Liquidity Risk & Gap Analysis Lecture – Session 6

The Contractual Cashflow Report of any banks will inevitably show

that liabilities have shorter maturities than assets.
 Historically, the underlying assumption for this fact has been
the belief that short term borrowings can be rolled over
(renewed, extended) without difficulty.
 This assumption proved to be the undoing of the financial
sector during the subprime crisis of 2007/8 and the liquidity
that was taken for granted all but dried up.

Stress testing, that we have discussed in the previous lecture, isn’t

simple and cannot predict the future, but it can give you a good
estimate of what magnitude of liquidity buffer is required.

Why do banks borrow short and lend long?

Because it makes money!!!

How does it make money?

 Yield curves are generally upward sloping partly due to the

built-in liquidity premium – Investors demand higher returns
for investing their money for longer periods. There is no
conflict with either the Market Segmentation Theory or the
Expectations Hypothesis.
o Market Segmentation
 states that demand and supply for securities at
various sections of the yield curve determine their
yields. Agreed!
 The group of investors who invest in the long end
demand higher yields for the longer term of their
investments than do the segment of investors who
prefer the shorter end.
 o Expectations Hypothesis
 states that longer term bond yields are nothing but
a reflection of investors expectation for future rates
 OR a forward rate is an unbiased predictor of the
future spot rate

 Upward sloping yield curves also imply that the short end of
the curve is at lower yields

 To borrow at lower yields for the short term and invest the
proceeds in higher yielding longer term maturities has been the
traditional ALM bread and butter

 However, liquidity risk is not always priced in correctly since

yields also reflect supply and demand for longer term financial
instruments

 Especially in low yield environments, it is tempting to borrow

short and lend/invest long for the yield pick-up

 In addition, if yields can be further enhanced by taking greater

credit risk – and that is what happened in the 2007 crisis.

 But to summarize, the shape of the yield curve is determined

by several factors:

o Investors demand higher returns for longer maturities as

payment for other lucrative opportunities that they may
not be able to avail

o Inflation is usually positive. Compounded inflation

expectations will produce a positive yield curve – which
investors demand to protect the value of their money
 o There are segments of investors that prefer the short end
of the yield curve and other segments that prefer longer
maturities – supply/demand differentials cause
differences in yields along the maturity ladder

KIBOR vs Government Yield Curves - Oct 3rd

PKRV KIBOR
12

11.5
11.52
11
11.11

10.5

9.95 10.37
10 10.28
%

9.69 10.1210.18
10.03
9.93
9.39
9.5 9.27 9.76
9.56
8.93 8.88 9
9 8.82 9.31
8.67
8.91
8.5 8.79 8.83
8.66
8.34 8.29 8.4
8
1w 2w 1m 3m 6m 9m 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y 30y

Historically, it has made sense for banks to borrow short and lend
long for the yield pick-up. This implies a maturity mismatch between
liabilities and assets and creates a Gap.

This Gap, also called the Gapping Position leaves the bank exposed
to interest rate risk.
Measuring Liquidity Risk

Liquidity risk can only be considered as fully hedged if asset and

liability maturities are completely matched. This never happens!

 Refinancing of the shorter maturity liability is an option that

you have sold to the depositor.
 However, standard option models cannot explain this risk as
depositor behavior does not fit any standard statistical
distributions.
 Hence a different approach needs to be adopted that makes
assumptions about behavior.

Illustrations

Let us start with an example of a balance sheet where a one-year

asset is funded with a rolling 3-month borrowing creating the classic
short funding position.

Classic Short Funding Position  1-Year asset is funded with a 3-

Month Asset Liability Cumulative month rolling borrowing
 In other words, there is a 3
month ‘grace period’ before the
0 0
need to rollover the borrowing
 Liquidity risk will crystallize if
3 -100 -100 the funding cannot be renewed
 Therefore, the earlier you run
6 -100 into a “cumulative net
outflow”, the earlier your
9 -100 potential funding risk arises
 How can this problem be
12 100 0 avoided?

One solution to avoid liquidity risk altogether is “match funding” as

illustrated below
Matched Funding
Month Asset Liability Cumulative  This is a simple
solution BUT a costly
one!
0 0  Term money (longer
term borrowing) is a
3 0 lot more expensive
than short term
6 0 money
 This would erode most
9 0 of the expected
margin on the asset
 Is there a better way?
12 100 -100 0

Yes! The both the asset and liability mix can be changed. Instead of
just a one year asset, a shorter dated asset could also be held. And
funding can be spread out over several time periods, preferably from
different sources. The balance sheet might then look something like
this:

Gapping Position
Month Asset Liability Cumulative  Liquidity risk has been
pushed out in time
0 25 25  The short-term asset
can also be used to
3 -25 0 repay the 3-month
liability should it need to
be repaid without
6 -25 -25
rollover
 The refinancing risk is
9 -25 -50 now in month six and it
is for 25 not 100
12 75 -25 0

In this contractual-payments model, it seems that as long as short

term positive cash balances are held (short term assets), there is not
over-extension of refinancing risk. BUT THIS IS HALF THE PICTURE!
It fails to consider the behavior of the parties that provide funding.
Where Liquidity Risk Can Bite!

This time the bank makes a 75 one year loan and places 25 in short
term assets. But this time it is financed with a mixture of sources:
Retail Funding is 20 with immediate access to the depositors and 80
in wholesale funds spread out over the remaining period.

Mixed Funding  This situation seems to be better

Month Asset Liability Cumulative managed
 But the bank is 80% reliant on short
0 25 -20 5 term wholesale funding
 Can the short-term asset be used
for repayment? Is it liquid?
3 -20 -15
 How mobile are the retail
depositors?
6 -20 -35  How dependable is the short-term
wholesale funding?
9 -20 -55  Can these short-term maturities be
rolled to ensure the cumulative
12 75 -20 0 short position is comfortably
covered?