Liquidity Risk Assessment

1. Liquidity Risk Assessment By A V Vedpuriswar October 4, 2009

2. Introduction • Banks must have sufficient liquidity to meet commitments as they fall due. • Liquidity risk is the risk that a bank will not have sufficient liquid resources available to meet commitments. • Maturing assets might turn out to be non-performing. • This may prompt the bank to liquidate other investments. • The volume of these other investments liquidated could significantly move the market price of the assets. • In extreme cases there might not even be a viable market in which to trade.

3. Understanding liquidity risk • By creating a diversified mix of assets and liabilities, the bank can access markets on an orderly basis, at the best rates. • If it only went to the market in an emergency, • Or if it continually sought short term funds, • It might have to pay higher rates or even go bankrupt in extreme situations. • The simplest method of identifying liquidity risk is to list all liabilities and assets in maturity date order. • The difference between amounts payable and receivable in each time band are referred to as maturity mismatches.

4. Anticipating daily liquidity needs • Throughout the day a bank can only make an intelligent guess as to what the position will be at the end of the day. • With experience, banks can make a reasonable allowance for the volume of unanticipated movements. • Based upon the best information available a bank will borrow or invest funds, often on an overnight basis. • This helps to keep its working balances as low as possible, since they earn little or no interest.

5. Liquidity ladder The usual way to measure liquidity requirements is by means of a liquidity ladder. Currency by currency, all liabilities and assets are placed by reference to their ultimate maturity date. When calculating liquidity ladders, there are a number of issues that the bank must consider: What proportion of current and savings accounts are likely to be withdrawn on demand or at short notice? What percentage of overdrafts will never be repaid or will have to be transformed into long-term loans? Undrawn lending commitments: how much of these are likely to be drawn down at short notice? How many loans are non-performing?

6. Liquidity characteristics of assets • Cash is the most liquid type of asset and yields no return. • Negotiable certificates of deposit, are more liquid, they generally yield less than a fixed deposit for the same term. • Trade paper attracts a liquidity premium by means of a relatively low yield. • Longer term personal and corporate lending is relatively illiquid. • Some high quality assets which are not naturally liquid can be liquefied by the process of securitization.

7. Sources of liquidity risk • Liquidity risk arises from numerous sources, including: • strategic decisions to provide liquidity to the markets • reputational problems or other negative news (for example, credit rating downgrades) • macroeconomic changes (for example, interest rate volatility and inflation) • changing market trends (for example, changes in funding sources) • specific products and activities (for example, OTC derivatives)

8. Types of liquidity risk • Conventional analysis of liquidity risk distinguishes between two different dimensions of liquidity risk. • Asset liquidity • Funding

9. Asset liquidity risk • The liquidation value of the assets may differ significantly from the current mark-to-market values. • When unwinding a large position or when the market conditions are adverse, the liquidation value may be depressed.

10. Funding liquidity risk • Thisrefers to the inability to meet payment obligations to creditors or investors when they do not want to roll over their positions. • This can force unwanted liquidation of the portfolio. • What happened during the sub prime crisis? .

11. Collateral Issues • Most financial institutions are leveraged. • They post collateral in exchange for cash from a broker. • Usually the collateral is slightly more than the cash loaned by an amount called haircut. • This provides a buffer against decreases in collateral value.

12. The value of the collateral is, however, constantly marked to market. • If this value falls, the broker will have to post some additional payment called the variation margin. • Brokers can also reserve the right to changes in collateral requirements. • Liquidity risk may also arise because of mis-matches in the timing of payments.

13. Liquidity Black Holes • The most severe liquidity crises occur when we have liquidity black holes. • They develop when the entire market moves to one side. • During a price decline, when everyone wants to sell, liquidity will dry up and distress sales will happen. • Liquidity holes may develop when banks with similar positions, do same trades to achieve a delta neutral position. • Liquidity can become a serious problem due to herd behavior.

14. Understanding herd behaviour • In a normal market, when prices fall, some people will want to buy. • A liquidity black hole results when virtually everyone wants to sell in a falling market. • Different traders use similar computer models. • Banks regulated in the same way, respond to changes in volatilities and correlations in the same way. • People start imitating other traders thinking there “must be something in it.”

15. The Crash of 1987 • The crash of October 1987, on the New York Stock Exchange is a good example. • Many traders followed a portfolio insurance strategy. • They sold immediately after a price decline and buying back immediately after a price increase. • As a result of these trades, the market plunged sharply. • The market declined rapidly. • The stock exchange systems were overloaded. • So many portfolio insurers were unable to execute the trades generated by their models.

16. Regulatory issues • A uniform regulatory environment may accentuate a liquidity crisis. • When volatility increases, value-at-risk (VaR) will increase. • Consequently, all banks will be forced to increase capital. • Alternatively, they will have to reduce their exposure in which case many banks will try to do similar trades. • Similarly during a downturn, banks will be less willing to make loans. • In all these situations, a liquidity black hole may result.

17. Need for diversity • For black holes not to happen, at least some of the market participants should pursue contrarian strategies. • Investors can often do well by selling when most people are buying and by buying when most people are selling. • Volatilities and correlations may increase but over time, they get pulled back to the long term average. • As such, long term investors need not adjust their positions based on short term market fluctuations. • One way forward is for regulators to apply different rules to asset managers and hedge funds. • Then there will be diversity in the thinking and strategies of different market participants.

18. Quantifying liquidity risk • How do we quantify liquidity risk? • The markets, especially, the bid-ask spreads tell use a lot about the state of the liquidity.  • Bid – ask spreads are driven by: • Order processing costs, which tend to decrease with volumes • Asymmetric information costs • Inventory carrying costs. •  One way of dealing with liquidity is to adjust the VAR rather than come up with a new risk measure. • Liquidity adjusted VAR can be calculated by adding s/2 for each position in the book, where  is the dollar value of the position and s is defined as (offer price – bid price) / mid-price. 17

19. Multiple positions If there are multiple positions, Liquidity adjusted VAR = VAR + Sum[(1/2)(Spread) (Size of position)] 18

20. Time horizon • Liquidity risk can be loosely factored into VAR measures by ensuring that the horizon is at least greater than an orderly liquidation period. • Sometimes, longer liquidation periods for some assets are taken into account by artificially increasing the volatility. • Alternatively, by increasing the time horizon, the capital requirement can be enhanced. • Thanks to more capital, a financial institution will be better placed to deal with a severe liquidity crisis.

21. Lines of defence • The first line of defense against funding liquidity risk is cash. • Another may be a line of credit. • New debt/new equity are also options but become difficult to tap during unfavorable times. • Avoiding debt covenants or options that force early redemption of the borrowed funds may also help.

22. Liquidity, model and market risks Liquidity, market and model risks are interrelated. Breakdown of markets leads to liquidity problems. When markets are not in place, models become necessary. Models pose various risks.

23. Standby facilities • Is it possible to draw down on standby (emergency) facilities with other banks? • These are formal agreements but it may prove very difficult to actually use them, especially if there is a general shortage of liquidity so that the providing bank is equally short of funds. • Even if funds are available from a standby facility, the supplying bank may simply withdraw other deposits or not renew deposits at maturity so the receiving bank is in no better position than before. • Utilization of standby facilities is a signal to the market that the bank is in difficulty and so other banks may aggravate the problem by refusing to deal.