Practical Liquidity Risk Stress Testing

Leonard Matz
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Agenda
Why Stress Test Liquidity General Considerations Four Methods Additional Considerations

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Why Stress Test?

Stress testing is an important element for sound risk management and contingency planning:
Stress scenarios highlight potential problems The untimely liquidation of assets can be costly Good advance planning can, at least potentially, prevent insolvency

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Why Stress Test?

BIS Guidelines Require Stress Testing
The liquidity strategy should set out the general approach the bank will have to liquidity, including various quantitative and qualitative targets. This strategy should address the bank's goal of protecting financial strength and the ability to withstand stressful events in the marketplace.

Source: paragraph 7, Sound Practices for Managing Liquidity in Banking Organizations Basel Committee on Banking Supervision, Basel February 2000

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Why Stress Test?

Holding Liquidity is Not Free
No bank can hold enough liquidity to survive anything close to a worst case liquidity crisis. The penalty for too little liquidity may be the failure of the bank but too much liquidity carries a penalty as well.

Optimal management of liquidity requires a delicate balance between liquidity risk and income.
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Agenda

Why Stress Test Liquidity General Considerations Four Methods Additional Considerations

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Definitions
Some risk professionals use the term scenario analysis to identify deterministic tests while stress testing refers to probabilistic tests. Some risk professionals define stress testing as uni-variant testing while scenario analysis is then defined as multi-variant testing. Sometimes, sensitivity analysis is used to refer to univariant testing while stress testing refers to multivariate testing. The BIS and defines scenarios to be the description of an integrated future view. Sensitivity tests are uni-variant tests used to establish the extent to which an outcome depends upon a single variable or single assumption. Stress tests are integrated, multivariant tests that show degrees of severity for scenarios. Integrated refers to the fact that assumptions for both independent and dependent variables reflect inter-relationships between variables.

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Definitions - Source
A Survey of Stress Tests and Current Practice at Major Financial Institutions, report by a working group established by the Committee on the Global Financial System, Bank for International Settlements, April 2001, page 7.

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What Liquidity Are We Stress Testing?

Market Liquidity Ability to sell a Financial Instrument in volume and time, without affecting the market price Funding Liquidity Capacity to raise sufficient cash when needed to meet its payment obligations Standby Liquidity Capacity, in non-normal conditions, to raise sufficient cash to meet its payment obligations Capacity to maintain perceptions of funds providers
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Sources of Contingent Risk

Unexpected loan demand Unforeseen increases in funding required. Unexpected credit draw downs and other commitment draws.

Requirements for increased collateral pledging.

Unexpected deposit withdrawals.

Unforeseen decreases in funding available.

Evaporation of unused funding capacity.

Erosion in the market value of unencumbered, marketable assets.

Source: Adapted from a slide created by Werner DHaese, Liquidity Contingency Plan: A Case Study at Fortis, Fortis Central Risk Management, ALM Europe, London, October 2005.

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The need for robust stress testing is driven by three underlying truths:
Financial institutions can never avoid liquidity risk. Serving as liquidity intermediaries is one of the main ways that banks add value to the economy. Financial institutions can do little to hedge liquidity risk. Some contingent lending arrangements exist. But only a few remain in place in the event that the borrowing banks risk increases. Most importantly, no financial institution can afford to hold enough liquidity to survive a severe or pro-longed funding crisis. Yet, since the least likely events can have devastating consequences, risk managers cant ignore them.

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What Do We Want To Learn?

What can go wrong, how, and how bad. What can the bank do in advance to minimize the potential damage from the worst case scenario? Opportunities for rapid and effective responses the ability to manage the transition from benign conditions to stress conditions. Does the bank have sufficient resources to last until remedial actions are implemented?
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What is An Extreme Event?

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Agenda
Why Stress Test Liquidity General Considerations Four Methods Additional Considerations

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Four Approaches for Stress Testing

Sensitivity testing VaR Deterministic Scenarios Probabilistic Scenarios

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(1) Sensitivity Analysis: Univariant Stress Tests

Moving key variables one at a time:
simple and intuitive method example:
the portfolio is ling the dollar vs. yen we suppose the dollar could fall by 15% in one week; this gives us a worst loss of $600 million

problem is with multiple sources of risk:

if the portfolio also contains positions in Japanese and US equities, we would have to predict movements in these markets as well we cannot assume the worst loss will occur at the same time in all markets
Source: Professor Philippe Jorion, U.C.

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(2) Historical VaR

Everyones favorite risk metric.

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Volatility of Savings Deposits

The good news: The bank has not experienced a severe loss of deposits. The bad news: The historical observations tell us NOTHING about a future stress environment.
10,000 8,000 6,000 4,000 2,000 0 -2,000 -4,000 -6,000 -8,000 -10,000

Red lines indicate 2 SD

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Loss Distribution
Selected c onfid ence le vel Mean F R E Q U E N C Y

U nex pected loss

T h e tail of the d istrib utio n represents the qu antity of ex tre m e loss.

S EV E RIT Y
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VaR Stress Tests

Stress testing typically applies statistical tools to provide more information about the tail.
VaR Extreme Value Theory Other tools

Probability

Severity of loss
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VaR Stress Tests and Liquidity Risk

We cant apply historical VaR to liquidity risk stress testing!

Probability

Very few banks have had the unfortunate experience of a near death experience. Those that have dont have any recent experience. The tail in any one banks data simply doesnt include the sorts of stress experiences that keep liquidity risk managers awake.

Severity of loss
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Whats Normal / Extreme ?

Market and Funding Liquidity Risk: concentrated in Normal Scenarios
What is normal?
Quantitative tools are applicable.

Liquidity Risk: is concentrated in Extreme Scenarios

What is extreme?
There is no Canonical Answer Distinctions are derived from everyday life; however as no consensus can be reached: They are meaningless in a quantitative context
Adapted from material developed by Dr. Robert E Fiedler.

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VaR Conclusions
Historical observation does not necessarily reflect what might happen (future events) Modelling a (fat tail) distribution does not solve the problem either:

Outlying point or fat tail? Risk is not linear in extreme events

The Question is not: What Risk will we get if we push out the quantiles? The answer to that question is only a matter of scaling and is therefore meaningless! Instead, the question is: Is there a structural change that the bank should model?
Adapted from material developed by Dr. Robert E Fiedler

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(3) Deterministic Stress Testing

BIS Recommends Scenario Analysis A bank should analyze liquidity utilizing a variety of what if scenarios.
BIS: Sound Practices For Managing Liquidity in Banking Organizations, February 2000.
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Basic Management Decisions for Deterministic Stress Tests

What risk scenarios are stressed? Market liquidity risk, systemic risk, bank specific risk? What risk exposures are stressed? Deposit losses, borrowings, off balance sheet in-flows, off balance sheet out-flows? How much stress? What time horizons? What are the impacts/results? What will the bank do about the indicated exposures? 25

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Step 1
Define the scenarios and stress levels you wish to test.
Important Point: It is not a good idea to use changes in the banks rating to define the stress levels. The ratings changes are lagging indicators of trouble and almost always follow the market. Identify and use precursors for ratings downgrades instead.

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Systemic Crises A Wide Variety

1987 1990 1991 1992 1994 1995 1997 1998 1999 2000 2001 2002 U.S. stock market crash collapse of U.S. high yield (junk) bond market oil price surge ERM (European Exchange Rate Mechanism) crisis U.S. bond market crash Mexican Crisis Asian crisis Russian default, Ruble collapse. LTCM gold prices TMT (telecommunications, media & technology ) sector collapse September 11 payments system disruption Argentine crisis 27

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Stages of a Funding Crisis

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Step 2
For each scenario, at each stress level, identify the contractual cash in-flows and outflows that can be expected to occur in each future time period for your forecast. The net contractual flows for each loan and deposit are clearly denoted in the line item descriptions.

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Step 3
For each scenario, at each stress level, estimate the cash in-flows and out-flows resulting from customer behaviour These may be from the exercise of contractual options such as loan prepayment options or options to withdraw funds from indeterminate maturity deposit accounts. Use the assumption estimation guidelines discussed in the prior section. Customer behavior changes also include noncontractual actions such as new loans. Make sure that each customer behavior driven change in your forecast is appropriate and consistent for the scenario and the stress level.

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Step 4
Add the non-discretionary treasury cash in-flows and out-flows. These include contractual maturities of investments and borrowings. Note that if you have callable securities, the call exercise needs to be forecast in a time bucket consistent with the interest rate assumption for that scenario at that stress level.

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Step 5
Sum the customer driven cash flows and the non-discretionary treasury flows. This total is the forecasted liquidity requirement for each time period in each scenario at each stress level.

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Format Suggestions
Important note: The contractual cash flows are shown separately from the assumption based cash flows. This permits you to easily identify net cash flows that are particularly assumption driven. Important note: None of the cash flows depicted reflects any discretionary asset sales or borrowings. The black line is showing the risk quantity before any management driven corrective actions are incorporated. Thus the forecasted risk quantity is in no way masked or hidden.
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Step 6
Calculate the net cash flow coverage ratio for each time bucket in each scenario at each stress level. This is the amount by which the forecasted cash in-flows exceed (or fall short of) the forecasted out-flows.

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Report and Analysis Suggestions

Important point: Forecasts for ordinary course of business scenarios and for scenarios at minimal stress levels should always show a cushion. A positive margin for error is required to offset potential model risk. Important point: The forecasted cash flow cushion for each time period, in each scenario at each stress level can be compared to either required liquidity risk minimums or recommended guidance minimums. Important point: The number of cash flow cushion ratios can quickly get out of hand. For example, if you use 12 time periods for bank specific scenarios done at each of three stress levels, you will have 36 cash flow cushion ratios just from this single scenario type. The solution is to report these in summary form.
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Step 7
Determine The Quantity of Standby Liquidity Available The quantity of liquidity needed, the black line, must be compared to a quantity of liquidity available. (The quantity of liquidity needed is sometimes called the counter-balancing capacity.) Important point: Unless we can compare some quantity of liquidity need to some quantity of liquidity available, it is impossible to answer the central liquidity risk management question: Is the current level of risk acceptable?
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In order to forecast the quantity of standby liquidity available, we need to do four things:
First, we need to determine what sources are available in each scenario at each stress level. Second, we need to determine in what order we plan to access each source. This can be described as a cash flow waterfall. Third, we need to forecast how long it will take to convert each source to cash. Fourth, but in no way least important, we need to determine how much cash we can obtain. Haircuts for marketable securities can very significantly with changes in prevailing interest rates and changes in credit spreads.
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What is Marketable?
A 2005 survey of large U.S. and Canadian banks found that only 4 out of 17 reported that they varied the projected quantity of liquid assets to fit the scenario.

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Step 8
Compare the Quantity of Forecasted Need to the Quantity of Forecasted Funds Available.

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Standby Liquidity Metrics

Net cash flow quantities by currency. Days of sufficient cash flow.

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Step 9
Make the Management Connection
No bank managers intend to preside over the failure of their bank. When we say that the bank has a large enough standby liquidity reserve to survive for five months, we definitely do not mean to imply that at the end of five months management locks to doors and gives the keys to the bank liquidators. It is essential to view the liquidity reserve survival period as a window of opportunity. It tells the banks managers how long they would have to come up with additional cash in the event of a scenario like the one projected. It also tells them how much additional cash they have to obtain.
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(4) Stochastic Stress Testing?

Use Monte Carlo for cash flow forecasts. At first glance, Monte Carlo stress testing for liquidity risk appears to suffer from the same limitations as historical VaR. How do we estimate the parameters? What about greatest hits , multi-period, Monte Carlo?
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Multi-Period Stochastic Stress Tests

Can we study sets of similar, historical liquidity events to estimate Monte Carlo parameters?
Initial state Mean reversion Volatility
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Agenda

Why Stress Test Liquidity General Considerations Four Methods Additional Considerations

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Liquidity Stress Testing

Must focus on the interactions between credit risk, rate risk, market risk and liquidity risk. Must recognize that liquidity problems do not arise in a vacuum. Must recognize that lack of sufficient liquidity almost never TRIGGERS a liquidity crisis.

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Liquidity Stress Testing

Must be relevant to the bank, its balance sheet and its business environment. Must be relevant to the economic environment, Must be severe enough to reveal tail risk exposure (i.e. improbable risk) without being completely implausible. Must be detailed enough to highlight vulnerabilities.
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Applying Stress Testing

Stress testing is not an end unto itself. Results have to be used in the risk management process. Results should be carefully considered when setting risk limits. Contingency plans for actions such as asset liquidations should be based on stress test results.
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Limitations of Stress Testing

Stress testing is only a tool for improving risk management not a substitute for risk management. Stress tests lack benchmarks or standards for evaluating results. Stress tests do not reveal probabilities. We focus on plausible improbabilities without knowing how plausible or improbable. Stress scenarios are deterministic and limited in number.
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Questions ?
lmm12@adelphia.net

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