Liquidity risk

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In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

Contents
[hide]

1 Types of Liquidity Risk 2 Causes of liquidity risk 3 Measures of liquidity risk

3.1 Liquidity gap 3.2 Liquidity risk elasticity 4 Measures of Asset Liquidity o 4.1 Bid-offer spread o 4.2 Market depth o 4.3 Immediacy o 4.4 Resilience 5 Managing Liquidity Risk o 5.1 Liquidity-adjusted value at risk o 5.2 Liquidity at risk o 5.3 Scenario analysis-based contingency plans o 5.4 Diversification of liquidity providers o 5.5 Derivatives 6 Case Studies o 6.1 Amaranth Advisors LLC - 2006 o 6.2 Northern Rock - 2007 o 6.3 LTCM - 1998 7 References 8 Further reading 9 External links

o o

[edit] Types of Liquidity Risk

Market liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:

Widening bid/offer spread Making explicit liquidity reserves Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities:

Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic

[edit] Causes of liquidity risk

Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found to be higher in emerging markets or low-volume markets. Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk. A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk examplethe two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contracts were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions. Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults. Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or mortgage-backed securities. If an organization's cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:

Construct multiple scenarios for market movements and defaults over a given period of time Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.

Regulators are primarily concerned about systemic and implications of liquidity risk.

[edit] Measures of liquidity risk

[edit] Liquidity gap
Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm's liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values. As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm's marginal funding cost.

[edit] Liquidity risk elasticity

Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank's marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates. Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.

[edit] Measures of Asset Liquidity

[edit] Bid-offer spread
The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product's mid price can be used. The smaller the ratio the more liquid the asset is. This spread is composed of operational, administrative, and processing costs as well as the compensation required for the possibility of trading with a more informed trader.

[edit] Market depth

Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.

[edit] Immediacy

Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.

[edit] Resilience
Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.

[edit] Managing Liquidity Risk

[edit] Liquidity-adjusted value at risk
Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.[1] Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions "... a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions." [2]

[edit] Liquidity at risk

Greenspan (1999) discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country's liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturityaveraged over estimated distributions for relevant financial variablesin excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.[3]

[edit] Scenario analysis-based contingency plans

The FDIC discuss liquidity risk management and write "Contingency funding plans should incorporate events that could rapidly affect an institutions liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.".[4] Greenspan's liquidity at risk concept is an example of scenario based liquidity risk management.

[edit] Diversification of liquidity providers

If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote "While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed." [5]

[edit] Derivatives
Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.:

Withdrawal option: A put of the illiquid underlying at the market price. Bermudan-style return put option: Right to put the option at a specified strike. Return swap: Swap the underlying's return for LIBOR paid periodicially. Return swaption: Option to enter into the return swap. Liquidity option: "Knock-in" barrier option, where the barrier is a liquidity metric.

[edit] Case Studies

[edit] Amaranth Advisors LLC - 2006
Amaranth Advisors lost roughly $6bn in the natural gas futures market back in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranths positions were staggeringly large, representing around 10% of the global market in natural gas futures.[6] Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to ones concentration in the security. In Amaranths case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions.[7] Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.[8]

[edit] Northern Rock - 2007

Main article: Nationalisation of Northern Rock Northern Rock suffered from funding liquidity risk in September 2007 following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets [9]. In response, the FSA now places greater supervisory focus on liquidity risk especially with regard to "highimpact retail firms".[10]

[edit] LTCM - 1998

Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in a cash-flow crisis when economic shocks resulted in excessive mark-tomarket losses and margin calls. The fund suffered from a combination of funding and asset liquidity. Asset liquidity arose from LTCM failure to account for liquidity becoming more valuable (as it did following the crisis) . Since much of its balance sheet was exposed to liquidity risk premium its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor.[11] LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, haircuts on AAArated commercial mortgages would increase from 2% to 10%, and similarly for other securitiles. In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk.[12]

[edit] References
1. ^ http://www.banque-france.fr/gb/publications/telechar/rsf/2006/etud2_0506.pdf Arnaud Bervas, Market Liquidity and its incorporation into Risk Management (2006). 2. ^ http://www.bis.org/publ/joint01.htm Final Report of the Multidisciplinary Working Group on Enhanced Disclosure (2001). 3. ^ http://www.bis.org/review/r990504a.pdf Mr Greenspan discusses recent trends in the management of foreign exchange reserves (1999) 4. ^ http://www.fdic.gov/news/news/financial/2008/fil08084.pdf Liquidity Risk Management (2008). 5. ^ http://www.actuary.org/pdf/naic/lifeliq_1200.pdf Report of the Life Liquidity Work Group of the American Academy of Actuaries to the NAICs Life Liquidity Working Group (2000). 6. ^ http://www.wilmott.com/blogs/satyajitdas/index.cfm/2007/1/26/Fear-and-Loathing-inDerivatives--The-More-Things-ChangeAmaranth 7. ^ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1086865# Natural Gas Futures and Spread Position Risk: Lessons from the Collapse of Amaranth Advisors L.L.C. Ludwig Chincarini (2008) 8. ^ http://www.gloriamundi.org/picsresources/lc_adr.pdf The Amaranth Debacle - A Failure of Risk Measures or a failure of Risk Management? Ludwig B. Chincarini (2006) 9. ^ http://www.princeton.edu/~hsshin/www/nr.pdf 10. ^ http://www.fsa.gov.uk/pages/Library/Communication/PR/2008/028.shtml 11. ^ http://www.erisk.com/Learning/CaseStudies/Long-TermCapitalManagemen.asp Sungard Ambit ERisk 12. ^ Brunnermeier, Markus; Pedersen, Lasse (2009). "Market Liquidity and Funding Liquidity". Review of Financial Studies 22 (6): 22012238. doi:10.1093/rfs/hhn098.

[edit] Further reading

Crockford, Neil (1986). An Introduction to Risk Management (2nd ed.). WoodheadFaulkner. ISBN 0-85941-332-2.

van Deventer, Donald R., Kenji Imai and Mark Mesler (2004). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. John Wiley. ISBN 978-0470821268. Culp, Christopher L. (2001). The Risk Management Process. Wiley Finance. ISBN 9780471405542. Hachmeister, Alexandra (2007). Informed Traders as Liquidity Providers. DUV. ISBN 978-3835007550. Bhaduri, R., G. Meissner and J. Youn (2007). Hedging Liquidity Risk. Journal of Alternative Investments, Winter 2007. John L. Knight, Stephen Satchell (2003). Forecasting Volatility in the Financial Markets. Butterworth-Heinemann. ISBN 978-0750655156.

[edit] External links

Papers about Liquidity Risk on DefaultRisk.com [hide]

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Financial risk and financial risk management

Credit risk Market risk Consumer credit risk Concentration risk Securitization Credit derivative Interest rate risk Currency risk Equity risk Commodity risk Volatility risk

Categories Liquidity Refinancing risk risk Operational Operational risk management Legal risk Political risk Reputational risk risk Settlement risk Profit risk Systemic risk Financial Market portfolio Risk-free rate Modern portfolio theory Risk parity RAROC risk Value at risk Sharpe ratio modeling Basic Diversification Systematic risk Hedge Risk pool Expected return Hazard concepts Risk Investment management Financial economics Mathematical finance Retrieved from "http://en.wikipedia.org/w/index.php?title=Liquidity_risk&oldid=465790163" View page ratings Rate this page What's this? Trustworthy

Objective Complete Well-written I am highly knowledgeable about this topic (optional) I have a relevant college/university degree It is part of my profession It is a deep personal passion The source of my knowledge is not listed here I would like to help improve Wikipedia, send me an e-mail (optional) We will send you a confirmation e-mail. We will not share your e-mail address with outside parties as per our feedback privacy statement. Submit ratings Saved successfully Your ratings have not been submitted yet Your ratings have expired Please reevaluate this page and submit new ratings. An error has occured. Please try again later. Thanks! Your ratings have been saved. Please take a moment to complete a short survey. Start survey Maybe later Thanks! Your ratings have been saved. Do you want to create an account? An account will help you track your edits, get involved in discussions, and be a part of the community. Create an accountorLog in Maybe later Thanks! Your ratings have been saved. Did you know that you can edit this page? Edit this page Maybe later Categories:

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Risk management in Indian banks

From Wikipedia, the free encyclopedia Jump to: navigation, search

Categories of financial risk

Credit risk Concentration risk Market risk Interest rate risk Currency risk Equity risk Commodity risk Liquidity risk Refinancing risk Operational risk Legal risk Political risk Reputational risk Volatility risk Settlement risk Profit risk Systemic risk

v d e

Risk management in Indian banks is a relatively newer practice, but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. In times of volatility and fluctuations in the market, financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Hence, an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Thus the need for an efficient risk management framework is paramount in order to factor in internal and external risks.[1] . The financial sector in various economies like that of India are undergoing a monumental change factoring into account world events such as the ongoing Banking Crisis across the globe. The 2007present recession in the United States has highlighted the need for banks to incorporate the concept of Risk Management into their regular procedures. The various aspects of increasing global competition to Indian Banks by Foreign banks, increasing Deregulation, introduction of innovative products, and financial instruments as well as innovation in delivery channels have highlighted the need for Indian Banks to be prepared in terms of risk management. [2]

Indian Banks have been making great advancements in terms of progress in terms of technology, quality, quantity as well as stability such that they have started to expand and diversify at a rapid rate. However, such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. In banks and other financial institution risk plays a major part in the earnings of a bank. Higher the risk, higher is the return, hence, it is most essential to maintain a parity between risk and return. Hence, management of Financial risk incorporating a set systematic and professional methods especially those defined by the Basel II norms because a essential requirement of banks. The more risk averse a bank is, the safer is their Capital base.[2]

Contents
[hide]

1 Risk Ratio 2 Total Impact of Risk 3 Risk and Reward 4 Types of Risk 5 See also 6 References

[edit] Risk Ratio

Risk ratio would be defined as the ratio of the probability of an issue occurring as against to an issue not occurring.[3]

[edit] Total Impact of Risk

Total impact of the risk (TIR) occurring would entail as the impact (I), the risk would cause multiplied by the Risk Ratio. It is essentially how much a bank would be impacted in the chance that the risk did occur. This essentially helps ascertain what is the total value of their investments that may be subject to risk and how it would impact them.[4]

[edit] Risk and Reward

The ratio is in simplest terms calculated by dividing the amount of profit the trader expects to have made when the position is closed (i.e. the reward) by the amount he or she stands to lose if the price moves in the unexpected direction (i.e. the risk).

To calculate the total risk ensuing with the total expected return, a favored method is the use of variance or standard deviation. The larger the variance, the larger the standard deviation, the more uncertain the outcome. The standard deviation, E is a measure of average difference between the expected value and the actual value of a random variable (or unseen state of nature).

Here, n stands for a possible outcome, x stands for the expected outcome and P is the probability (or likelihood) of the difference between n and X occurring.[5]

[edit] Types of Risk

Types of Risks in Banking The term Risk and the types associated to it would refer to mean financial risk or uncertainty of financial loss. The Reserve Bank of India guidelines issued in Oct. 1999 has identified and categorized the majority of risk into three major categories assumed to be encountered by banks. These belong to the clusters:[6]

Credit Risk Market Risk Operational Risk

The type of risks can be fundamentally subdivided in primarily of two types, i.e. Financial and Non-Financial Risk. Financial risks would involve all those aspects which deal mainly with financial aspects of the bank. These can be further subdivided into Credit Risk and Market Risk. Both Credit and Market Risk may be further subdivided.

Non-Financial risks would entail all the risk faced by the bank in its regular workings, i.e. Operational Risk, Strategic Risk, Funding Risk, Political Risk, and Legal Risk.[2]

[edit] See also

Risk management tools Probabilistic risk assessment

[edit] References
1. ^ Risk Management Framework for Indian Banks. http://www.coolavenues.com/know/fin/fayaz_1.php3. 2. ^ a b c "RISK MANAGEMENT IN INDIAN BANKS: SOME EMERGING ISSUES". IJER. December 2010. http://www.ijeronline.com/documents/volumes/vol1issue1/ijer2010010109.pdf. 3. ^ Sistrom CL, Garvan CW (January 2004). "Proportions, odds, and risk". Radiology 230 (1): 129. doi:10.1148/radiol.2301031028. PMID 14695382. http://radiology.rsnajnls.org/cgi/pmidlookup?view=long&pmid=14695382. 4. ^ ART, RiskAoA, RiskPath, SCHRAM 5. ^ Fundamental Analysis Workbook. National Stock Exchange of India Limited. 6. ^ "Trend and Progress of Banking in India". Reserve Bank of India. 199697, 199899, 200102 and 200203.

[hide]

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Financial risk and financial risk management

Credit risk Market risk Consumer credit risk Concentration risk Securitization Credit derivative Interest rate risk Currency risk Equity risk Commodity risk Volatility risk

Categories Liquidity Refinancing risk risk Operational Operational risk management Legal risk Political risk Reputational risk risk Settlement risk Profit risk Systemic risk Financial Market portfolio Risk-free rate Modern portfolio theory Risk parity RAROC Value at risk Sharpe ratio risk

modeling Basic Diversification Systematic risk Hedge Risk pool Expected return Hazard concepts Risk Investment management Financial economics Mathematical finance Retrieved from "http://en.wikipedia.org/w/index.php?title=Risk_management_in_Indian_banks&oldid=4645956 09" View page ratings Rate this page What's this? Trustworthy Objective Complete Well-written I am highly knowledgeable about this topic (optional) I have a relevant college/university degree It is part of my profession It is a deep personal passion The source of my knowledge is not listed here I would like to help improve Wikipedia, send me an e-mail (optional) We will send you a confirmation e-mail. We will not share your e-mail address with outside parties as per our feedback privacy statement. Submit ratings Saved successfully Your ratings have not been submitted yet Your ratings have expired Please reevaluate this page and submit new ratings. An error has occured. Please try again later. Thanks! Your ratings have been saved. Please take a moment to complete a short survey. Start survey Maybe later Thanks! Your ratings have been saved. Do you want to create an account? An account will help you track your edits, get involved in discussions, and be a part of the community. Create an accountorLog in Maybe later Thanks! Your ratings have been saved.

Did you know that you can edit this page? Edit this page Maybe later Categories:

Financial risk Risk Banking in India India Education Program

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Create a book Download as PDF Printable version This page was last modified on 7 December 2011 at 17:19. Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. See Terms of use for details. Wikipedia is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization. Contact us Privacy policy About Wikipedia Disclaimers Mobile view