Liquidity Management Lecture – Session 5

What is Liquidity?

In financial markets, liquidity can mean two things:

1- How easy is it to sell an asset and convert it into cash?

2- How much of such assets and/or case do you have available to
make contractual payments and/or maintain regulatory
required ratios?

For banks this is an existential issue since they can experience

sudden “maturity transformation” – at any one time all their
depositors seek to be repaid all their money. This can happen but
only if some event gives rise to loss of confidence in a bank.

Managing liquidity is about understand how and why money is

withdrawn. During the years preceding the Sub-Prime Crisis of 2008,
banks were permitted to invest in risky assets to increase their
profits – and that was in part what exacerbated the crisis.

Since then, regulators have tried to balance greater regulation for

strengthening banks’ liquidity and not over doing it so that they are
able to lend enough to support the needs of the real economy.

Managing Liquidity

All regulators share a common concern – that banks need to be self-

sufficient in terms of liquidity and should not need to rely on the
central bank.

In Europe, banks are required to regularly assess their liquidity risk –

the risk of not having sufficient funds to meet sudden and large
withdrawals of deposits.
Ten key “drivers” of liquidity risk have been identified:

1- Wholesale secured and unsecured funding risk

2- Retail funding risk
3- Intra-day liquidity risk
4- Intra-group liquidity risk
5- Cross-currency liquidity risk
6- Off-balance sheet risk
7- Franchise viability risk
8- Marketable asset risk
9- Non-marketable asset risk
10-Funding concentration risk

Stress Testing & Survival

These risks are assessed under various stress conditions relating
to both the firm and the market – business-specific as well as
systemic – stress testing. Banks are expected to survive for 30
days and three months for the firm stress and market stress
respectively.

The analysis done is both quantitative as well as qualitative.

Past data are helpful in forming an opinion on how things could

turn out with adjustments for the changed circumstances of the
stress test.

“Days of survival” is undertaken regularly. This is not a theoretical

exercise. In order to determine whether there is a shortfall in
liquid resources a firm must compare its actual liquid resources to
those that would be required under stressed conditions.

Regulators have made it clear that Liquidity Risk is a Board of

Directors (BOD) responsibility. Hence, the Board of every bank
needs to establish its liquidity risk appetite and articulate it to the
business.
Buffers
In times of stress, cash outflows increase which is why banks must
hold ready pools of liquidity to meet this sudden and sharp
increase.

Only higher quality assets – which are easily convertible into cash
through outright sale or repo – no count towards these liquidity
buffers.

High quality assets are generally considered to be government

bills and bonds and also reserves at the central bank. Over time,
this requirement has been relaxed somewhat.

Basel III Committee of Banking Supervision

In 2013, this committee provided specific guidance to banks on
liquidity management – The Liquidity Coverage Ratio & Risk
Monitoring Tools. This approach has been largely adopted by
regulators to ensure banks hold sufficient liquidity to meet short
term liquidity stresses.

Liquidity Coverage Ratio (LCR)

Under Basel III guidelines, LCR is the key metric that measures
whether a bank holds sufficient liquidity.

To meet regulatory requirements:

 banks are required to hold High Quality Liquid Assets
(HQLA) to meet 100% of their potential cash outflows over a
30-day stressed period.
 The recommended 30-day period can be extended by bank
boards or regulators should they so choose.

Banks calculate the net cash outflow they would face under
stressed conditions and compare it with the HQLA they hold.
For example, if the net outflow was estimated at Rs 100 Bn and
HQLA are calculated at Rs 130 Bn, the LCR would be 130/100 =
1.3 or 130%. This would imply that the bank can comfortably
meet its liquidity requirements under stressed conditions.

The LCR is being phased in by regulators across the world. In

most countries, banks will be required to have and LCR in
excess of 100% by January 2019.

High Quality Liquid Assets (HQLA)

HQLA are defined as being:

 “easily and immediately” available to be converted into
cash at no material loss in value during times of stress.
Ideally, HQLA are central bank eligible meaning that
central banks will accept them as collateral for lending.
 HQLA should be unencumbered (not assigned or pledged
as collateral).
 In some cases, securities that have been reversed in
(through a reverse-repo) can be included provided they
cannot be withdrawn during the 30-day period.

HQLA need to exhibit certain characteristics including:

 Low risk: high credit standing, low duration
 Ease of valuation: transparent and widely agreed
valuation process
 Low correlation: Not subject to “wrong-way risk” –
securities that the bank may have issued whose value
declines under stressed conditions
 Listing: ideally on a major recognized exchange
 Sizable Market: the security is a part of an active sizable
market with:
o Narrow bid-offer spreads
o High traded volumes
o Multiple market participants
 o Robust market structures
 Low price volatility: evidenced by price data
 Flight to quality: typically, these assets are bought by
investors in times of stress

Some flexibility is provided in the composition of HQLA to give banks

additional scope to use further assets, albeit with appropriate
haircuts. These haircuts impose a downward adjustment to the asset
market value depending on quality, liquidity and other prescribed
criteria. This compositional flexibility is provided by designation of
quality levels 1, 2a and 2b as follows:

 Level 1 Assets: these assets include:

o Coins & notes
o Reserves held at the central bank, BIS, ECB or the FED
o All these assets have a risk weighting or “0” under Basel II
o These assets trade in a liquid market
o No haircut is applicable

 Level 2a Assets: These are marketable securities:

o These securities are carry sovereign or central bank
backing
o These securities must be traded in a liquid market
o The issuer cannot be a financial institution
o A haircut of 15% applies to the market value

 Level 2b Assets: These are corporate debt securities:

o Including commercial paper (CP) and covered bonds not
issued by the bank itself
o Residential Mortgage Backed Securities can be included
which are:
 Not self-issued and
 With a minimum AA credit rating
o Corporate debt can be included but:
 Must be investment grade (BBB- or higher)
  With an active traded market
 Should not historically exhibit a price decline of
more than 20% over any 30-day period
 A 50% haircut applies to these securities for
inclusion in HQLA
o Equities can be included:
 Provided they are not financial institutions (systemic
risk)
 Are included in the calculation of a major index –
large cap and liquid
 Should not historically exhibit a price decline of
more than 40% over any 30-day period
 A 50% haircut applies to the qualifying equities

Other conditions to meet the HQLA requirements:

 Level 1 Assets can be held without any limits
 Level 2a Assets can be held up to 40% of the requirement
 Level 2b Assets cannot make up more than 15% of the 40% in
2a
 It is recommended that banks periodically test the liquidity of
their designated HQLA through sales and repos.

The cost of Liquidity Management: Maintaining such a high-

quality asset buffer has a cost to the bank. Since these securities
are high in quality they are relatively low in return. This does
impact profitability of the banking sector but that is the cost or
reducing bank liquidity risk as well as the associated systemic risk.

Where are HQLA held?

These high-quality assets are held by responsible control function

which is the Treasury. Treasury must have continuous authority over
this asset stock and be charged with managing it, in consultation
with ALCO, in an efficient and most cost-effective manner.
How much of HQLA should be held?

Since this is clearly a costly process, each bank needs to assess as

precisely as possibly, the level of HQLA it needs to maintain. This is
done by stress testing the balance sheet to determine “net cash
outflows” during a 30-day period. The regulator is responsible to
ensure that each bank’s stress test is based on reasonable
assumptions given its size and market standing.

What are some of the major risk drivers to determine the net cash
outflow under stress testing?

1- The Classic – Retail Deposit Run-off:

a. This depends on depositor type – demand & time
deposits – “Stable” & “Less Stable” funding sources
i. Stable Deposits:
1. Long-standing client relationships
2. Cash deposits related to transactions
ii. Less Stable Deposits:
1. Run-off rate of 3 – 5% for fully insured deposits
(this % depends on public awareness of the
insurance scheme and if the scheme is robustly
maintained)
2. Run-off rate of 10% or higher for:
a. Uninsured deposits
b. Deposits from sophisticated investors
c. Internet accounts
d. Foreign currency deposits
3. Deposits that are longer than 30 days are
generally excluded if it can be demonstrated
that the depositor
a. has no legal right of early redemption OR
b. the penalty for early redemption is too
onerous (loss of interest)
 Regulators do assign a run-off rate to such
deposits if they think that the bank would
allow early redemption to maintain its
reputation.

2- Unsecured Wholesale Funding Run-off:

a. SME deposits that can mature or be withdrawn within the
30-day period - run-off of 5 – 10%
b. Operational deposits generated by clearing and cash
management activities – run-off 25%
c. Financial institutions’ deposits – run-off 25 – 100%
d. Unsecured wholesale deposits: - run-off 20 – 40%
i. Non-financial corporates
ii. Sovereigns
iii. Central Banks
iv. Multilateral Development Banks
v. Public Sector Entities
e. Unsecured wholesale deposits of other legal entities –
run-off rate 100%

3- Secured Funding Run-off: This refers to repo borrowings:

a. Secured borrowing from the Central Bank using Level 1
assets – run-off 0%
b. Secured borrowing using Level 2 assets provide a 15%
run-off rate
c. Lower quality collateral may be deemed to have 100%
run-off rates

4- Derivative Cash Outflows: This refers to margin calls relating to

changes in market value of derivatives and need to be included
in cash outflows.

5- Downgrade Triggers: A bank that suffers a downgrade in credit

rating may be contractually required to post additional
collateral on transactions. To estimate this requirement, banks
 are required to calculate the additional liquidity required for a
3-notch rating downgrade in a 30-day period.

6- Valuation Changes of Posted Collateral: Posted collateral may

itself suffer a decline in value. While Level 1 collateral is
exempt, any Level 2 or lower collateral is deemed impaired up
to 20% for the sake of inclusion in the net cash outflow
calculations.

7- Loss of Funding from Secured Funding Programs: This includes

Asset Backed Securities and Covered Bonds as 100% of the
maturing amount over 30-days should be included in the HQLA.

8- Liquidity Guarantees: Whereby a bank has a legal obligation to

provide funding to conduits, special purpose vehicles or offers
similar facilities should be included in the calculations.

9- Drawdowns on committed credit: Undrawn portions of

committed facilities should also be included – there is guidance
in Basel III on this depending on type of facility and the
counterparty involved.

10-Other Contingent Obligations: This can include associations or

linkages to products or services that may require liquidity
support in times of stress which the bank may feel obliged to
deliver.
Cash Inflows

These are contractual inflows that are:

 Fully performing
 Where there is no expectation of counterparty default
 BIS caps the use of cash inflows to 75% of HQLA
requirement
 Hence, banks have to hold 25% of the required HQLA in
exactly that – High Quality Liquid Assets
 Various hair-cuts are also applicable to cash inflows which
differ by country and regulatory jurisdiction

Monitoring Tools

 Banks report liquidity date to regulators

 This reporting is important since it is used by regulators to
monitor the bank and the wider financial system
 The qualitative assessment of a bank’s ability to manage
liquidity depends on
o The resources dedicated to monitoring
o Its accuracy and timeliness
o Integration into risk reporting AND
o The overall understanding by of this critical risk by
management of the bank (Treasury &ALCO)

The Monitoring Tools include:

 Contractual Maturity Mismatch Report:

o This time-banded report refers to contractual cash inflows
and outflows from all on-balance sheet and off-balance
sheet instruments
o Time bands may be daily, monthly or annually depending
on level of granularity required
 o In its basic format, this report excludes behavior,
forecasts and changes in strategy
o However, behavioral assumptions, stresses and strategic
plans can be overlaid to provide a useful discussion tool
regarding the nature of liquidity

 Funding Concentration: This report helps determine how

diversified the funding sources are, breaking out by:
o Significant counterparties
o Wholesale/Retail mix
o Secured/unsecured mix
o Maturity profile
o Currency amounts
o Instrument types

 Unencumbered Assets: This report shows the bank’s capacity

for further secured borrowing and also to replenish shortfalls in
funding by listing:
o The percentage of assets that are already encumbered or
pledged
o Amount of assets eligible for Central Bank standing
facilities
o Assets that can be used to raise funding from secondary
market transactions like repos – taking haircuts into
account

 LCR by Significant Currency:

o This report measures the stock of HQLA by significant
currency against stressed net outflows for that currency
over a 30-day period
o Significant currencies are those which constitute more
than 5% or total liabilities
o This measure indicates whether a bank holds sufficient
currency resources without the need to undertake FX
transactions
 Market-wide Monitoring Tools: This report includes
information on (ALCO Pack):
o Financial markets and financial sector
o Information about the bank itself
o Equity prices
o Money market rates
o Central Bank’s policy and repo rates
o CDS spreads
o FX rates
o Funding rollover conditions
o Changes in funding maturities and sources of funds