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The Liquidity Crunch Causes and Consequences 10 June 2008

The Liquidity Crunch Causes and Consequences 10 June 2008 . Martyn Hoccom Lloyds TSB. How did we get here?.

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The Liquidity Crunch Causes and Consequences 10 June 2008

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  1. The Liquidity Crunch Causes and Consequences10 June 2008 Martyn Hoccom Lloyds TSB

  2. How did we get here? “They were impelled to it by the seminal lunacy which has always seized people with the notion they can become very rich. There were many Wall Street insiders who fostered this insanity…” The Great Crash 1929 – JK Galbraith

  3. The Liquidity storm of 2007 “When the music stops in terms of liquidity things will be complicated. But as long as the music is playing , you’ve got to get up and dance. We’re still dancing” Chuck Prince Citigroup, July 9th 2007 “This was obviously a very disappointing quarter for us” Chuck Prince Citigroup, October 1st 2007 4 November 2007 - Chuck Prince resigns

  4. Size of the global securities marketSource :Bank of England Stability review

  5. Markit iTraxx Index Markit iTraxx Europe Crossover Index (series 8) Source : Bloomberg

  6. Credit Pricing 1 Year Bond Spread over UK Gilts by Rating: 2003 to 2008

  7. UK Macro – Market Background UK – Sterling Liquid Assets relative to total asset holdings of UK banking sector Source : Bank of England

  8. UK Macro – Market Background UK-resident banks' and building societies' net sterling lending to UK households and non-financial companies Source : Bank of England Notes: It is the difference between household's and PNFCs' M4 lending and M4 M4 Lending is the lending made by banks and building societies to the personal sector

  9. Days of August 2007 • Sub prime mortgages were the trigger – amongst the underlying causes were: • Take away the modern terminology and you have something very old fashioned - Banks lost money on fuelling a speculative asset boom - • In a period of remarkable stability and low credit spreads a “search for yield” – this is why mortgages originated in Paris Texas ended up on the balance sheet of banks in Paris France • Weakened Credit Standards as a result of dislocation between originators and investors • Increasing Sophistication of products whose “ model to market” became very misaligned from “mark to market” under stress • The herd mentality and extreme difficulty to stand against the crowd

  10. The Market Story

  11. ABCP Market DROUGHT US asset-backed commercial paper outstanding - $ Trillions

  12. ABCP Market Asset Backed commercial paper spreads One-month top-tier ABCP versus one-month Libor (basis points)

  13. CDS Spreads

  14. What has the Liquidity Crisis Changed ? • Short answer – Everything !! • Originate and Distribute Model • Conduit Vehicles • Liquid asset definition • Cost of funding • Basel 2 and ratings • Transfer pricing • Balance sheet structure • Value of Retail Deposits • SIVS • CP Markets……etc etc

  15. Risk Appetite Design • Clear Articulation and measurement system so Board can know under stress how institution is performing • Governance linkage from Board approved limits to operational activities • Resolution of potential conflicts of interest over treating liquidity management as a cost resource versus a profit centre • Measurement and allocation mechanism of costs of liquidity • Operational risk tolerance – problems very visible in “ real time” world of settlements • Consistency across measures and clear definition

  16. What is Liquidity Management ? • A profit centre ? • Fully costed and allocated operation with cost recognised and allocated across business lines ? • Something treasury and the money markets desk do ? • Integrated part of financial plan ? • Driving strategy

  17. What is a Liquid asset ? • Not an issue greatly discussed prior to August 2007 !! • AAA securities ?? • Secured Repo- Issuer / Collateral / Haircuts/Relationship • Eligible at central Bank in normal operations-back to the 1980’s ? • New arrangements with Bank , Fed , ECB – how enduring-how act in a future market dislocation

  18. Stress Testing “ Liquidity Stresses are low-frequency , but extreme severity , events that are not well understood” FSA Section 3.5 DP07 “ Stress tests and contingency funding plans funding plans have not generally assessed impact of simultaneous disruption to securitisation and interbank markets “ Bank of England - April 2008

  19. Stress Testing • Well defined and granular stress testing against a range of events • A continual process not a one off piece of analysis as markets and business profile changes • Flexible and interactive so scenarios can be rapidly changed and updated • Comprehensive across the institutions on and off balance sheet exposures • Judgement ; business sense-not spitting out dozens of unchecked data sheets

  20. Stress Testing Data • Retail • Off Balance Sheet • Liquidity Commitments • Conduits • Money Markets • Medium Term Market Assumptions • Time & Speed • Rollover Vector • Nature of Stress • Central bank actions • Market Capacity • Behavioural Assumptions Stress Model

  21. Secured Funding under Stress Assesses the amount of secured funding that could be lost in a crisis Source : Lehman Brothers

  22. Contingency Planning • Asset Inventory • Use/Availability of Central Bank Facilities • Depth of Repo/Funding Market • Assessment of Collateral • Reputational / Market signalling Impact • Backup Liquidity Lines • Funding Relationships

  23. Pricing for Liquidity • “ Off balance sheet contingent liquidity exposures appear not to have been priced adequately into internal models at firms ” Bank of England April 2008 • Pricing of on balance sheet lending need to address impact on bank costs of the credit crunch • Credit Crunch has put more focus on ability to fund growth • Value of long term deposits • Market characterised by increased focus on aligning internal funds transfer pricing for Liquidity premia with external market conditions

  24. Pricing for liquidity • The “nice decade “ is over • Asset led income targeted planning assuming an limitless supply of close to Libor wholesale funding is over • Not aligning the true market costs of funding to assets may lead to excessive non value generating activity • Words are easy-establishing the Governance, MI and culture to live the story of economic value is a challenge

  25. Commitments/ Liquidity facilities • Effectively liquidity options written to clients • Charging often “bundled” into overall product offering • Credit crunch, Mono line rating issues etc have highlighted risks • Pricing needs to reflect risks of draw - a function of market spread movements ; drawn margins , collateralisation etc …

  26. Valuation of Deposits • Deposit gathering the non-glamorous / non sexy • The value of strong deposits are now much more widely appreciated • More focus going forward on the value of the “Funding Franchise” too often neglected in the recent asset boom.

  27. Closing thought “ The squall became a hurricane…plain folk will ask. Why should we trust anyone?” Philip Stephens FT - 21 September 2007

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