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Copyright 2003 The Kamakura Corporation – Confidential Information

Managing Liquidity Risk: Preparing for

Extreme Events

Leonard Matz

2Copyright 2003 The Kamakura Corporation – Confidential Information

Why Stress Test?

“The liquidity strategy should set out the general approach the bank will have to liquidity, including various quantitative and qualitative targets. This strategy should address the bank's goal of protecting financial strength and the ability to withstand stressful events in the marketplace.”

Source: paragraph 7, Sound Practices for Managing Liquidity in Banking OrganizationsBasel Committee on Banking Supervision, Basel February 2000

BIS Guidelines Require Stress Testing


What’s Normal / Extreme ?

Market Risk ‘normally’ is about ‘Normal Scenarios’

What is normal?–Quantitative tools are applicable.

Liquidity Risk is concentrated in “Extreme Scenarios’

What is extreme? …–There is no Canonical Answer

–Distinctions are derived from everyday life; however as no consensus can be reached:

–They are meaningless in a quantitative context

Adapted from material developed by Dr. Robert E Fiedler.


Volatility of Savings Deposits

The good news: The bank has not experienced a severe loss of deposits.

The bad news: The historical observations tell us NOTHING about a future stress environment.

-10,000

-8,000

-6,000

-4,000

-2,000

0

2,000

4,000

6,000

8,000

10,000

Red lines indicate 2 SD


Measurement and Quantification ProcessesPr

obab

ility

Severity of loss

Stress testing typically appliesstatistical tools to provide moreinformation about the tail.

VaRExtreme Value TheoryOther tools

14


Measurement and Quantification Processes

Prob

abilit

y

Severity of loss

We can’t apply the usual statistical tools to liquidity risk stress testing!

Very few banks have had the unfortunate experience of a “near death” experience. Those that have don’t have any recent experience. The tail in any one bank’s data simply doesn’t include the sorts of stress experiences that keep liquidity risk managers awake.

KEY ISSUE

15


Measurement and Quantification Conclusions

• Historical observation does not necessarily reflect what might happen (future events)

• Modelling a (fat tail) distribution does not solve the problem either:

–Outlying point or fat tail?

–Risk is not linear in extreme events

• The Question is not: ‘What Risk will we get if we push out the quantiles?’ – The answer to that question is only a matter of scaling and is therefore meaningless!

• Instead, the question is: ‘Is there a structural change that the bank should model?’

Adapted from material developed by Dr. Robert E Fiedler


Stress Testing Should Reflect Both Internal and External Scenarios

• Capital markets disruptions• Systemic shocks• Payment system disruptions• Prolonged global recession

External

•Credit losses•Operational losses•Problem merger or acquisition

Internal


Stress Environments Affect Both Cash Availability And Needs

Cash availability: asset liquidity unused funding capacity cost of borrowing

Needs: deposit withdrawal undrawn credit facility drawdown collateral pledging


Systemic Crises – A Wide Variety

1987199019911992199419951997199819992000

20012002

U.S. stock market crashcollapse of U.S. high yield (junk) bond marketoil price surgeERM (European Exchange Rate Mechanism) crisisU.S. bond market crashMexican CrisisAsian crisisRussian default, Ruble collapse. LTCMgold pricesTMT (telecommunications, media & technology ) sector collapseSeptember 11 payments system disruptionArgentine crisis


1. Normal course of business, including any seasonal fluctuations: VaR Works here, but who cares?

This is not a stress scenario.

2. Bank specific funding crisis

3. Systemic liquidity crisis

Use At Least Three Scenarios


It is imperative to use multiple degrees of severity (stress levels) for each need scenario!


Key Facts:

The amount of contingent liquidity risk varies depending on the severity of crisis.

Crises rarely occur instantaneously. They usually develop in stages.

The duration of liquidity crises has ranged from days to over a year.


Stages of a Funding Crisis


From Funding Liquidity Cash Flows to Contingent Liquidity Stress Tests

Source: Dr. Michael Reuther


Stress Test Process



Forecasting Cash Out-Flows More than Just Contractual Claims

• Perception risk

• Surviving a liquidity crisis is not the same as successful liquidation.


Stress Test Process



Liquidity From Assets



Stress Test Process



Stress Tests Detail

Stress Level 1 1 2 1 1Cash AvailabilityLiquid Assets Bills 92% 95% 99% 99% 99% Bonds 95% 90% 95% 98% 98% CP 96% 90% 97% 99% 99%Unused funding capacity Wholesale 90% 70% 90% 0% 50% Commercial 96% 80% 95% 25% 75% Retail 97% 90% 100% 50% 100%

Scenario

Economic Political Market PaymentsBank Specific


Stress Tests Detail

Stress Level 1 1 2 1 1Cash NeedCredit Drawdown Risk Wholesale 10% 15% 20% 5% 0% Commercial 5% 10% 15% 5% 0% Retail 5% 5% 5% 0% 0%Deposit Risk Wholesale 10% 20% 10% 50% 0% Commercial 5% 10% 10% 30% 0% Retail 0% 5% 0% 5% 0%Collateral Risk Payments 5% 5% 5% 5% 50% Derivatives 5% 10% 5% 10% 0%

Source: Tom Bermingham

Bank Specific

Scenario

Economic Political Market Payments


Should You Forecast Cash In-flows?

If you are covering today’s risk with tomorrow’s promises, you are masking risk.

But if you fail to include future cash in flows, your projection is incomplete and your forecasted quantity of liquidity need is unrealistically large.


Assumption Relevanancy

Is the scenario relevant to your bank? (e.g. foreign exposure, equity exposure, etc.)

Is the scenario relevant to your balance sheet? (e.g. core funding versus wholesale funding)

Is the scenario relevant to your competitive environment? (e.g. ability to generate new deposits)

Does the scenario capture relationships between changes in credit risk, interest rate risk and liquidity risk


Measurement is Not Management

Evaluate stress tests to identify major contributors to risk exposures. Requires the ability to “drill down” into detail.

Reduce risk exposures if possible. (Topic for another day.)

Combine stress testing and limits.

Combine stress testing and liquidity contingency planning.


Liquidity Warehousing – the Easy Stuff

NOT cash or interbank deposits

net funds sales, repos and borrowings – BY TIME PERIOD & SCENARIO

unpledged, AFS investment securities

loans or portions of loans that can sold quickly (government guaranteed, loan sale channels, securitizations in process)


Adding Liquid Assets – What Do We Accomplish?

Core Assets

Liquid Assets

Volatile Liabilities

Core Funding

+ Equity

Structural Liquidity

DeficitCore

Assets

Liquid Assets

Volatile Liabilities

Core Funding

+ Equity

Structural Liquidity

Deficit


No Bank Can Afford To Hold Enough Liquid Assets to Cover All

Contingent Needs in The Worst Scenario at The Highest Stress Level

Liquid Assets Are Ideal, But …


Too little liquidity may kill the bank suddenly but too much can

kill it slowly.

KEY ISSUE


Beyond Liquid Assets

• Loans can also provide liquidity value – Mortgages as collateral for FHLB borrowings– Salable and securitizable assets where bonds have not

yet been issued

• A $1 reduction in liquidity risk is just as good as a $1 increase in liquid assets holdings.– Do not have to hold liquid assets, therefore saves the

cost

In practice, it depends on the scenario and stress level. When is an asset liquid? When is a liability volatile?


Planned Responses to A Crisis:Asset Management

Rank all assets by how quickly and easily they can be sold

Start preparations for loan sales or securitizations

Maintain primary and secondary liquidity from assets warehouses

Manage pledging to free up excess collateral Manage pledging to use the least readily

salable assets


Most Common Contingency Plan

OKAY, BUT … “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.” Walter Bagehot

THE WELL PREPARED NEED BETTER PLANS

“Our Plan is Draw Down Our Committed Lines”


Wholesale Funds Providers Are Brutal Arbiters of Creditworthiness

• Quickly recognize potential problems

• Respond rapidly


Segmenting the Propensity to Withdraw Deposits

Insured or Secured

Depositors' Reliance On Information

Depositors' Relationship

With the Bank

Overall Assessment of Stability

consumers yes low high high

small business in part low high medium

large commercial no medium medium low

banks no high medium medium

municipalities yes high medium high

capital markets funds

providersno high low low


Very Sensitive to Perceived

Deterioration in Credit Quality or

Safety

money market mutual fundsrating sensitive providerspension fundsinsurance companiesother funds providers with fiduciary responsibilitybroker/dealersregional and money center banks in your countryforeign bankslarge corporationscommunity banks in your market area

Only sensitive to credit quality and

liquidity when problems are very

bad and highly publicized.

local, uninsured, unsecured depositorscustomers who are net borrowers (their loan balances exceed their deposit balances)local, secured funds providers insured depositors

Sensitivity of Funds Providers By Type


Diversification of Funding Sources

16%

4%9%15%

2%

20%

6%

28%

Retail Deposits Fiduciary

Deposits

Capital Markets Small/Mid Cap CP-CD Bank Deposits Central Bank

Deposits

Other Non-Bank

Deposits

Should this bank reduce retail deposits and increase fiduciary deposits to improve diversification?


Applying Five Diversification Tools For Wholesale Funding Sources

Product type Counterpart Maturity Currency Region Deposit CD CP

Commercial bank

Central bank

Insurance Investment

company Corporates

ON 1 month 3 months 6 months 12 months

EUR USD JPY GBP

Continental Europe

Americas London Asia Pacific

Source: Michael Reuther, Deutsche Bank


Managing Funding Sources

Rank, measure, manage for both current needs and for contingent needs.

Encourage funding from more sticky sources.

Monitor borrowing spreads – not unused borrowing commitments.

Take advantage of market conditions to lengthen maturities when possible.

Maintain an appropriate amount of time deposits and borrowing with remaining lives greater than 90 days, 180 days and one year.


Wrapping Up


Applying Stress Testing

Stress testing is not an end unto itself. Results have to be used in the risk management process.

Results should be carefully considered when setting risk limits.

Contingency plans for actions such as asset liquidations should be based on stress test results.


Four Essential Liquidity Management Tools

1. Always keep some asset liquidity reserves. This is the insurance cost of liquidity management. But recognize that you cannot and do not want to hold enough for a catastrophe.

2. Extend liability terms to reduce liquidity risk.

3. Be prepared to enhance liquidity quickly at the first signs of increased potential need.

4. Manage cash flow profiles.


For More Information

LIQUIDITY RISK LIQUIDITY RISK MANAGEMENTMANAGEMENT

and

SELF PACED A/L SELF PACED A/L MANAGEMENTMANAGEMENT

published by: Sheshunoff Information Services, Inc.

1-800-456-2340www.sheshunoff.com

written by: Leonard Matz, [email protected]

http://www.sheshunoff.com/

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