weight under the Basel II standardised approach
ii. deep repo-markets exist for these securities
iii. the securities are not issued by banks or other financial services entities
d) Gov.t or CB debt issued in domestic currencies by the country in which
the liquidity risk is being taken or the banks home country
Liquidity coverage ratio
Net cash outflows
Cumulative expected cash outflows minus cumulative
expected cash inflows arising in the specified stress
scenario in the time period under consideration
Net cumulative liquidity mismatch position under the
stress scenario measured at the test horizon
Cumulative expected cash outflows are calculated by multiplying
outstanding balances of various categories of liabilities by
assumed % that are expected to roll-off, and by multiplying
specified draw-down amounts to various OBS commitments
Cumulative expected cash inflows are calculated by multiplying
amounts receivable by a percentage that reflects expected inflow
under the stress scenario
Liquidity coverage ratio
Scenario combined idiosyncratic & market-wide shock:
a) a three-notch downgrade in the institutions public credit rating;
b) run-off of a proportion of retail deposits;
c) a loss of unsecured wholesale funding capacity and reductions of
potential sources of secured funding on a term basis;
d) loss of secured, short-term financing transactions for all but high
quality liquid assets;
e) increases in market volatilities that impact the quality of collateral or
potential future exposure of derivatives positions and thus requiring
larger collateral haircuts or additional collateral;
f) unscheduled draws on all of the institutions committed but unused
credit and liquidity facilities
g) need for the institution to fund balance sheet growth arising from
non-contractual obligations honoured in the interest of mitigating
reputational risk
many of the shocks actually experienced during the financial
crisis
Liquidity coverage ratio
Available amount of stable funding/Required amount of
stable funding > 100%
NSFR standard is structured to ensure that investment
banking inventories, off-balance sheet exposures,
securitisation pipelines and other assets and activities are
funded with at least a minimum amount of stable liabilities
in relation to their requirement as these inflows and
outflows are assumed to off-set each other
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
Net stable funding ratio
Net stable funding ratio
Goal:
To reduce the
mismatching of
asset and liabilities
We could say banks
should drive a bike
whose liability
turns over more
rapidly than asset
speed
Stable asset must be
covered by the
same volume of
stable liabilities
Assets
Liabilities
Andrea Resti
Net stable funding ratio
ASF Factor Component of AFS Category
100% - Capital (both Tier 1 and Tier 2)
- Preferred stock not included in Tier 2 (maturity > 1 year)
- Secured and unsecured borrowings and liabilities (including term deposits) with
maturities > 1year
85% - Stable" non-maturity retail deposits and/or term retail deposits with residual
maturities < 1 year
- "Stable" unsecured wholesale funding, non-maturity deposits and/or term deposits
with a residual maturity < 1 year, provided by small business customers
70% - "Less stable" non-maturity retail deposits and/or term retail deposits with residual
maturities of less than one year.
- "Less stable" unsecured wholesale funding, nonmaturity deposits and/or term
deposits with a residual maturity of less than one year, provided by small business
customers
Less stable deposits not covered by deposit insurance, high value-deposits,
deposits of high net worth individuals, deposits which can be withdrawn quickly (eg
internet deposits) and foreign currency ones
50% - Unsecured wholesale funding, non-maturity deposits and/or term deposits with a
residual maturity < 1 year, provided by non-financial corporate customers
0% - All other liabilities

Available amount of stable funding (ASF)
Net stable funding ratio
Required Stable Funding (RSF): Asset Categories and Associated Factors
RSF Factor Summary Composition of Asset Categories RSF Factor
0% - Cash, money market instruments
- Securities with effective remaining maturities of less than one year
- Outstanding loans to financial entities having effective maturities of less than one
year.
5% - Unencumbered marketable securities with residual maturities one year representing
claims on sovereigns, central banks, BIS, IMF, EC, noncentral government PSEs or
multilateral development banks which are rated AA or higher and are assigned a 0%
risk weight under the Basel II standardised approach, provided that active repo-
markets exist for these securities.
20% - Unencumbered corporate bonds (or covered bonds) rated at least AA with an
effective maturity of one year which are traded in deep, active and liquid markets
and which also have a demonstrated history of being a reliable liquidity source in a
stressed market environment.
50% - Gold
- Unencumbered equity securities listed on a major exchange and included in a large
capital market index and unencumbered corporate bonds (or covered bonds) rated
AA- to A- with an effective maturity of one year which are traded in deep, active and
liquid markets and which also have a demonstrated history of being a reliable liquidity
source in a stressed market environment.
- Loans to non-financial corporate clients having a residual maturity of less than one
year.
85% - Loans to retail clients with a residual maturity < 1 year
100% - All other assets

LCR
Similar to a CCP minimum requirement where the
denominator is substituted by a net cash outflow
estimate
Combination of a stock based and a cash flow based
measure
NSFR
Similar to a long term funding ratio (LTFR)
More sophisticated as different items are assigned
different weights
The Basel requirements
Market liquidity risk risk that a F.I., to liquidate a sizable
amount of assets, will end up affecting the price in a
considerable (and unfavourable) manner, because of the limited
depth of the market where the assets are traded
Market liquidity risk can be twofold
Exogenous general market characteristics outside control of bank
Endogenous banks characteristics (e.g. composition and size of its
portfolio)
Market liquidity is measured through the lack of it transaction
costs explicit and implicit incurred by investors to trade:
Bid-ask spread
Market impact difference between actual transaction price and price that
would have prevailed if the transaction had not taken place the higher
the lower is market liquidity
Market liquidity risk
Market liquidity risk
If no uncertainty on market impact liquidation value is
equal to bid price transaction cost



If large sale impact on spread deviation from its
mean value s + k (increasing function of position size
P and decreasing function of market size M)

2
S
P C
t
=
bid/ask spread
mid-quote at time t
( )
,
2
s k P M
C P
+
(
+
(
=
(

Market liquidity risk

ask price
mid price
p
r
i
c
e
s
bid price
Quote depth
Size of the Position (P)
Transaction costs
can be expected to
increase with the
transaction size, or,
namely, with its
impact in relation to
market depth
Traded volume and bid-ask spread (Bangia, et al. 1999)
Market liquidity risk
1
2
1 ( )
2
hp
PS S
TC AL e
MS


(
= +
(

The function linking k to P and M is not easy and tends to
change over time
Transaction costs also depend on the time period (e.g.
gradual liquidation vs. sudden fire sale)
Dowd (2002) more sophisticated version of the function

Relative size of
the position to
liquidate
Hp is the time period the
bank wants to liquidate
its position (holding
period)

2
is the elasticity of TC
to hp
Both need to be
estimated empirically
Elasticity of
transaction costs
to the relative
position size
Liquidity risk has been overlooked in the recent past
As clearly shown by the financial crisis, liquidity risk is
crucial for individual financial institutions and for the
stability of the financial system as a whole
Liquidity risk measurement methodologies are still at an
initial stage in the financial services industry
Some indicators are already used by most banks cash
capital position, liquidity gaps, long term funding ratios
It is more complex to deviate from expected future cash
flows and take into account stress scenarios
The regulators are stepping in with some new
requirements and general principles
Conclusions