Framework for Liquidity Risk and Cost

Management: steering clear of the liquidity gap and

navigating through the competitive environment

PRMIA Munich

April 15th 2010

PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Global stress scenario: liquidity shortage

Liquidity in British Banks Balance sheets of central

banks in percent
(Jan 2007 = 100%)

 Idiosyncratic risk can lead

to systemic risk
 Economic damage
 Bail out
 Transmission failure
 Economic downturn

© 2010 d-fine All rights reserved.

2
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Other global
FSF - Addressing Procyclicality
Recent regulation IOSCO - Disclosure Principles
in the Financial System

for Public Offerings and Listings IOSCO - Principles for Periodic

of ABSs Disclosure by Listed Entities

BCBS - Principles for

Sound Liquidity Risk BCBS -Principles for Sound BCBS - International
Management and Stress Testing Practice and Framework for Liquidity Risk
Supervision Supervision – final paper Measurement, Standards and
Monitoring – consultative

BASEL
BCBS - Liquidity Risk: BCBS - Strengthening the document
Management and Resilience of the Banking
Supervisory Challenges Sector

BCBS - Due Intelligence and BCBS - Stock Taking on the

BCBS - Guidelines for
Transparency Regarding Cover Use of Credit Ratings
Computing Capital for
Payment Messages Related to
Incremental Risk in the BCBS - Revision to Basel II
Crossborder Wire Transfers
Trading Book Market Risk Framework

CEBS - Technical CEBS - Technical CEBS CP36 - Draft

CEBS CP28 – Liquidity Buffers

EU
Advice on Liquidity Advice on Liquidity Risk CEBS - Guidelines on Liquidity Guidlines on Liquidity
Risk Management Management (second and Survival Periods Buffers Cost Benefit
(first part) part) Allocation

FSA DP07/7 - Review FSA CP09/13 - Strengthening FSA CP09/14 - Strengthening

of the Liquidity Liquidity Standards 2: Liquidity Liquidity Standards 3: Liquidity
FSA CP08/22 -
Reporting Transitional Measures

UK
Requirements for Strengthening Liquidity
Banks and Building Standards FSA PS09/16 - Strengthening
Societies Liquidity Standards

2007 2008 2009 2010

…and further relevant documents…

© 2010 d-fine All rights reserved.
3
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Regulation perspectives
 Common goal: to make the economy more efficient
 Regulation as a corrective tool (for risk pricing)
 Reduce the systemic risk in the financial sector
– Identification and assessment of risks to financial stability
– Surveillance of key risk indicators from banks and the economy
– Issuance of risk warnings and recommendations

 How may liquidity risk guidance be applied in practice?

– Benchmarking: setting limits on the tracking error of a „market
funding portfolio“ to reduce the systematic risk
– Individual guidance taking into account the specific business model
– Legislative actions
– Regulators themselves are in the learning process

© 2010 d-fine All rights reserved.

4
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

FSA proposal: pro-active, continuous regulation

Screen shot of FSA regulator BI tool (prototype), PS09/16 (2009)

© 2010 d-fine All rights reserved.
5
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Liquidity – a complex network of dependencies

Expenses Profitability
P&L
Earnings
Growth
Off-balance
Cash flow Capital
positions Rating /
Balance sheet Solvency
positions Balance sheet
Downside
Derivative
Risk
Optionalities Hedge Investor
opinion

Risk Cash flow External funding

Liquidity
levels
Investment
Liquidity risk opportunities

From: Managing Liquidity in

Banks, R. Duttweiler, 2009

© 2010 d-fine All rights reserved.

6
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Cycles of growth and sustainability

Business Cash flows Cash flow P&L Profitability

Liquidity

Growth Risk Liquidity risk Solvency Capital

Rating

External funding Investor opinion

Market Liquidity Coverage Ratio

Net Stable Funding Ratio

© 2010 d-fine All rights reserved.

7
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Funds Transfer Pricing

Internal market for interest, funding (and liquidity)
Risk-free rate Cost of Carry based on
 Funding Cost anticipated holding periods
Liquidity spread

 Prepayment penalties (Internal) Only for customer credits

 Opportunity costs for liquidity options Mostly based on expected
(credit commitments, call/put options) cash flow, often neglected
 Collateral Costs
Often treated as fixed cost,
 Liquidity Buffer Costs attribution to trade difficult

 Avoid double payments

Regulators opt for consistent internal prices of liquidity

© 2010 d-fine All rights reserved.
8
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Pricing of Liquidity: Attribution of Opportunity Costs

→ Business decisions need to consider the Price of Liquidity
→ Attribute Cost of Liquidity (additional cost of carry, calculated on
net level) to the business units on trade level
→ Re-credit supplier of liquidity
→ Calculate:
• Level, composition and cost of group-wide Liquidity Buffer
• Attribution to assets and liabilities on trade level

FTP

Group-wide Liquidity Management Liquidity Cost of single trade

© 2010 d-fine All rights reserved.

9
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Funds Transfer Pricing for Liquidity

Risk-free Treasury Risk-free
interest for interest for
expected expected
cash flow Interest Rate Desk cash flow

Liquidity Liquidity
spread for spread for

Liabilities
Assets

expected expected
cash flow Funding Desk cash flow

Liquidity Liquidity
premium for premium for
unexpected Liquidity Desk unexpected
cash flow cash flow

Extending the Marktzinsmethode – Internal market for liquidity

© 2010 d-fine All rights reserved.
10
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Appropriate Level of the Liquidity Buffer

Cover unexpected cash flow (Counterbalancing Capacity)
 BCBS – cover possible outflow under defined stress scenarios
liquidity risk coverage ratio (LRCR) = Stock of high quality liquid
assets / Net cash outflows over a 30-day time period ≥ 1
 LaR – cover high quantile of cash account movements,
extreme values stochastics of cash account fluctuation
 Historical (or MC) simulation – cover high quantile of simulated portfolio
outflow in (historical) liquidity risk factor scenarios
Stress scenarios LaR Simulation model
- Regulatory approach - Easy access to cash - Advanced model similar to
- Simple assumptions on account data market risk models
scenario impact on business - Few model assumption - Estimations base on mrkt data
- Scenario selection difficult - Interpretation and attribution - Definition of risk factors,
of risk to trades difficult sensitivities and data complex

Pile cash and high quality assets to survive medium term crisis
© 2010 d-fine All rights reserved.
11
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Composition and Cost of the Liquidity Buffer (1/2)

 Characteristics for high quality liquid assets
 Low credit and market risk, low correlation with risky assets
 Reliable valuation, active and sizable market
 Central bank eligibility desirable Economic impact of
investment decisions?
 Assets meeting these criteria
1. Cash, central bank reserves, government bonds
2. High quality corporate and covered bonds ?
How to fund the
Liquidity Buffer?

 Cost of Liquidity Buffer = Return of Liquidity Buffer

- Funding Cost (…?)

© 2010 d-fine All rights reserved.

12
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Composition and Cost of the Liquidity Buffer (2/2)

Assets Liabilities

Money
Liquidity market
Buffer
funding
spread
Medium = cost
Customer
Term government
Deposits
Funding swap

Equity

Costs of Liquidity Buffer need to be calculated

© 2010 d-fine All rights reserved.
13
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Pricing of Liquidity: Attribution of Opportunity Costs (1/2)

 Charge for unexpected cash flow
Retail
Long Term
Credits
Commitments Funding
Corporate
Credit events Credits Short Term Market dry-up
Funding
Investments
Value leakage Deposits Withdrawals
Cash

Assets Liabilities
 Instrument classification necessary (FSA and QIS forms)
 Measures for uncertainty
1. Calculated volatility (with normal distribution assumption)
2. Extreme value statistics (with inappropriate data series)
3. Expert opinion depending on business model and/or defined stress
scenarios (as for the calculation of the level of the LRC buffer)

© 2010 d-fine All rights reserved.

14
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Pricing of Liquidity: Attribution of Opportunity Costs (2/2)

Example calculation (stress test value approach)
 Customer deposit: FTP rate = 1% + 0.8% - 0.27% = 1.53%
Interest Rate: Money market rate = 1%
+ Liquidity Spread: 60%*100bp(10Y) + 20%*60bp(5Y) +20%*40bp(3M) = 0.8%
- Liquidity Premium: Liquidity Weight * Liquidity Buffer Cost = 0.27%
Liquidity Weight = Individual cash outflows / Notional / All cash outflows (LRC)
≈ Class cash outflow / Class Notional / All cash outflow (LRC)
 Re-credit sources of liquidity → based on investment objective for Liquidity Buffer
 Should/can Liquidity Premium be fixed at origin?
 More open questions...

Practical model for Pricing of Liquidity needed

© 2010 d-fine All rights reserved.

15
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Outlook: Holistic Risk Management

Links to Credit Risk and Market Risk Models

Default Probabilities Haircuts and margin calculations

Recovery Definition of stress scenarios
Counterparty Risk Valuation of call and put options
... ...

→ Regulators will ask for a „consistent“ methodology

The future (Liquidity) Risk Manager must know it all

© 2010 d-fine All rights reserved.
16
PRMIA Munich 2010 - Framework for Liquidity Risk and Cost Management

Other global
FSF - Addressing Procyclicality
Recent regulation IOSCO - Disclosure Principles
in the Financial System

for Public Offerings and Listings IOSCO - Principles for Periodic

of ABSs Disclosure by Listed Entities

BCBS - Principles for

Sound Liquidity Risk BCBS -Principles for Sound BCBS - International
Management and Stress Testing Practice and Framework for Liquidity Risk
Optimal cost/
Supervision Supervision – final paper Measurement, Standards and
benefit ratio Monitoring – consultative

BASEL
BCBS - Liquidity Risk: BCBS - Strengthening the document
Management and Resilience of the Banking
Supervisory Challenges Sector Utility
Strategy Depth/
function
BCBS - Due Intelligence and BCBS - Stock Taking on the
BCBS - Guidelines for
Transparency Regarding Cover Complexity
Use of Credit Ratings
Computing Capital for
Payment Messages Related to
Incremental Risk in the BCBS - Revision to Basel II
Crossborder Wire Transfers
Trading Book Market Risk Framework

CEBS - Technical
Controllability
CEBS - Technical CEBS CP36 - Draft
CEBS CP28 – Liquidity Buffers

EU
Advice on Liquidity Advice on Liquidity Risk CEBS - Guidelines on Liquidity Guidlines on Liquidity
Risk Management Management (second and Survival Periods Buffers Cost Benefit
(first part) part) Allocation

FSA DP07/7 - Review FSA CP09/13 - Strengthening FSA CP09/14 - Strengthening

of the Liquidity Liquidity Standards 2: Liquidity Liquidity Standards 3: Liquidity
FSA CP08/22 -
Reporting Transitional Measures

UK
Requirements for Strengthening Liquidity
Banks and Building Standards FSA PS09/16 - Strengthening
Societies Liquidity Standards

2007 2008 2009 2010

…and further relevant documents…

© 2010 d-fine All rights reserved.
17
Liquidity risk management: regulatory landslide or rediscovered success factor?

Tasks of an „inverse portfolio manager“

Consider actively managing a funding portfolio for a given (static) asset
portfolio:

Central
bank
Return

Cost
Cost
Bonds

Stock Short-term
funding risk
Bonds
Deposits

Business
Risk Risk viability

Of course, this is a highly simplified representation; one would have to

consider the asset and liability side simlutaneously adding at least one
more dimension to the diagram
© 2010 d-fine All rights reserved.
18
Liquidity risk management: regulatory landslide or rediscovered success factor?

Assets Liabilities
Inverse „portfolio theory“ of funding Equity
Cost Loans Preferred
Stock

Central
Bonds
bank Securities

Deposits
Short-term Shares
funding risk Deposits
trust Cash
Bonds events
Long-Term

Cont. Outflows
Non-core
deposits
CP Short-Term
Funding

Total
Business
viability risk
spread
rating
7D 14D 1M 3M 6M 1Y 10Y
O/N

© 2010 d-fine All rights reserved.

19
Liquidity risk management: regulatory landslide or rediscovered success factor?

Regulatory influence
A regulatory framework based on guiding principles must somehow restrict the
refunding space
Cost

Risk

 Challenge to optimal manage refunding cost

 Increasing competition

© 2010 d-fine All rights reserved.

20
Thank you for your attention! d-fine GmbH
Opernplatz 2
60313 Frankfurt
Deutschland
Your contact at d-fine Tel +49 (0) 69 90737 0
www.d-fine.de

Dr Oliver Hein d-fine Ltd

28 King St
Head of ALM Solutions London, EC2V 8EH
Senior Manager, Frankfurt United Kingdom
+49 (0)69 90737 324 Tel +44 (0) 20 7776 1000
oliver.hein@d-fine.de www.d-fine.co.uk

d-fine Central Europe s.r.o.

Staromestská 6/D
801 03 Bratislava
Slovakia

d-fine Hong Kong Ltd.

© 2009
2010 d-fine All rights reserved.
No. 32 Hollywood Rd,
Central, Hong Kong Special
Administrative Region
People’s Republic of China21