Matz - Liquidity risk measurement and management: Basel III and beyond

Liquidity Risk Measurement and Management

Basel III and Beyond

Leonard Matz

Copyright 2011 by Leonard Matz.

Library of Congress Control Number: 2011912791

ISBN: Hardcover 978-1-4628-9243-3

ISBN: Softcover 978-1-4628-9244-0

ISBN: Ebook 978-1-4628-9245-7

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Contents

What Went Wrong? An Organized Review of Follies and Failures

Managed Buffers for Yield Assuming Markets Would Always Be Liquid

Overconfident that Wholesale Funds Providers Will Always Be Willing to Lend

Tolerated Excessive Liquidity Mismatches

Ignored Worst-Case Stress Tests and the Cassandra Effect

Moved Risks Off-Balance Sheet and Out of Sight

Risk Taking Not Matched by Risk Management

Misallocation of Risk Resources

Misaligned Incentives

Organizational and Execution Weaknesses

Overreliance on Ratings

Failure of Some Institutions to Embrace Forward-Looking Measures

Failed to Perform Worst-Case Stress Tests

Misunderstanding and Misapplying VaR

Insufficient DataEspecially for New Products

Confusion between Risk and Uncertainty

Preparing to Fight the Last War

Severely Underestimated Potential Funding Requirements

Failed to Recognize Risk Linkages and Macro Factors

Capital Is Not a Solution for Liquidity Risk.

Basel II Arbitrage Increased Liquidity Risk on Balance Sheet.

Basel II Arbitrage Contributed to Increases in Off-Balance Sheet Risks

Permitted a Large Increase in Systemic Risk from Banks Reliance on Short-Term Capital Markets Funding.

Almost No Change in Regulation despite Obvious Risks in Mortgage Lending and Securitized Assets

Lack of Cooperation among Regulators

Mark-to-Market Accounting

Impact of the Financial Crisis on Liquidity Risk Management

Measuring Liquidity Risk

Measuring Funding Risk

Organization

Funding Mix

Liquidity Reserve

Funds Transfer Pricing (FTP)

Limit Setting

Contingency Plan

Misallocation of Liquidity

Liquidity Risk and Credit Risk

Conceptual Underpinnings

Why Bother with Old Theories and Basic Facts We All Know Already?

Idiosyncratic Crises

The Commercial or Real Bills Theory of Liquidity

The Shiftability Theory of Liquidity

The Anticipated Income Doctrine of Liquidity

The Liability Management View of Liquidity (or Illiquidity)

The Balance Sheet Management View of Liquidity

Liquidity Risk Rules

Rule 1: Liquidity risk is unavoidable.

Rule 2: Liquidity risk is heterogeneous.

Rule 3: You always have more than you need until you dont.

Rule 4: Scenarios are the language of liquidity risk.

Rule 5: Too little liquidity can kill a bank suddenly, but too much liquidity will kill a bank slowly.

Rule 6: Cash sources and uses are fungible.

Rule 7: Rewards from good liquidity risk management are not directly observable.

Rule 1: Liquidity risk management nets to zero for the system as a whole.

Rule 2: Regulation is necessary but insufficient.

Rule 3: The primary goal must be preservation of confidence in financial institutions. Over time, confidence can only be maintained by preserving the soundness of financial institutions. Soundness, in turn, cannot be maintained without minimizing incentives for management failures.

Scenario Analysis

Liquidity Events Are Often Global and Have Interrelated Elements

Capital Markets Crisis1998

Capital Markets Crisis2007-2008

All for One and One for All

GeneralizingA Classic Bank-Specific Scenario

What Are Silent Runs, Really?

Critical Structural Changes

Agency Risk

Information Asymmetry

Wachovia Reveals an Important Silent Run Perspective

Rush to ExistsA Capital Market Disruption Scenario

Implications for Liquidity Scenario Analysis

Implications for Liquidity Scenario Analysis

Interaction between Funding Liquidity and Market Liquidity

Unfolding of a Systemic Event: The Great Meltdown of 2007-2008

Lessons to be Learned from Scenario Evolution

Cash Flow Forecasts

First DigressionLiquidity Ratios

Advantages of Cash Flow Forecasts

Seven Important Cash Flow Forecast Topics

Scope

Combining Stock Measures and Flow Perspectives

Second DigressionInterest Rate Risk Gaps and Liquidity Gaps Are Similar But Not Identical

Time Buckets and Granularity

Combining Contractual and Behavioral Cash Flows

Contractual Cash Flows and Maturity Transformation

Once Again, This Time with Behavioral Assumptions

Format Is Surprisingly Important

Additional ClarityFCE and CBC

Data

Practical Stress Testing

Historical VaR and Extreme Value Analysis

VaR Is NOT Appropriate for Liquidity Risk

Key Point: Stress Testing Is NOT a Predictive Exercise

If Stress Tests Arent Predictive, Why Stress Test?

Deterministic Scenario Modeling at Multiple Stress Levels

Requirements for Best Practice Stress Tests

Steps for Stress Testing

Stress Testing in Multiple Currencies

Stress Testing for Banks in Groups

Jurisdictional Ring Fencing

Reverse Stress Tests

Backtesting Stress Tests

Quantifying Stress Tests Variables

Normal versus Stress Assumptions

Is a Conservative Bias Necessary?

Is Accuracy a Requirement?

Intrinsic Subjectivity

General Guidelines for Sound Assumptions

Rate Changes and FCEImpact Is Often Overestimated

Loan PrepaymentsA Resource Soak

Rate SwapsA Contra-Example

Rate Changes and CBCImpact Is Often Underestimated

Wrong Method

Wrong Target

First Required Step: Define Stickiness Attributes

Second Required Step: Calculate a Stickiness Score

Third Required Step: Calculate a Stickiness Hierarchy

Fourth Required Step: Generate Estimates for Each Source Type

Quicker and Easier Assumption Sources

Insufficient Distinction of Liquidity and Repricing Lives

The Constraints Are Market Access and Collateral

The Impact of Credit Risk on Market Access

Cash Generated and Consumed by Funded Loans

Cash from Loans Sales and Securitizations

Funding Requirements for Uncommitted Loans

Funding Requirements for Loans Originated for Sale

The Impact of Other Contracts on Funding

Cash, Deposits at Correspondent Banks, and Deposits at the Central Bank

Liquidity and Marketability Are Relative

Understanding Marketability in the Context of Scenarios and Stress Levels

Assets That Can Be Included in the Buffer

Size and Market Price of Buffer Assets

Discounts and Haircuts for Buffer Assets

Managing FCE and Buffers

The Buffer Fallacy and the Management Equivalency

Practical Application

Diversification Does Not Always Reduce Risk

Diversification of Wholesale Funding Sources Does Not Always Reduce Liquidity Risk

Using Diversification Effectively

Two Risk Characteristics

Tactics for Managing Capital Markets Access

Optimize the Overall Size of the Buffer

Optimize the Composition of the Buffer

Control Activities that Consume Buffer Assets

Minimize the Risk of Trapped Collateral

Currency Warning

Even Strong Banks Can Be Impacted

Mange so the Markets and the Public See Your Strength