Basel III Liquidity Risk Management

Jun Zhu 11/19/2012

Basel III Liquidity Risk Requirements New regulation for liquidity risk Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Monitoring standards

Modeling on liquidity risk Cash flow modeling Deposit modeling Stress test

What can be done in E*Trade? eTrade balance sheet structure Integrate liquidity into business strategy

Agenda

Goal of Basel III Liquidity Risk Regulation

Learning from the recent crisis….. • The recent credit crisis compounded itself quickly into a major liquidity

crisis (or funding problem), leading to insolvency of major financial institutions

• A key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk in many banks

• Many banks did not have a dedicated liquidity buffer or liquidity portfolio that was managed

Regulators response….. • The Basel III liquidity risk regulation underscores the importance of

managing the liquidity contingency buffer in much the same way as capital • Focusing on maintaining a high quality liquidity portfolio that can hedge

out liquidity outflows under stress scenarios • And, integrate the liquidity pricing and hence incentive to raise liquidity as

well as price costly liquidity according to the opportunity cost of raising the needed buffer

Liquidity Risk Management

A New Regulation for Liquidity risk

Basel III Regulation for Liquidity Risk

Guiding Principles Basel (2009) ‘Principles for Sound Stress Testing Practices and Supervision’

Regulatory Reporting Standards Monitoring Standards

Liquidity Coverage Ratio (LCR)

Contractual Maturity Mismatch

Funding Concentration

Unencumbered Assets

Market Monitoring

Net Stable Funding Ratio (NSFR)

Guiding Principles Basel (2008) ‘Principles for Sound liquidity Risk Management and Supervision’

Minimum Reporting Basel (2010) ‘International Framework for Liquidity Risk Measurement, Standards and Monitoring’

Introduced on Jan 1, 2015

Introduced on Jan 1, 2018

Liquidity Coverage Ratio The LCR aims to ensure that banks maintain an adequate level of high-quality liquid assets to survive a severe liquidity stress scenario lasting for 30 days

Liquidity Coverage Ratio (Cont’d)

Total net cash outflows are defined as the total expected cash outflows minus total expected cash inflows in the specified stress scenario

Liquidity Coverage Ratio (Cont’d)

Fundamental characteristics of high quality liquid assets: • Low credit and market risk • Ease and certainty of valuation • Low correction with risky assets • Listed in a developed and recognized exchange Market-related characteristics • Active and sizable market • Presence of committed market makers • Low market concentration • Flight to quality

Liquidity Coverage Ratio (Cont’d)

The definition of high quality liquid assets and the treatment of interbank funding are the keys

Liquidity Coverage Ratio (Cont’d)

Potential ways to manage LCR:

Hold more Cash

Sell illiquid assets and buy level 1 or 2 assets

Increase duration of liabilites (e.g. short term deposits)

Liquidity buffer LCR = (Cash outflow – Cash inflowcap 75%) ≤ 30d

Levers to manage the ratio:

Increase Liquidity buffer (-> higher costs)

Decrease Cash outflow (-> lower returns)

Increase Cash inflow (-> lower returns)

Increase stability of deposits (e.g. stable retail deposits and wholesale operational accounts)

Decrease duration of assets (e.g. short term loans)

Decrease potencial liquidity drains (credit/ liquidity facilities)

Net Stable Funding Ratio The NSFR should ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles

Net Stable Funding Ratio (Cont’d) Funding provided by financial institutions and loans to such firms are assigned with a low ASF and a high RSF respectively

Net Stable Funding Ratio (Cont’d)

Available amount of stable funding: • Capital • Preferred stock with maturity of equal to or greater than one year • Liabilities with effective maturities of one year or greater • The portion of “stable” non-maturity deposits and/or term deposits with

maturities of less than one year that would be expected to stay with the institution extended stress

Required amount of stable funding: • The value of assets held and funded by the institution, multiplied by a

specific required stable funding factor assigned to each particular asset type

• The amount of off-balance sheet activity (or potential liquidity exposure) multiplied by its associated required stable funding factor

Net Stable Funding Ratio (Cont’d)

Originate new liabilities (and invest cash into assets with lower RSF)

Securitize existing business which is already term funded (and keep existing funding)

Substitute liabilities with short duration (<1y) by liabilities with longer duration (>1yr)

Substitute liabilities with low ASF (wholesale) by liabilities with higher ASF (retail)

Sell (non-level 1/2) assets

Substitute assets with longer duration (>1yr) by assets with shorter duration (<1y)

Substitute assets with high RSF (illiquid bonds, term loans, retail loans) by assets with lower RSF (0%-risk weight govies, short term loans to financial institutions)

New asset business does not improve the ratio

Available Stable Funding (ASF) NSFR = Required Stable Funding (RSF)

In principle, the bank has two levers to manage the ratio:

Increase ASF (-> higher costs)

Decrease RSF (-> lower returns)

Potential ways to manage NSFR:

Net Stable Funding Ratio

ASF

RSF

NSFR Isolines

1

2

To improve a given NSFR (indicated by in the chart above) an institution has two options:

1. The institution can increase the ASF by adjusting the liability side of its balance sheet (e.g. liabilities with higher roll-over factors or longer duration)

2. The institution can decrease the RSF by adjusting the asset side of ist balance sheet (e.g. assets with lower roll-over factors or shorter duration)

NSFR = ASF

RSF

Potential Adjustments on Business Model • compress net position of derivatives • cut credit lines • focus on advisory business • revival of ‚originate and distribute‘ model

Adjust Asset Side • reduce maturities • shift to assets with

lower RSF

Adjust Liability Side • increase maturities • shift to liabilities with

higher ASF

NSFR

impact on earnings

impact on costs

Liquidity Monitoring Standards

Modeling for Liquidity Risk

Liquidity Risk Management Components

Cash Flow Projection

Static Liquidity Measures

Typical Static Liquidity Gap Report

Dynamic Liquidity Measures

Balance Sheet Organization

Dynamics of Cash Flow Distribution

Dynamic analysis: Integrating business strategies • Future business assumptions will largely impact the cash flow distribution • Time dynamics (including external economic variables) will change the distribution

too

Stochastic distribution of cash flows without future business assumptions

“Shifted” stochastic distribution after inclusion of business strategy and future business assumptions

Reference: Algo – Liquidity Risk Management

Quantifying Behavioral Dynamics

Liquidity Risk Components

Modeling Cash Flows

Modeling Cash Flows (Cont’d)

Deposit Balance Modeling • First, we segregated deposit accounts into tiers

based on the amount held in each account

– We believed tiers were necessary due to dissimilar depositor behaviors between holders of larger accounts versus holders of smaller accounts

• We tiered accounts by end of opening month balances

Tiers used for deposit amounts 1. < $5,000 2. $5,000 - $10,000 3. $10,000 - $25,000 4. $25,000 - $50,000 5. $50,000 - $100,000 6. $100,000 - $250,000 7. > $250,000

Deposit Balance Forecast =

(existing accounts)

2

1 Aging Term

Build Incentive Term

Seasonal Term

Rate Seeking Term

Burnout Term

External Market Term

3

4

5

Deposit Model Equation: One month change in log of balance ∆lnB(t) = ln(B(t)/B(t-1)) = f(X) + ε

• From our analysis of historical deposit data, we determined deposit balances were driven by six primary factors or “terms”

6

Stress Test Stress Scenarios: • Stress scenarios are essential for evaluating the durability and dependability of the liquidity

management processes. • Stress scenarios are generated according to the three risk factors: structural, contingent, and

market risk.

Stress Test (Cont’d) The stress scenario incorporates many of the shocks experienced during the crisis: (a) the run-off of a proportion of retail deposits; (b) a partial loss of unsecured wholesale funding capacity; (c) a partial loss of secured, short-term financing with certain collateral and counterparties; (d) additional contractual outflows that would arise from a downgrade in the bank’s public credit rating by up to and including three notches, including collateral posting requirements; (e) increases in market volatilities that impact the quality of collateral or potential future exposure of derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs; (f) unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to its clients; and (g) the potential need for the bank to buy back debt or honour non-contractual obligations in the interest of mitigating reputational risk.

Reference: Basel 2010 - ‘International framework for liquidity risk measurement, standards and monitoring’

Parameters for Scenario Analysis

E*Trade Liquidity Risk Management

E*Trade 2011 10K Balance Sheet December 31, 2011 2010

ASSETS

Cash and equivalents $ 2,099,839 $ 2,374,346 Cash and investments required to be segregated under federal or other regulations 1,275,587 609,510 Trading securities 54,372 62,173 Available-for-sale securities (includes securities pledged to creditors with the right to sell or

repledge of $3,916,927 and $5,621,156 at December 31, 2011 and 2010, respectively) 15,651,493 14,805,677

Held-to-maturity securities (fair value of $6,282,989 and $2,422,335 at December 31, 2011 and 2010, respectively; includes securities pledged to creditors with the right to sell or repledge of $2,092,570 and $884,214 at December 31, 2011 and 2010, respectively) 6,079,512 2,462,710

Margin receivables 4,826,256 5,120,575 Loans receivable, net (net of allowance for loan losses of $822,816 and $1,031,169 at

December 31, 2011 and 2010, respectively) 12,332,807 15,121,919 Investment in FHLB stock 140,183 164,381 Property and equipment, net 299,693 302,658 Goodwill 1,934,232 1,939,976 Other intangibles, net 285,805 325,403 Other assets 2,960,673 3,083,673

Total assets $ 47,940,452 $ 46,373,001

LIABILITIES AND SHAREHOLDERS’ EQUITY

Liabilities: Deposits $ 26,459,985 $ 25,240,297 Securities sold under agreements to repurchase 5,015,499 5,888,249 Customer payables 5,590,858 5,020,086 FHLB advances and other borrowings 2,736,935 2,731,714 Corporate debt 1,493,552 2,145,881 Other liabilities 1,715,673 1,294,329

Total liabilities 43,012,502 42,320,556

E*Trade Liquidity Risk Management

Potential Liquidity Challenges: (a) Mismatch of long-term assets and short-term liabilities (b) Funding diversity (c) Unexpected liquidity events (d) Lack of capacity to precisely predict future net cash flow

Solutions: (a) Closely monitor the contractual maturity mismatch, and propose the

optimized way to manage the mismatch (b) Diversify the asset and liability (c) Stress test – integrate stress scenarios into business decision (d) Introduce advance modeling techniques to model cash flow and liquidity

Hedging Interest Rate Risk and Impact on Liquidity

Purpose Action How It Works Impact on Balance Sheet Impact on Liquidity

Duration risk

Issue bullet (non-callable) debt

Short duration to offset long duration of asset portfolio

Add cash on assets side, add debt on liability side

Gain high quality liquidity asset (e.g. Cash) Issue callable debt

Swaps: pay fixed rate and receive floating (3m Libor)

Offset the duration change by floating rate

Net value recorded on either asset or liability side

Swap is highly liquid on exchange and liquid on OTC

Convexity Risk

Issue callable debt Call the bond and re-issue at lower rate when rates fall

Add cash on assets side, add debt on liability side

Gain high quality liquidity asset (e.g. Cash)

Options: swaptions, call or put option on treasury futures

Positive convexity to offset the negative convexity of prepayment

Net value recorded on either asset or liability side

Swaptions / options is highly liquid on exchange and liquid on OTC

Integrate Liquidity into Business Strategy

Integrate planned transactions into the liquidity picture • Large liquidity gaps are highly likely to disappear • Mismatches will be reduced • The probability distribution of mismatches will reflect a more realistic view of

future exposures • Integrate stress scenario into the decision Fully incorporate Dynamics into liquidity risk analysis and business decisions • Stress simulations can produce a comprehensive view of a firm’s current exposure

to liquidity risk, as well as the potential evolution of liquidity risk within the business planning horizon

• Firms should have the ability to integrate business development strategies as well as inherent business constraints into their liquidity planning activities

• Incorporate time dynamics to modeling for cash flow and liquidity forecasting

Reference

Basel Committee • 2008 ‘Principles for sound liquidity risk management and supervision’ • 2009 ‘Strengthening the resilience of the banking sector’ • 2009 ’Principles for sound stress testing practices and supervision’ • 2010 ‘International framework for liquidity risk measurement, standards

and monitoring’ • 2011 ’Basel III: A global regulatory framework for more resilient banks and

banking systems’ OCC • 2012 ‘Liquidity: Comptroller’s handbook’ • 1998 ‘Interest rate risk: Comptroller’s handbook’ FDIC • 2008 ‘Liquidity risk management’

Appendix

E*Trade Q3 2012 Balance Sheet

E*Trade Deposit

• Deposit accounts for 64% of the liability • Need to build deposit balance model to predict balance change

– Main portion of the liability

Amount

Weighted-Average Rate

September 30, 2012

December 31, 2011

September 30, 2012

December 31, 2011

Sweep deposits (1) $ 21,874,534

$ 18,618,954

0.05 %

0.08 %

Complete savings deposits

5,184,141

5,720,758

0.05 %

0.15 % Other money market and savings deposits

1,003,200

1,033,254

0.05 %

0.15 %

Checking deposits

950,840

863,310

0.10 %

0.10 % Time deposits (2)

115,111

223,709

1.86 %

2.96 %

Total deposits (3) $ 29,127,826

$ 26,459,985

0.06 %

0.12 %

(1) A sweep product transfers brokerage customer balances to banking subsidiaries, which hold these funds as customer deposits in FDIC insured demand deposit and money market deposit accounts.

(2) Time deposits represent certificates of deposit and brokered certificates of deposit. (3) As of September 30, 2012 and December 31, 2011, the Company had $101.3 million and $89.2 million in non-interest bearing deposits, respectively.

Capital One’s Q3 2012 Balance Sheet

Contingency Funding Plan (CFP)

Basel (2008) • A bank should have a formal contingency funding plan (CFP) that clearly sets out

the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.

FDIC (2008) • Contingency funding plans should incorporate events that could rapidly affect an

institution’s 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.

OCC (2012) • A contingency funding plan (CFP) includes policies, procedures, projection reports,

and action plans designed to ensure a bank’s sources of liquidity are sufficient to fund normal operating requirements under contingent liquidity events.

Note: Stress tests must be the basis for elaborating contingency plans

Balance Sheet Management Functions

Liquidity Risk Management vs. FTP

Basel III will influence internal processes, but is neither a blue-print for an internal steering system nor for an internal (liquidity) funds transfer price system

Fund Transfer Pricing

• The FTP reflects the fair economic value (or spread) of a contract

• Equivalently, it is the (fictitious) price of hedging all financial risks in the market

Best Practices FTP Principles

1. Reflect marginal wholesale funding costs to ensure arms-length product pricing

2. Insulate LOBs from interest rate risk, while managing rate risk within Treasury

– Mirror the duration and cash flow characteristics of the underlying product – Incorporate costs and credits for prepayments and pricing caps/floors – Capture any mismatch between FTPs and actual interest expense in the Treasury P&L

3. Use a consistent methodology across the enterprise that enables fair performance measurement across LOBs and sound risk management

4. Treat deposits as a line of business by transfer pricing balances using the same FTP principles as we do for loans