Liquidity Risk Standards and Measurement (& Liquidity Measures taken during & after the crisis)

1. Liquidity Risk Standards and Measurement (& Liquidity Measures taken during & after the crisis) 23rd BSCEE Conference Ohrid, 16 June2010 Jean-Philippe Svoronos Senior Financial Sector Specialist Financial Stability Institute

2. Outline • Financial crisis and emergency measures • Lessons learned • International framework for liquidity risk measurement, standards and monitoring (Dec 2009 consultative paper) 2

3. FX and maturity mismatches: Optimistic assumptions “Mitigating” factors: Access to short-term FX funding through subsidiaries of foreign banking groups (E and C Europe), branches in the US (W Europe) Use of FX market rather than US funding markets “Diversification”: access funding markets in Asia for USD funding Liquidity/credit risk assumptions: Structured bonds (securitization assumed to be liquid because highly rated Some private label MBSs (in USD) considered fully liquid and made part of banks’ liquidity/treasury reserves Underestimation/”hidden” liquidity risks Increasing complexity of products & lack of transparency “Shadow” banking system and use of OBS vehicles (SIVs) Secured funding always available provided you have good quality collateral. 3

4. Triggers and transmission: the US subprime crisis Strains in funding markets started in mid-2007: growing unease about the exposure of US FIs to US subprime mortgages and related securitizations Contagion spreads to European banks (large buyers of structured products and large borrowers of USD) Factors increasing uncertainty and contagion: complexity of products and off-balance sheet leverage (SIVs) “deleveraging” and fire sales increasing reliance on short-term funding and secured funding Consequences: Liquidity dries up Shortening of interbank lending tenors Closures of markets for lengthy periods (e.g. “private label” MBSs, CP, etc…) Several episodes destroy market confidence over time: Sept-Dec 2007, March 2008 and Sept 2008 to March 2009. 4

5. Private sector responses to liquidity pressures Uncertainty led to: Tightening of counterparty limits: less lending, shorter lending & more expensive Hoarding and flight to quality (growth of bank deposits with the ECB, fall in yields on US notes and Treasuries) “Fire sales” of seized collateral (SIVs) increase falls in asset prices Illiquid, fall in asset prices and one-sided markets meant: Hard and sometimes impossible to price in a reliable way Lack of visibility: unknown losses, size of hit to P&L unknown US dollar shortages increased in Europe after failure of Lehman and MMMF “breaking the buck”. 5

6. Central Banks’ emergency measures “Pre-Lehman” measures: Extraordinary market operations (outside of regular schedule, longer terms and/or larger than usual amounts. Some 17 ECB operations between 9 August & 20 December 2007) 12 Dec. 2007 (FED): Introduction of a Term Auction Facility (TAF): gives depository institutions (including foreign bank branches & subsidiaries) access to term funds via auctions against a wider range of collateral Complementary USD term auctions by ECB and SNB funded by USD swap lines with Federal Reserve (put in place the same day) Other measures (extending range of eligible collateral): FED for primary dealers: Term Securities Lending Facilities (TSLF) lending UST for 28 days against high quality MBSs Primary Dealer Credit Facility (PDCF) overnight loans against investment grade debt securities Bank of England (April 2008): Special Liquidity Scheme: asset swaps (high quality illiquid assets versus UK Treasury bills) 6

7. Governments and Central Banks’ emergency measures “Post-Lehman” measures to address acute USD global shortage, impact on local currency liquidity and seizing up of unsecured funding markets Unprecedented range of measures to support financial institutions: Increase in deposit insurance to prevent bank runs Government guarantees on banks’ liabilities (prevent run on wholesale funding) Asset purchase or guarantee schemes to protect financial institutions from extreme losses Recapitalizations with public funds Measures to address FX currency shortages In some countries (Brazil, Korea, Mexico), wider use of FX reserves to help banks and corporates Expansion of USD swap lines in number (2 to 14), size (unlimited for 4 central banks) and reach (1 to 5 continents) Policy responses within euro and Swiss franc markets Swap lines between SNB, ECB, National Bank of Poland and Magyar Nemzeti Bank Swap line between ECB and Nat. Bank of Denmark Repos between ECB and Hungarian and Polish central banks. 7

8. Lessons learned Markets: Even interbank markets and secured funding can freeze up Some key assumptions were misguided Interaction of market liquidity, credit risk, and funding liquidity under stress misunderstood, under-appreciated Current shifts in banks’ liquidity risk management Improved monitoring, analysis, stress testing of tenor and FX mismatches Centralization of collateral management, contingent liabilities and access to central bank facilities More stringent counterparty limits Efforts to develop retail deposit bases and/or longer-term (more stable) funding Supervision Banks’ liquidity risk management needs improving Regulation & supervision of liquidity is just as crucial as capital adequacy Cross-border supervisory cooperation is essential for supervising liquidity at large international banks. 8

9. Objectives and components of liquidity supervision • Ensure the bank maintains sufficient liquidity • cushion of unencumbered, high quality liquid assets • withstand loss of both secured and unsecured funding sources • Key components of framework • Standards • Liquidity Coverage Ratio (LCR) – 30 days horizon • Net Stable Funding Ratio (NSFR) – 1 year horizon • Monitoring tools • Contractual maturity mismatch • Concentration of funding • Available unencumbered assets • Market-related monitoring tools. 9

10. LCR – definition Stock of high quality liquid assets ≥ 100% Net cash outflows over a 30-day time period • Supervisory scenario (idiosyncratic and market-wide) • 3-notch downgrade (triggers) • partial loss of retail deposits • loss of unsecured wholesale and secured, short-term funding (except for ‘liquid’ assets per this standard) • increased collateral calls and/or haircuts • draws on committed lines, non-contractual obligations 10

11. LCR – liquid assets (narrow & wider definitions) Narrow definition Cash and central bank reserves that can be drawn in time of stress Marketable securities issued / guaranteed by sovereigns, central banks, other PSEs, IMF, MDBs if: 0% risk weight under Basel II SA deep repo markets, and not issued by banks, other financial institutions Government or central bank debt issued in domestic currency where the risk is taken, or by home country Wider definition Level 1: assets eligible for narrow definition (at least 50% of the stock) Level 2: haircut of 20% (AA- corporate & covered bonds) Level 3: haircut of 40% (A- corporate or covered bonds) BCBS decision to use broader definition pending on QIS results. 11

12. LCR – net cash outflows (denominator) Net cash outflows = cumulative expected cash outflows minus cumulative expected cash inflows in a given time bucket under specified stress scenario Most ‘factors’ harmonized but some subject to national discretion No double-counting with assets included in numerator All cash outflows and inflows based on assumptions Example for retail demand funding Stable … ≥ 7.5% runoff covered by deposit insurance denominated in local currency transactional account (e.g. salary deposited) or other established relationship Less stable … ≥ 15% runoff - all other 12

13. NSFR – definition Available amount of stable funding (i.e. sources) > 100% Required amount of stable funding (i.e. uses) • Uses with maturity > 1 year should be funded by sources that are expected to be available for a period > 1 year • Supervisory scenario = mild idiosyncratic (longer-term focus) • decline in profitability and/or solvency • downgrade in credit rating • reputational event 13

14. NSFR – available stable funding (sources) 1. As defined for the LCR 14

15. NSFR – required stable funding (uses) 15

16. NSFR – required stable funding (uses) – cont’d 16

17. Monitoring tools – firm-based Contractual maturity mismatch Provides insight into the extent to which the bank relies on ‘maturity transformation’ contractually Standardization enables comparison, identification of outliers Contractual cash and security inflows and outflows in specified time buckets: overnight; 7- and 14-day; 1-, 2-, 3- and 6-month; 1-, 3- and 5-year; beyond 5 years Asset flows per latest / liability flows per earliest possible date Concentration of funding: identify wholesale funding sources whose significance could result in liquidity problems if funding is withdrawn Unencumbered assets: collateral for funding in secondary markets and for central bank facilities monitor amount, type and location also consider haircut and currency 17

18. Monitoring tools – market-related Market-wide information absolute level of, and trend in, major markets (e.g. equity indices, debt markets, FX markets) Financial sector market information equity/debt markets for financial sector broadly Bank-specific information equity prices, CDS spreads, price/yield of debentures in the secondary market – for individual banks 18

19. Application issues Scope of application at least on a consolidated basis potentially also on sub-consolidated (legal entity) basis (ring-fencing?) Currencies at least aggregated across transferable and convertible currencies potentially also by ‘significant’ currency Frequency of calculation and reporting at least monthly, as often as daily in stressed conditions maximum two-week lag standards to be met ‘continuously’ Public disclosure value and level of the metrics, drivers behind the metrics size and composition of the components frequency? not specified in consultative document … 19