Liquidity Risk

Question 1

What are the types of liquidity risks?

Answer 1

1. Funding risk
2. Market liquidity risk

Question 2

What is the definition of funding risk?

Answer 2

Funding risk is a risk that a financial institution may not be able to face efficiently (i.e. without jeopardising its orderly operations and its financial balance) any expected or unexpected cash outflows.

Question 3

What is the definition of market liquidity risk?

Answer 3

Market liquidity risk, is a risk that if a financial institution was to liquidate a sizable amount of assets, it will affect the price in a considerable (and unfavourable) manner, because of the limited depth of the market where the assets are traded

Question 4

What are the factors relevant to funding liquidity risk?

Answer 4

1. Contractual maturity of assets and liabilities
2. Optionalities in bank products

Question 5

What are the two main types of events relevant to funding liquidity risk?

Answer 5

1. Bank specific events (events that distress the confidence of third parties, leading to rating downgrades, with persistent heterogeneity)
2. Systemic events. Systematic heterogeneity in funding costs.

Question 6

What are the three main measurement approaches to managing the funding liquidity risk?

Answer 6

1. Stock based approach:
   * Measures the stock of financial assets that can promptly be liquidated to face a possible liquidity shock
2. Cash flow based approach:
   * Compares expected cash inflows and outflows, groupin them in homogeneous maturity buckets and checking that cash inflows are large enough to cover cash outflows
3. Hybrid approach
   * Potential cash flows coming from the sale (or use as collateral) of financial assets are added to actual expected cash flows

Question 7

What are the cateogries of assets for restating the bank’s BS for the stock based approach?

Answer 7

1. Cashable assets (CA): all assets that can quickly be converted to cash.
2. 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)
3. Commitments to lend (CL): OBS items representing irrevocable commitment to issue funds upon request
4. Steadily available credit lines (AL): irrevocable commitments to lend issued to the bank by third parties

Question 8

What is the formula for the Cash Capital Position (CCP)?

Answer 8

CCP = CA-VL-CL

Question 8

What is the benefit of the cash flow approach to liquidity risk over the stock based approach?

Answer 8

CCP in the stock based approach is based on assets and liabilities being stable or unstable (binary), CF based approach uses a maturity ladder (mismatch based approach)

Question 8

What are cash flows in the cash flow method for liquidity risk management sorted on?

Answer 8

Contractual maturities (including intermediate cash flows)
Bank’s expectations
Past experience

Question 9

What are the two types of indicators used in the cash flow based approach for liquidity risk management?

Answer 9

1. Cumulative liquidity gap: calculate the net cash flow for each maturity band, then sum up every unbalance betweens flows associated with a given band and all shorter maturities
2. Marginal liquidity gap: Gap related to one time band

Remember: cash flows not stocks
Expected maturity, not the repricing period

Question 10

How are the hybrid approach for liquidity risk management cash flows calculated?

Answer 10

We calculated expected CFs taking into account only unencumbered assts.

Question 11

What is the advantage of the hybrid approach for liquidity risk management?

Answer 11

Takes into account possibility of seeling the bonds to cover liqudity shortages.

Question 12

What are the three main approaches to stress testing liquidity risk?

Answer 12

1. Historical approach
2. Statistical approach
3. Judgement-based approach

Question 13

What is the liquidity coverage ratio?

Answer 13

Aimed at ensuring that a bank maintains an adequate level of high quality assets that can be converted into cash to meet is liquidity needs for a 30-day horizon under a liqudity stress scenario.
LCR = (High Quality Liquid Assets)/(Net Cash Outflows over 30 days) >= 100%

Question 14

What is the net stable funding ratio?

Answer 14

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 bank’s assets and activities over a 1 year horizon.
NSFR = (Available Stable Funding)/(Required Stable Funding) >= 100%

Question 15

What is considered as high quality liquid assets for the liquidity coverage ratio?

Answer 15

Unencumbered assets, liquid during a time of stress, low credit and market risk, ease and certainty of valuation, low correlation with risky assets, listed on a developed exchange, active and sizable market, present of commited market makers, low market concentration, flight to quality.

Question 16

How to measure transaction cost if no uncertainty on market impact?

Answer 16

C = P_t * (S/2)

P_t is the mid-quote at time t, S is the bid/ask spread.