Liquidity risk

Definition, Measurement,
Management and Regulation.
Claudio Morelli
Martina Tognaccini
What is Liquidity Risk?
Is the risk that financial institution may not be able to pay back its liabilities
in a timely manner because of an unexpectedly large amount of claims or
that they are obliged to sell long term assets at a price lower than their
market value.

We can distinguish between two different kinds of liquidity risk:

1. Market liquidity risk: is the risk in which a financial institution could
incur, if there is no more market for the asset that it wishes to sell.
Amaranth Advisor example: undiversified and leveraged position on
natural gas features after the hurricane was good, after the oversupplying
of natural gas went bad and nobody wanted to buy features

2. Funding liquidity risk: risk linked to a wrong management on funding
positions . Northern Rock example: the bank decided to fund itself by
short debt in covered bonds and securitized bond. After the financial
crisis on 2007 and the run of depositors (scared by the rumors) that
wanted their money back, the bank had no more money to draw back. It
was bail out by the bank of England with the nationalization.
Causes of Liquidity Risk
Internal factors:
High off balance sheet exposure
Rely heavily on corporate
deposits
Gap in asset liability maturity date
Massive asset expansion
exceeding liability side
Short term deposit concentration
Less allocation in liquid
government instruments
No incentive offered for long
term investment

External factors:
Very sensitive financial market and
depositors
External and internal sudden
economy shock
Low economic performances
Decreasing trust on banking sector
Non-economic factors (political,
social)
Sudden cash needed for project
financing
Governments need for external
obligation purposes

How to Measure Funding Liquidity Risk
(Stock Based Approaches)
1. STOCK BASED APPROACHES: The stock-based approaches look
at liquidity as a stock. By comparing the balance-sheet items, these
financial metrics aim at determine a bank's ability to reimburse its short-
terms debts obligations as a measurement of the liquid assets amount
that can be promptly liquidated by the bank or used to obtain secured
loans.
The most commonly used SBA are:
The Long Term Funding Ratio: is based only on the cash flow profile
arising from on- and off-balance sheet items of an institution. It indicates the
share of assets with a maturity of n years or more, funded through liabilities
of the same maturity.

=
_utJux (> n
erx
)
_nJux (> n
erx
)


In a short-term horizon, the LTFR is frequently lower than 100 percent, because
of maturity mismatches between assets and liabilities.
Cash Capital Position (CCP): in order to guarantee an appropriate balance
sheet structure with respect to liquidity risk, illiquid assets should be funded by
stable liabilities, or otherwise total marketable assets (TLA) should be funded
by total volatile liabilities (TVL)


How to Measure Funding Liquidity Risk
(Stock Based Approaches)
CCP = TLA TVL CLT
CCP measures a banks ability to fund its assets on a fully collateralized basis
and ensures the bank to conduct business for the survival period.
If the result is negative, it means that illiquid assets are greater than long-term
funding
How to Measure Funding Liquidity Risk
(Cash Flow Based Approach)
Institutions control their liquidity principally by managing the structure of the
respective maturities of their assets and liabilities, so as to generate adequate
net cash flows.
This model is based on a maturity ladder used to compare bank's future cash
inflows and outflows.

This grid allows to measure a cash flow mismatch or liquidity gap analysis
In this approach we consider that modifying the temporal axis, the same
asset/liability could have different values; we are looking for mismatching.
How to Measure Funding Liquidity Risk
(Hybrid Approach)
The hybrid approaches combine elements of the cash flow matching and of
the liquid assets approaches. The idea underlying these models is that
every credit institution is exposed to unexpected cash in- and outflows,
which may occur in the future because of unusual deviations in the timing
(term liquidity risk) or magnitude (call liquidity risk), so requiring a
considerably larger quantity of cash than the amount needed for bank
projects.
Financial Institutions usually use the Unencumbered assets to
counterbalance the NFR an so the CFR.
Transactional data: we measure the risk with respect to the volume
traded on the market. There is the need of the availability of volume
traded: Problem on exchange market
Bid-Ask spred: the risk depends upon the distance between the two
values. The spreads are influenced by the lack of information and by the
fact that they are the premia for the dealers.


How to Measure Market Liquidity Risk
(Dynamic Models)
Limit book order: the risk is a function of the expected lag in the
execution of the stock. Need of a very epensive database. Doesnt exist
for any kind of market
This kind of model are based upon the discovery of the liquidity risk
by the analysis of the characteristic elements of an asset.

For example, for a bond:
Listed or not listed asset
Outstanding
Currency
Coupon type
Maturity
Credit Spread
Bond rating
Issuer rating
Options
How to Measure Market Liquidity Risk
(Static Models)
How to Measure Market Liquidity Risk
(Static Models)
There is the usage of dummies in order to select each variable as a
component that could influece the asset in a liquid or illiquid way.
Then upon the results we construct the probability of the asset to be
Liquid or illiquid.
Liquidity Risk Management
There is no off-the-peg liquidity risk management strategy that will fit
all banks. The nature of a banks market and business strategies will
shape its risk management strategies.
We can find different risk management strategies for funding and
market liquidity risks but the main ones are common for both of them
1-MANAGING MARKET ACCESS
Market access is critical for liquidity risk management. It includes:
Diversification of liabilities: instrument type and nature of the
provider of funds;
The ability of establishing relationship with liability holders: a
bank should maintain an active presence within markets relevant to its
funding strategy;
The ability to develop asset-sales market: a bank should identify
and build strong relationships with current and potential investors to
liquidate assets
1-Funding Liquidity Risk Management(1)
1-Funding Liquidity Risk Management(2)
2-MANAGING SHORT TERM ASSETS and LIABILITIES
Banks manage their liquidity risk by monitoring the relationship
between short-term liabilities as opposed to their short-term assets.
which must be readily available to satisfy short-term liabilities.
To reduce liquidity risk
Minimize the amount of
marketable securities classified
as held to maturity assets
Make shorter term investments
or loans (e.g., auto loans mature
sooner than mortgage loans).
Reduce the number of short-term
and increase long term liabilities
(but extending liability maturities
has a cost)
ASSETS SIDE LIABILITIES SIDE
Cash in-flows from asset sales can be timed to fund expected cash
out-flows from maturing liabilities
Joining the two sides
2-Market Liquidity Risk Management
1-LIQUIDITY ADJUSTED VALUE at RISK (LAVaR)
VaR=maximum potential loss, with a certain
confidence level, within a certain time horizon
V=Value of the portfolio; =Expected Return; =Volatility
=confidence interval; =normal deviate or critical z
Absolute VaR with:
Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk
It introduces the Mean Spread
It increases the value of risk as a function of the spread: the higher the spread,
the less the liquidity of the instrument and the greater the VaR.
With Static Spread
With Volatile Spread
Calculate the spread volatility
The Static case uses the mean spread. The Volatile approach uses the
worst expected spread based on some confidence level.
3-Liquidity Risk Management(1)
1-STRESS TESTING PROCESS
Need to analyze the institutions liquidity profile and funding needs under current
market conditions but also under Adverse Scenarios:
Simulations that quantify the consequences of adverse
scenarios on the cash flows, liquidity position, profitability
and solvency of the bank
Consideration of many liquidity risk drivers linked to the banks business;
The scenarios incorporate the major internal and external scenarios;
Simulations for different time horizons (also intra-day) made frequently;
Historical data can be used with results of stress tests performed for various
other risk types and with subjective appraisal by the banks management;
Senior management should be actively involved in stress test process.
The scenario design should be subject to regular reviews to ensure that
severity of the tested scenarios remain appropriate and relevant to the bank.
Main features of the Stress Test:
Managing Funding and Market Liquidity Risk in particular the Funding one
STRESS
TESTS
3-Liquidity Risk Management(2)
2-CONTINGENCY FUNDING PLAN (CFP)
The results of stress tests play a key role in shaping the banks
contingency planning
CFP
It is a plan that clearly sets out the
strategies for addressing liquidity short falls
in emergency situations rising from internal
and/or external scenarios.
Main features:
Gives a description of sources of extra funds and amount of funds in the
event of a liquidity shock;
Gives a priority order to the procedures to be followed;
Address issues over a range of different time horizons, including intraday;
Contains the specification of roles and responsibilities for the decision
making during a liquidity crisis.
3-Liquidity Risk Management(3)
3-CUSHION OF UNENCUMBERED, HIGH QUALITY
LIQUID ASSETS
Insurance against a range of liquidity stress scenarios that can be
sold to obtain funds and that should ensure the bank to continue
to meet its obligations for the duration of the stress
Size of the cushion: related to the estimates of liquidity needs under
stress. Key considerations include assumptions about the size of cash
flow mismatches, the duration and severity of stress and the liquidation
value of assets in stress situations
Composition: core of the most reliably liquid assets, such as cash and
high quality government bonds .For insuring against less intense, but
longer duration stress events, a bank may choose to widen the
composition of the cushion to hold other unencumbered liquid assets
which are marketable
3-Liquidity Risk Management(4)
The best way to Manage Liquidity Risk is given by the joint use of
Management of assets and liabilities, Market Access Management,
Stress Tests, Contingency Funding Plan and Cushion of
Unencumbered, high quality liquid assets
Example: UNICREDIT GROUP
Key principles of the UniCredit Group's liquidity risk management model
The Group aims to be liquid at all times, namely to maintain liquidity at the level
enabling to conduct safe operations and its liquidity policies are based upon:
Short-term liquidity risk management (operational liquidity),: considers the events
that will impact upon the Group's liquidity position from 1 day up to one year. Uses:
management of the access to payment systems and management of cash payments
Structural liquidity risk management (structural risk), which considers the events
that will impact upon the Group's liquidity position over one year. Uses:
postponement of liabilities maturities
Liquidity Stress Test with systemic, specific and combined scenarios
Use of a Contingency Funding Plan
Source: Unicredit Annual Report 2010
Identify Liquidity
Risk Drivers
Erosion in value of
liquid assets
Additional collateral
requirements
Evaporation of funding
Withdrawal of
deposits
Etc.
Design Stress
Scenarios and
Probabilities
Internal Scenarios:
Ratings downgrade
Bank-run
Loss of access to the
unsecured inter-bank
market
Name crisis
External scenarios:
Market Downturn
Scenario
Critical political events
Systemic shock in many
centers of business
Country crisis .
Model Stress
Tests
Step 1:
Quantify liquidity
outflows in all
scenarios for each risk
driver
Step 2:
Identify cash inflows to
mitigate liquidity
shortfalls identified
Step 3:
Determine net
liquidity position under
each scenario
3-Liquidity Risk Management(5)
Stress Testing Process for Unicredit Group
The regulation of liquidity risk is mainly made by the Basel Committee on
Banking Supervision which gives a framework of global regulatory
standards on bank capital liquidity. The regulation is referred to both
funding and market liquidity risk but is concentrated on the former.
The most recent document before the crisis about liquidity risk made by
the Basel Committee is Sound Practices for Managing Liquidity in
Banking Organizations (February 2000)
It develops an understanding of the way in which banks manage their
liquidity on a global, consolidated basis.
It sets out 14 principles that highlight the key elements for effectively
managing liquidity and the more important refer to:

Need of a good management for a day-to-day liquidity
The senior management has to control and monitor liquidity risk
Limits to be imposed by the senior management to the cumulative cashflow
mismatch and to the liquid assets as a percentage of short term liabilities


Regulation Before the Crisis(1)
Suggested method to measure the risk: Cash Flow Approach
Use of What if scenarios which can take into account external and/or
internal factors that could lead to extreme scenarios with liquidity losses.
(Banks should give to each asset or liability the probability of the behaviour
of their cashflow for each scenario and then tabulate them for various point
in time);
Need to review periodically the main assumptions used to manage the risk
Need to manage the market access
Need of contingency plans with a strategy to address liquidity problems
and procedures for making up cash flow shortfalls in adverse situations that
consider also the risk given by asset securitization
The measurement and management should be done for each currency in
which the bank is involved
Need of an adequate system of internal controls
Need of mechanisms that ensure an adequate level of disclosure of
information
Supervisors should require that banks use a management plan to face
liquidity risk, should evaluate it and should receive timely information from
banks.


Regulation Before the Crisis(2)
The recent financial crisis has highlighted the importance of liquidity to the
proper functioning of financial markets and banking sector.
The difficulties experienced were due to the increase of off-balance sheet
operations and lapses in basic principles of liquidity risk management.
In response, the Committee in 2008 has published Principles for Sound
Liquidity Risk Management and Supervision which provides detailed
guidance on the risk management and supervision of funding liquidity risk with
17 PRINCIPLES.
Several principles recall the same framework of 2000 while others introduce
a new and more prudential regulation
MAIN INNOVATIONS:
Liquidity risk tolerance appropriate for the banks business strategy;
Senior management should develop a strategy risk in accordance with the risk
tolerance and a banks board of directors should review and approve the
Strategy
A bank should incorporate liquidity costs, benefits and risks in the internal pricing,
performance measurement for all significant business activities ;

Regulation After the Crisis(1)
A bank should measure future cash flows of assets and liabilities but also
triggers associated with off-balance sheet positions: in particular special
purpose vehicles and financial derivatives;
Banks should identify Early Warning Indicators and potential responses
A bank should actively manage its collateral positions, differentiating
between encumbered and unencumbered assets;
A bank should conduct Stress Tests on a regular basis
A bank should have a formal Contingency Funding Plan (CFP) that clearly
sets out the strategies for addressing liquidity shortfalls in emergency situations;
A bank should maintain a Cushion of Unencumbered, high quality liquid
Assets to be held as insurance against a range of liquidity stress scenarios;
Supervisors should intervene to require effective and timely remedial action by
a bank to address deficiencies in its liquidity risk management processes and
they should create cooperation with the other supervisors.
To complement the principles, the Committee has strengthened
its liquidity framework by developing, in Basel III (December
2010), two minimum standards for Funding Liquidity
which have been developed to achieve two separate but
complementary objectives
Regulation After the Crisis(2)
Regulation after the Crisis: Basel III
Objective: promote short-term resilience of a banks liquidity risk profile
by ensuring that it has sufficient high quality liquid resources to survive
an acute stress scenario lasting for one month
To meet funding obligations over the next 30 days, the LCR requires
banks to hold a stock of high-quality liquid assets equal to or
greater than stressed net cash outflows
High-Quality Liquid Assets:
Level 1 Cash, central bank reserves and sovereign debt
(measured at full value, they can be used unlimitedly)
Level 2 Lower-rated public debt and higher-rated covered bonds and non-
financial corporate bonds. (max 40% of the total liquid assets and haircut of 15%)
Net Cash Outflows during a 30-day period = liabilities with maturity within 30 days
under a scenario that combines an idiosyncratic and systemic liquidity shock
1-LIQUIDITY COVERAGE RATIO (LCR)
LCR has to be implemented by banks by 2015
Regulation after the Crisis: Basel III
Time horizon of 1 year: was developed to achieve the 2nd objective:
promote resilience over a longer time horizon by creating
additional incentives for a bank to fund its activities with more
stable sources of funding
Available stable funding: assets and liabilities with remaining maturities of one
year or more, and the portion of deposits and funding with maturities of less than
one year expected to remain for an extended period in an idiosyncratic stress event.
Required stable funding: sum of unencumbered assets, off-balance-sheet
exposures and other activities
Aimed to reduce the mismatching of assets and liabilities: stable
assets must be covered by the same volume of stable liabilities
2-NET STABLE FUNDING RATIO (NSFR)
NSFR has to be implemented by banks by 2018