Chapter 10: Liquidity risk Flashcards
What is liquidity risk?
Liquidity risk is the risk associated with the uncertainty in meeting all obligations as they fall due. This means banks must at all times be able to service their obligations, as they fall due, on both sides of the balance sheet, e.g., if a depositor wants their money back or if a customer wants to use their credit card.
The core business of banking (maturity transformation) involves originating lending of longer-terms (assets) from deposits of short-terms (liabilities). The maturity mismatch between the assets and liabilities creates uncertainty (i.e., liquidity risk)
This means, they should have the ability to fund loans throughout their life (assets), be able to meet demand of withdrawals (liabilities) when they arise.
Define the three types of liquidity
Trading liquidity
Trading liquidity refers to a bank’s ability to buy or sell financial assets, such as stocks, bonds, and currencies, quickly and at a fair price. It is a measure of how easily a bank can trade its financial assets without significantly affecting their market prices.
Redemption liquidity
Redemption liquidity refers to a bank’s ability to meet the demands of its depositors who want to withdraw their funds from the bank. In other words, it is the bank’s ability to redeem its liabilities to its depositors as they fall due.
Funding liquidity
Funding liquidity refers to the availability of funds that a bank has to meet its immediate cash needs. Banks use the funds they receive from their depositors, such as checking and savings accounts, to fund their lending activities, such as making loans to businesses and individuals.
What is LDR
Loan-to-deposit ratio (LDR)
Measures the relationship between lending and customer deposits over the same period.
The metric gives a view of the self-sustainability or reliance on wholesale funding of the fund and be monitored against a specific limits and targets to ensure sufficient customer contribution to overall funding
A ratio of > 100% can be an early warning indication of excess asset growth, or a loss of customer deposits, and a potentially risky reliance on wholesale funds.
A ratio of < 70% implies excess liquidity and a potentially inadequate return on funds if these funds are invested in low yielding assets or cash
A ratio of 85% - 95% is best practice, but dependent on the business model and risk tolerance of the bank.
What is 1-week and 1-month liquidity ratios
1-week and 1-month liquidity ratios
Measured against regulatory limit requirements.
These metrics aim to essentially measure gap risk. They show net cashflows, including the cash effect of liquidating liquid securities, as a percentage of liabilities for different maturity buckets.
Measure of structural liquidity and gives an early indication of stress points. If the liquidity ratios worsen, management should provide information that should drive change in the funding strategy or rapid structural changes to the composition of the balance sheet.
What is Cumulative liquidity model
Cumulative liquidity model
Extension of the liquidity ratio and is a forward-looking model of inflows, outflows and available liquidity, accumulated for a 12-month period
Aims to identify liquidity stress points on a cash basis
What is Liquidity risk factor
Liquidity risk factor
LRF measures the static snapshot of the aggregate size of the liquidity gap, measures the average tenor of the assets to the average tenor of the liabilities and is hence referred to as the maturity transformation ratio.
The average is calculated as a weighted average of either (or both) the behavioural and contractual tenros, weighted by the nominal amounts or drawn balances.
The larger the LRF, the larger the liquidity gap, the greater the liquidity risk.
On its own, a one-off LRF number is of little value. It is important to observe the trend over time and the change to long-run averages, so as to get early warning of the build-up of a potentially unsustainable funding structure.
The process of modelling cash inflows and outflows in liquidity risk management
- Measuring contractual maturity gap
Banks choose the time bucket it wishes to report the balance sheet gap and place cashflows in those buckets - Modelling behaviour of demand deposits
* Observe month-end spot and average balances over time to build a picture of behavioural tenor, by product type
* Observe the behaviour at expected outflow points like month-ends and quarter ends
* Observe the behaviour at times of stress - Banks should also analyse according to:
* Is it insured?
* Is it secured?
* Are the funds controlled by the owner?
* Customer’s relationship with the bank (e.g., loans)
* Internet access?
* Is the depositor a net borrower
* Type of counterparty – level of financial sophistication?
* Direct depositor or via a third party? - Uses of the analysis
* FTP
* LCR
* Determining LAB
* Determining the strategic setting for customer pricing - Pre-payment behaviour
Prepayment assumptions need to be made as assets behaviour profiles are shorter than contractually stipulated – flows in the FTP process
Expect full contractual tenor for undrawn facilities and credit cards
Back up liquidity lines (to customers) are likely to be drawn on at precisely the time when the bank will want to be preserving liquidity and lending less It’s imperative that these facilities be allocated appropriate charge when they originate
Modelling behaviour of contingent funding obligations
Contingent, off-balance sheet and collateral obligations also generate term funding requirement for a bank. Important to understand the tenor characteristics of these cash-flows
Define LCR
Liquidity coverage ratio (short-term liquidity metric)
Purpose is to promote short-term resilience of a bank’s liquidity risk profile by ensuring it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for 30 calendar days
(Stock of HQLA)/(Total net cashflows over the next 30 calendar days)>100%
HQLA are defiend as assets that can be easily convered and immediately in private markets into cash at no (or little) loss of value
Total net cashflows are defined as the total expected cash outflow minus total expected cash inflow in a specific stressed scenario over 30 days
Define NSFR
Net stable funding ratio (long-term liquidity measurement metric)
NSFR requires a bank to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities
Purpose is to promote resilience over a longer time horizon (1 year) by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis
A low ratio indicates a concentration of funding in shorter maturities, which can give rise to rollover and mismatch risk
(Available amount of stable funding)/(Required amount of stable funding)>100%
Available stable funding (ASF) is measured based on broad characteristics of the relative stability of an institution’s funding sources.
Required stable funding (RSF) is measured based on the broad characteristics of the liquidity risk profile of an institution’s assets and off-balance-sheet exposures.
How to improve NSFR
- Increase the ASF by adjusting the liability side of the BS (e.g., liabilities with higher rollover factors or longer duration)
- Decrease RSF by adjusting the asset side of the BS (e.g., assets with lower rollover factors or short duration)
- Difficult to change the shape of the BS in the short-term thus cannot change NSFR in the short term
What is a concentration report?
A report that shows the extent of reliance on a single source of funds. This can be an indication of a possible stress point in the event of a crash
Banks should not be reliant on a single counterparty - outside of deposit sector, they should be wary of excessive reliance on a singel class of depositor
THis is managed through deposit limits
