FRM Part II Exam

By AnalystPrep

Study Notes - Liquidity and Treasury Risk Measurement and

Management

Last Updated: Jul 27, 2023

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 Table of Contents

123 - Liquidity Risk 3

124 - Liquidity and Leverage 21
125 - Early Warning Indicators 43
126 - The Investment Function in Financial Services Management 53
127 - Liquidity and Reserves Management: Strategies and Policies 84
128 - Intraday Liquidity Risk Management 102
129 - Monitoring Liquidity 112
130 - The Failure Mechanics of Dealer Banks 129
131 - Liquidity Stress Testing 140
132 - Liquidity Risk Reporting and Stress Testing 161
133 - Contingency Funding Planning 179
134 - Managing and Pricing Deposit Services 193
135 - Managing Nondeposit Liabilities 206
136 - Repurchase Agreements and Financing 220
137 - Liquidity Transfer Pricing: A Guide to Better Practice 233
The US Dollar Shortage in Global Banking and the
138 - 255
International Policy Response
Covered Interest Rate Parity Lost: Understanding the Cross-
139 - 264
Currency Basis
Risk Management for Changing Interest Rates: Asset-Liability
140 - 278
Management and Duration Techniques
141 - Illiquid Assets 302

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 Reading 123: Liquidity Risk

After compl eti ng thi s readi ng, you shoul d be i n a posi ti on to:

Explain and calculate liquidity trading risk via the cost of liquidation and liquidity-adjusted

VaR (LVaR).

Identify liquidity funding risk, funding sources, and lessons learned from real cases:

Northern Rock, Ashanti Gold-fields, and Metallgesellschaft.

Evaluate Basel III liquidity risk ratios and BIS principles for sound liquidity risk

management.

Explain liquidity black holes and identify the causes of positive feedback trading.

Liquidity refers to a company’s ability to make cash payments as they become due. It is different

from solvency, which is the aspect of a company having more assets than liabilities such that its

equity value is positive.

Liquidity Trading Risk Using the Cost of Liquidation and

Liquidity-Adjusted Var (LVaR)

Liquidity Trading Risk

T rading liquidity risk is defined as the risk that an institution fails to sell its assets within an

appropriate amount of time at a desirable price. Liquidity is measured depending on how quickly an

asset can be disposed of at a reasonable price. For instance, an institution, say a bank holding a vast

volume of widely-traded, liquid U.S. T reasury Bills in its investment portfolio, has a minimum liquidity

risk compared to a bank holding a large volume of thinly-traded, illiquid Non-Agency Mortgage-backed

Securities in their investment portfolio.

For a bank to sell an illiquid asset quickly, it should expect taking a loss on the sale due to bigger bid-

offer spreads, just like in a fire sale. Some of the factors facilitating liquidity trading risk are predator

trading, where markets compete in doing similar trades with each competitor craving for massive

profits.

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Four factors influence the price at which an asset can be sold. T hese are:

1. T he amount of the asset is to be sold;

2. T he mid-market price of the security (asset), or an estimate of its value;

3. T he urgency with which it is sold; and

4. T he prevailing economic environment.

For a financial instrument where there is no market maker, the implicit bid-offer spread comes in.

T he bid price decreases while the offer price tends to increase with the size of a trade. For an

instrument where there is a market maker, the bids and offers are the same up to the market

maker’s size limit and then start to diverge. T he following figure illustrates the above:

Measuring Market Liquidity

The Bi d-Offer Spread Measure

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T he bid-offer spread measure is one of the ways of measuring market liquidity. It can be measured as

a dollar amount or a proportion of the asset price. T he dollar bid-offer spread is calculated as follows;

p = Offer price − Bid price

On the other hand, the proportional bid-Offer spread for an asset is equivalent to

Offer price − Bid price

s=
Mid-market price

T he mid-market price is halfway between the offer price and the bid price commonly regarded as the
sα
fair price. A bank experiences a cost equal to , whenever it liquidates an asset position, where α is
2

the dollar (mid-market) value of the position. T his fact implies that trades are not done at the mid-

market price. T herefore, a buy trade is made at the offer price while a sell trade is made at the bid

price.

One way of measuring the liquidity of a book is finding how much it would cost to liquidate the book

in normal market conditions within a stipulated time. Supposing that sj is an estimate of the

proportional bid-offer spread in normal market conditions for the jth financial security held by a

financial institution, and α j is the dollar value of the security’s position, then:

n Sj α j
Cost of liquidation (normal market) = ∑
j=1 2

Where n represents the number of positions. It is worth noting that diversification does not

necessarily reduce liquidity trading risk. However, Sj increases with the size of position j. T his

implies that holding small positions instead of a few large ones entails less liquidity risk. Setting limits

to the size of any position can thus, be one way of reducing liquidity trading risk.

Example: Cost of Liquidation (Normal Market)

Suppose that HBC bank has bought 15 million shares of one company and 45 million ounces of a

commodity. Assume that the shares are bid $90.4, offer $91.6. T he commodity is bid $20, offer $

20.2.

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T he mid-market value of the position of the shares is equivalent to:

15 × 91 = $1, 365 million

Note that the mid-market price is halfway between the offer price and the bid price.

T he mid-market of the position in the commodity is:

45 × 20.1 = $904.5 million

T he proportional bid-offer spread for the position of the shares is equivalent to:

Offer price − Bid price

s=
Mid-market price
(91.6 − 90.4)
s= = 0.01318
91

Similarly, the proportional bid-offer for the position in the commodity is:

(20.2 − 20)
= 0.00995
20.1

And hence the cost of liquidation in a normal market is:

1, 365 × 0.01318 × 0.5 + 904.5 × 0.00995 × 0.5 = $13.495 million

Cost of Liquidation (Stressed Market)

T he cost of liquidation in a stressed market within a specified period is another liquidity cost

measure.

n (μj + λσj)α j
Cost of liquidation (stressed market) = ∑
j=1 2

Where:

μj is the mean, while σj is the standard deviation of the proportional bid-offer spread for the jth

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instrument held.

λ is the parameter that gives the required confidence level for the spread. Suppose that we are

considering the “worst-case” spreads that are exceeded only 1% of the time, if the spreads are

assumed to be normally distributed, then λ = 2.326.

Example: Cost of Liquidation (Stressed Market)

Suppose that HBC bank has bought 15 million shares of one company and 45 million ounces of a

commodity. Assume that the shares are bid $90.4, offer $91.6. T he commodity is bid $20, offer $20.2.

T he bid-offer spread for the shares has a mean and standard deviation of $1.5 and $1.8, respectively.

Further, the mean and standard deviation for the bid-offer spread for the commodity are both $0.14.

T he proportional bid-offer spread for the position of shares has a mean of 0.01158 and a standard

deviation of 0.02678. On the other hand, the proportional bid-offer spread for the position of the

commodity has a mean of 0.004898 and the same standard deviation of 0.004898.

Assuming the spreads follow a normal distribution, calculate the cost of liquidation at the 99%

confidence limit.

0.5 × 1, 365 × (0.01158 + 2.326 × 0.02678)

+ 0.5 × 904.5 × (0.004898 + 2.326 × 0.004898) = 57.79

T his is more than five times the cost of liquidation in normal market conditions.

Liquidity-Adjusted VaR

T he liquidity-adjusted VaR is the regular VaR plus the cost of unwinding positions in a normal market,

which is equivalent to:

k Sjα j
Liquidity-Adjusted VaR = VaR + ∑
j=1 2

Alternatively, liquidity-adjusted VaR can also be defined as regular VaR plus the cost of unwinding

positions in a stressed market. T his is equivalent to:

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 k (μj + λσj )α j
Liquidity-Adjusted VaR = VaR + ∑
j=1 2

Unwinding a Position Optimally

To unwind a strong financial position in a financial instrument, a trader must decide on the best

trading strategy to employ. T he trader faces a large bid-offer when the position is unwound quickly,

but the possible loss from the mid-market price changing against the trader is small. If the trader

hesitates from unwinding the position, low bid-offer accrues with substantial potential loss from the

mid-market.

According to Almgren and Chriss, suppose that the size of a position is L units, and a trader gets to

decide how to liquidate it over a k-day period. It is convenient to define the bid-offer spread in dollars

rather than as a proportion for this case.

Define the dollar bid-offer spread when the trader trades q units in one day as p(q) dollars. Define qj

as the units traded on day j and X j as the size of the trader’s position at the end of day j where

1 ≤ j ≤ k.

It follows that x j = x j−1 − qj for 1 ≤ j ≤ k where x 0 is defined as the initial position size, L.

Each trade costs half the bid-offer spread, and the total of the costs related to the bid-offer spread is

therefore given by:

k p(qj )
∑ qj
j=1 2

Assume that trading takes place at the start of a day, and the mid-market price movements follow a

normal distribution with a daily standard deviation of σ. T he variance of the change in the value of the

traders' position on day j is σ 2x 2j. If price changes on successive days are independent, the variance

of the change in the value of the position applicable to the unwind is:

k
∑ σ 2x 2j
j=1

If a trader wishes to minimize VaR, his/her objective should be to choose qj such that

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 k k p(qj )
λ ∑ σ 2 x 2j + ∑ qj
⎷ j=1 j=1 2

is minimized to

k
∑ qj = L
j=1

When a position is to be closed out over k days, more than 1/k of the position should be traded on the

first day as the longer any part of the position is held, the higher the risk of adverse market moves.

Liquidity Funding Risk

Liquidity funding risk is the ability of a financial institution to finance its financial needs when due.

Liquidity is different from solvency; a financial institution with a high level of solvency may fall due

to lack of liquidity. Factors that may cause liquidity problems in a financial institution include;

Li qui di ty stresses i n the economy: In this case, investors are unwilling to provide

funding in situations where there is any credit risk at all. An example is a flight to quality,

such as that seen during the 2007 to 2009 crisis.

A poor fi nanci al performance: T his leads to a lack of confidence that can result in a

loss of deposits and difficulties in rolling over funding.

Excessi vel y aggressi ve fundi ng deci si ons : T his is when all financial institutions tend

to use short-term instruments to fund long-term needs, hence creating a liquidity

mismatch.

It is essential to predict cash needs and ensure that they are realizable in adverse situations to

managing liquidity risk.

Sources of Liquidity

T he core sources of liquidity for a financial institution include:

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The capability to liquidate trading book positions

T his source of liquidity is related to liquidity trading risk since a financial institution can meet its

funding requirements by liquidating part of its trading book. T herefore, it is significant for a financial

institution to quantify the liquidity of its trading book to establish how easy it would be to use the

book to raise cash.

Holdings of cash and treasury securities

Cash is always an available source of liquidity, while treasury securities are issued by countries such

as the US and the UK and are quickly convertible into cash within short notice. Although cash and

T reasury securities are excellent sources of liquidity, they are expensive as there is a limit to the

cash and treasury securities that can reasonably be held by an institution.

Borrowings from the central bank

Central banks such as the Federal Reserve Board in the United States, the Bank of England in the UK,

or the European Central Bank are often referred to as “lenders of last resort.” When banks are

experiencing financial challenges, they usually borrow from the central bank.

The capacity to securitize assets such as loans at short notice

T he capacity to securitize assets is another source of liquidity that has got its challenges. In August

2007, securitization led to liquidity problems whereby banks had entered liquidity backstop

arrangements on the asset-backed commercial paper (ABCP) that was used to fund debt instruments,

such as mortgages, before their securitization. Failure to find buyers, selling institutions had to buy

the instruments themselves, and in some cases, they had to provide financial support to conduits and

other off-balance-sheet vehicles that were involved in the securitization, even though they were not

legally required to do so.

The ability to offer sound terms to attract retail and wholesale

deposits at short notice

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In stressed market conditions, wholesale deposits can quickly disappear as they are volatile.

Similarly, retail deposits are not reliable sources of liquidity. T he issue of liquidity funding is hard to

achieve as when one financial institution wants to improve its retail or wholesale deposit base for

liquidity purposes by offering more attractive rates of interest, others usually want to do the same

thing, and hence increased funding becomes hard to realize.

The ability to borrow money at prompt notice

A creditworthy bank usually has no problem in borrowing money, but in stressed market conditions,

there is a sensitive aversion to risk leading to higher interest rates, shorter maturities for loans, and

in some cases, a complete refusal to provide funds. Financial institutions should monitor the assets

that can be pledged as collateral for loans at short notice and invest in such.

Lessons Learned from Real Cases: Northern Rock, Ashanti

Gold-Fields, and Metallgesellschaft

As we had highlighted earlier, solvency is very different from liquidity. Solvency reflects the equity

status of a financial institution, while liquidity is more critical as it determines a financial institution’s

ability to fund its future financial needs when they are due. T his is evident through three real cases,

as discussed below:

The Northern Rock Bank

Northern Rock Bank was one of the top five mortgage lenders in the United Kingdom in 2007. It

offered deposit accounts, savings account loans, and house/content insurance. T he bank was growing

rapidly, but at some point, its liquidity position worsened due to its poor sources of liquidity. T he

bank depended on selling short-term debt instruments for much of its funding, which was not enough

to offer stable liquidity.

Consequently, the bank opted for borrowing. It experienced difficulties due to the economic crisis,

which were prevailing in 2007. Lenders were not willing to lend because they were very nervous

about lending to banks that were heavily involved in the mortgage business.

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T hough the bank’s assets were enough to cover its liabilities, so it was not insolvent, the inability to

fund itself was a severe problem, and it opted to borrow from the Bank of England. However, the fall

of the Northern Bank precipitated by the excessive withdrawals from its clients, which crippled its

liquidity status, leading to an increase in emergency borrowing requirements. Finally, the bank could

not fund its financial needs, and as a result, it was nationalized, and its management was changed.

T he above scenario illustrates how quickly liquidity problems can lead to a bank spiraling downward.

If the bank had been managed a little more conservatively and had paid more attention to ensuring

that it had access to funding, it might have survived.

Ashanti Goldfields

Similarly, Ashanti Goldfields of West Africa experienced problems resulting from its hedging program.

Following the stressed gold market, the European central banks surprised the market with a

declaration that they would limit their gold sales over the subsequent five years.

T he price of gold shot up by over 25% and Ashanti was unable to meet margin calls. T he company

restructured by selling a mine. T his led to a dilution of the interest of its shareholders. Additionally, it

restructured its hedge positions. In a nutshell, the Ashanti Goldfield closure was due to insufficient

liquidity sources.

Metallgesellschaft

Metallgesellschaft company is another example of how poor liquidity management can lead to an

institutions' failure. Initially, the company was making substantial sales. T he company was using long

positions in short-dated futures contracts that were rolled forward to hedge against exposure.

However, the price of oil dipped, and there were margin calls on the futures positions. MG’s trading

became complicated by the fact that its trades were substantial and also anticipated by others. T he

closure of the institution was due to short-term cash flow pressures, as its liquidity was crippled.

Basel III Liquidity Risk Ratios

T he Basel III introduced two liquidity risk requirements, namely; the liquidity coverage ratio (LCR)

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and the net stable funding ratio (NSFR).

The Liquidity Coverage Ratio (LCR)

T he LCR requirement is expressed as follows:

High-quality liquid assets

≥ 100%
Net cash outflows in a 30-day period

In the calculation of LCR we consider a 30-day period which is one of acute stress involving a

downgrade of the following three notches (e.g., from AA+ to A+);

Partial loss of deposits

Complete loss of wholesale funding

Increased haircuts on secured funding and drawdowns on lines of credit.

T he required LCR was 100% in 2019.

Example: Liquidity Coverage Ratio

Suppose that ABC bank has high-quality liquid assets that are valued at $50 Million. Additionally, the

bank has $30 million in expected net cash flows over a 30-day stress period. T he LCR for ABC bank

is equivalent to:

High-quality liquid assets

LCR =
Net cash outflows in a 30-day period
$50
= = 167%
$30

T herefore, ABC Bank meets the requirement under Basel III. On the other hand, the NSFR

requirement is calculated as follows;

Amount of stable funding

≥ 100%
Required amount of stable funding

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T he numerator is determined by multiplying each category of funding, such as capital, wholesale

deposits, and retail deposits by available stable funding (ASF) factor, reflecting their stability. On the

other hand, the denominator is calculated from the assets and the funded off-balance-sheet items.

Note that the above categories are multiplied by a required stable funding (RSF) factor to reflect the

permanence of the funding.

The Net Stable Funding Ratio (NSFR)

T he net stable coverage ratio is designed to encourage and incentivize banks to use stable sources to

fund activities and reduce dependency on short-term wholesale funding. It aims at mitigating funding

risk by reducing maturity mismatches between assets and liabilities on the balance sheet. T he ratio

has a time horizon of one year and can be calculated as follow:

Amount of stable funding

N SF R = ≥ 100%
Required amount of stable funding

Example: Net Stable Funding Ratio (NSFR)

T he following is a balance sheet for XYZ Bank that separates short term and long term assets

according to Basel III guidelines. In this case, the short term indicates less than or equal to 30 days,

while the long term indicates more than one year. Note that we do not consider durations between

these two for simplicity. Additionally, Basel III weighting factors are also included. T he Basel III

NSFR is calculated using these weighting factors.

Use the balance sheet to evaluate whether the bank meets the Basel III requirements using the

NSFR ratio.

Balance Sheet for XYZ Bank as at 31 December 2019

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 Assets Amount NSFR Liabilities Amount NSFR
Short-Term Short-Term
Cash 0 0% Deposits 3000 80%
T-notes 400 0% Deposits Fin 1000
Institutions
Loan corporates 200 85% Long-Term
Mortgages 250 65% Owner's equity 1200 100%
Corporates 100 50% Deposits 2000 100%
Loans Fin 500 0% Unsecured debt 3000 100%
Institutions
Long-Term Deposits Fin 1200 100%
Institutions
Cash 100 0%
T-notes 0 0%
Loan corporates 2500 100%
Mortgages 3500 65%
Corporates 2200 100%
Loans Fin 0 100%
Institutions

Recall that the NSFR requirement is such that:

Amount of stable funding

≥ 100%
Required amount of stable funding

Amount of stable funding is equivalent to:

= (1200 × 100%) + (3000 × 80%) + ((2000 + 3000 + 1200) × 100%)
= 9, 800

T he required amount of stable funding is equivalent to:

(200 × 85%) + ((250 + 3500) × 65%) + (100 × 50%) + ((2500 + 2200) × 100%))
= $7, 357.5

T herefore:

$9800
NSFR = = 133%
$7, 357.5

NSFR is greater than the required ratio of 100%. T herefore XYZ bank meets Basel III net stable

funding requirement.

BIS Principles for Sound Liquidity Risk Management

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Bank regulators issued revised principles on how banks should manage liquidity following the 2007

subprime crisis. T hese are as follows:

1. A bank takes the responsibility of sound management of liquidity risk in that it should

establish a robust liquidity management framework for enough liquidity.

2. A bank should explicitly articulate a liquidity risk tolerance that is convenient for its

business strategy as well as its role in the financial system.

3. Senior management should develop strategies, policies, and practices to manage liquidity risk

in line with the risk tolerance and to certify that the bank maintains sufficient liquidity.

4. A bank should consider liquidity costs, risks in the internal pricing, benefits, performance

measurement, and new product approval process for all substantial business activities. T his

aids the bank in aligning the risk-taking interests of individual businesses with the potential

liquidity risks their activities generate for the bank as a whole.

5. A bank should employ an effective procedure for identifying, measuring, tracking, and

controlling liquidity risk. T he procedure should encompass a robust framework for a large

projection of cash flows arising from assets, liabilities, and off-balance-sheet items over a

suitable time frame.

6. A bank should manage the intraday liquidity positions and risks to cover payment and

settlement liabilities under both normal and stressed market conditions promptly. T his

creates a smooth functioning of payment and settlement systems.

7. A bank should manage its collateral positions, establishing a difference between encumbered

and unencumbered assets.

8. A bank should create a funding strategy that offers adequate diversification in the sources

and tenor of funding. It should further monitor the legal entity and the place where the

collateral is held and how to mobilize it on time.

9. A bank must have a strict contingency funding plan (CFP) that sets out the strategies for

addressing liquidity shortfalls in emergencies.

10. A bank should track and control liquidity risk exposures and funding needs within and across

legal entities, business lines, and currencies, considering the legal, regulatory, and

operational limitations to the transferability of liquidity.

11. A bank should regularly reveal public information that helps market participants to make an

informed decision about the effectiveness of its liquidity risk management framework and

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 liquidity position.

12. A bank should keep a cushion of unencumbered, high-quality liquid assets to be held as

insurance for a range of liquidity stress scenarios, including those that involve the loss or

impairment of unsecured and typically available secured funding sources

13. A bank should employ stress tests regularly for a diversity of short-term and protracted

institution-specific and market-wide stress scenarios to establish the sources of potential

liquidity strain and to ensure that current exposures remain following a bank’s established

liquidity risk tolerance.

14. Supervisors should frequently perform a comprehensive assessment of a bank’s overall

liquidity risk management framework and liquidity position to establish whether they deliver

an adequate level of resilience to liquidity stress given the bank’s role in the financial

system.

15. Supervisors should communicate among themselves and between public authorities, such as

central banks, both within and across national borders, to facilitate practical cooperation

regarding the supervision and oversight of liquidity risk management.

16. Supervisors should intervene to require useful and timely corrective action by a bank in

addressing deficiencies in its liquidity risk management or liquidity position.

17. Supervisors should supplement their standard assessments of a bank’s liquidity risk

management framework and liquidity position by monitoring a mix of internal reports,

prudential reports, and market information.

Liquidity Black Holes and the Causes of Positive Feedback

Trading

Liquidity Black Holes

A liquidity black hole refers to a situation whereby liquidity has dried up in a market as every

participant wants to sell, and no one wants to buy and vice versa. T his situation is also known as a

crowded exit. A liquidity black hole is generated when a price decline makes more market

participants want to sell, forcing prices well below where they eventually settle. During the sell-off,

liquidity dries up, and the asset can be sold only at a fire-sale price.

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The Causes of Positive Feedback Trading

T here exist negative feedback traders and positive feedback traders in a market. T he behavior of

these traders drives the changes in the liquidity of financial markets. Negative feedback traders

usually buy when prices fall and sell when prices rise. On the other hand, positive feedback traders

sell when prices fall and buy when prices rise.

Negative feedback traders dominate the trading in liquid markets as these traders buy when the price

of an asset gets reasonably low, creating demand for the asset, which restores the price to a

reasonable level. T he converse is also true. In contrast, positive feedback traders dominate illiquid

markets. T his is because a fall in the price of an asset causes traders to sell., resulting in a further

price fall and more selling. An increase in the asset price causes traders to buy. T his causes the

price of the assets to increase further and, thus, more buying.

T he reasons why positive feedback trading exists include:

Trend tradi ng: T hese traders identify trends in an asset price and buy when the asset

price appears to increase and sell when it appears to decrease. A related strategy is the

breakout trading whereby trading occurs when an asset’s price moves outside a stipulated

range.

Stop-l oss rul es: T hese are rules which limit traders from losses. As a result, when the

price of an asset that is owned falls below a given level, they sell to limit their losses.

Dynami c hedgi ng: Hedging a short option position, either a call or put, involves buying

after a price rise and selling after a price fall. Dynamic hedging is a positive feedback

trading that can reduce liquidity.

Creati ng opti ons syntheti cal l y: Hedging a short position in an option makes a financial

institution to create a long option position synthetically by doing the same sort of trading as

it would do if it were hedging a short option position, hence leads to positive feedback.

Margi ns: Margin calls are caused by significant movement in market variables,

specifically for highly leveraged traders. Eventually, the traders are forced to close out

their positions, which reinforces the underlying move in the market variables.

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Predatory tradi ng. Predatory trading reinforces price decline and results in the price

falling even further than it would otherwise do.

Long Term Capi tal Management: T he failure of the hedge fund Long-Term Capital

Management (LT CM) is an example of positive feedback trading. An example of this trade is

the “relative value fixed income.”

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Practice Question

T he liquidity manager for HBC bank learns that the bank is facing a liquidity crisis. T he

manager opts to sell some liquid assets owned by the bank to increase its liquidity. T he

following factors affect the price at which the asset will be sold. Which one is

inaccurate?

A. T he mid-market price of the instrument, or an estimate of its value

B. T he prevailing economic environment

C. T he urgency with which the asset can be sold

D. T he price at which the asset was bought

T he correct answer is: D).

The correct answer i s D: T he price at which an asset was bought does not affect the

selling price of the asset in this case.

A i s i ncorrect: T he mid-market price of an asset or an estimate of its value affects the

price at which the asset will be sold.

B i s i ncorrect: T he prevailing economic environment usually affects the price at

which an asset is sold.

C i s i ncorrect: How vital an asset is to be sold usually affects the prices it fetches.

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 Reading 124: Liquidity and Leverage

After compl eti ng thi s readi ng, you shoul d be abl e to:

Differentiate between sources of liquidity risk and describe specific challenges faced by

different types of financial institutions in managing liquidity risk.

Summarize the asset-liability management process at a fractional reserve bank, including

the process of liquidity transformation.

Compare transactions used in the collateral market and explain risks that can arise through

collateral market transactions.

Describe the relationship between leverage and a firm’s return profile (including the

leverage effect) and distinguish the impact of different types of transactions on a firm’s

leverage and balance sheet.

Distinguish methods to measure and manage funding liquidity risk and transactions liquidity

risk.

Calculate the expected transactions cost and the spread risk factor for a transaction and

calculate the liquidity adjustment to VaR for a position to be liquidated over a number of

trading days.

Discuss interactions between different types of liquidity risk and explain how liquidity risk

events can increase systemic risk.

Sources of Liquidity Risk and How Each of the Risks Arise for
Financial Institutions

In financial markets, an asset is liquid if it is a good substitute for cash. In other words, the asset can

be converted into cash quickly at a reasonable price without fluctuating the price significantly. A

market is liquid if market participants unwind positions rapidly, at reasonable transaction costs, and

without excessive price deterioration.

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Liquidity has two major categories: transaction liquidity and funding liquidity. T ransactions liquidity

takes into consideration financial assets and financial markets. It is the ability to buy or sell an asset

without moving its price. On the other hand, funding liquidity relates to an individual’s or an

organization’s creditworthiness. It is the ability to finance assets continuously at an acceptable

borrowing rate.

T here are different risks related to liquidity which include:

Transacti on l i qui di ty ri sk : T his is the risk that results in the adverse price movement of an

asset during buy and sell transactions. T ransaction liquidity risk is low if assets can be liquidated

quickly and cheaply, without moving the price “too much to exchange an asset for other assets

easily.”

Bal ance sheet ri sk (fundi ng l i qui di ty ri sk ): Funding liquidity risk occurs when lenders

withdraw or change the terms of borrowing due to the deteriorating credit position of the borrower.

T ypically, in the banking sector, funding liquidity risk is high due to maturi ty mi smatch, i.e.,

funding long term assets (bank loans) with short term liabilities (bank deposits).

A maturity mismatch is often profitable for a short-term borrower. T his is because of the lower cost

of capital owing to less risk of borrowing and a decreased required rate of return. T he profit is even

more in case of an upward sloping yield curve. However, maturity mismatch exposes the borrower

to rollover risk. Also called cliff risk, it is associated with the refinancing of debt at higher interest

rates.

Systemi c ri sk : T his is the risk of failure of the entire financial system due to heavy financial

stress.

Different types of liquidity risks are correlated, and this accelerates problems. For example, if the

counterparty increases collateral requirements, the investor may have to unwind it before the full

realization of the expected return. Reducing the trade horizon causes deterioration of funding

liquidity, which increases the transaction liquidity risk.

Asset-Liability Management Process at a Fractional Reserve

Bank and Liquidity Transformation

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A commercial bank’s core function is to take deposits and to provide loans to non-financial

institutions. It transforms long-term illiquid assets (loans) into short-term liquid ones (deposits). T his

enables the banks to carry out liquidity, credit, and maturity transformation. Banks also raise funds by

issuing bonds, commercial paper, and other forms of debt. T his is called wholesale funding, and it

involves longer-term deposits, which can be redeemed at short notice. Bank deposits are “sticky.”

Depositors remain in the bank unless impelled to change banks' circumstances such as moving

houses.

Bank assets are typically long term and less liquid (Loans). On the other hand, bank deposits that

contribute to roughly 60-70% of the bank’s liabilities are short term, sticky, and more liquid. Banks

use deposits for lending purposes. In other words, banks match short-term liabilities with long term

assets. T his is referred to the as fractional reserve banking system. A bank that lends deposits is

known as a fractional-reserve bank. Banks also borrow (raise capital) from the external market

through issuing bonds or commercial paper and use it for lending purposes. T his is called wholesale

funding and involves longer-term deposits.

A traditional asset-liability function of the bank is to ensure that it remains liquid by reducing funding

liquidity risk. In other words, asset-liability management (ALM) is the process of using deposits to

finance loans.

ALM is a crucial process which includes measures such as:

T racking and forecasting available cash and cash needs; and

Keeping specific ratios of cash and marketable securities to meet unusual demands by

depositors.

However, so asset-liability management system can adequately protect a fractional-reserve bank

against a loss of confidence in its ability to pay out depositors. No degree of liquidity can secure a

bank entirely against a run as long as it executes a liquidity and maturity transformation, and has

liabilities on-demand.

T he following figure demonstrates the impact on a bank when its customers withdraw more than the

bank’s reserves.

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24
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A high fragility can be mitigated through higher capital. High capital reduces depositors’ concern

about solvency, the typical trigger of a run, and higher reserves, which reduces concern about

liquidity.

T he fragility of bank funding was illustrated following the Lehman Brothers bankruptcy. Following

the crisis, commercial paper borrowing abruptly declined as it could no longer be placed. Banks faced

difficulty in rolling over the long-term commercial paper, and in obtaining funding with maturities of

more than a few weeks. T he share of very short-term issuance significantly increased to almost 90%

due to fewer alternatives.

T he Federal Reserve intervened after the Lehman bankruptcy and created the Commercial Paper

Funding Facility (CPFF), which purchased the commercial paper from issuers unable to roll the

paper over. It also purchased the Asset-Backed Commercial Paper Money Market Mutual Fund

Liquidity Facility (AMLF), which lent to financial institutions purchasing ABCP from MMMFs.

Markets for Collateral and Risks Associated with Collateral

Market Transactions

Markets for collateral are created when securities are used as collateral to obtain secured loans of

cash or other securities. T he borrower of securities can lend them to another, a practice called

rehypothecati on or repl edgi ng of collateral. Collateral is of the essence in credit transactions as

it provides security for lenders, hence ensures the availability of credit to borrowers. Besides, the

use of collaterals makes it easy to establish short positions in securities.

A haircut is equivalent to the value of the collateral less the amount borrowed. From the lender’s

perspective, the haircut is the extent to which collateral value can fall and still be fully

collateralized. For example, suppose that an investor borrows $100. He invests a collateral of $102.

T he $2 difference is the one referred to as the haircut. T he lender aims to ensure that the loan

amount is less than the collateral.

Additionally, the lender may insist on the vari ati on margi n. T his is a periodic additional fund

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deposit to maintain the difference between the lent amount and the collateral. T he variation margin

protects the lender against fluctuations in the value of the collateral. For example, if the haircut of

$2 reduces to $1 at any particular period, the borrower must top up the amount by an additional $1 to

maintain the haircut at $2.

T he role of collateral has expanded in modern finance, following the progression of securitization.

Securitization generates securities that can be pledged as collateral for credit. Securitized assets

generate cash flows, may appreciate and can be used as collateral for other transactions.

Collateral markets prop up the growth of non-bank intermediaries. Life insurance companies own

portfolios of high-quality securities. T his enables them to borrow cash at a low rate, which they can

then invest in earning higher rates of return. Furthermore, hedge funds have inventories of

securities which they use as collateral to get financing of the portfolio at a reduced rate than

unsecured borrowing. Finally, Firms with excess cash are more willing to lend at a low rate of

interest if the loan is secured by collateral.

Types of Collateral Markets

Margi n l oans: Margin loans are short term financial securities that are collateralized with a broker

in street name account. In other words, the broker acts as an intermediary for the trade. He/she

retains custody of the securities in a different customer account, a street account, (i.e., registered in

the name of the broker rather than that of the owner). Registering using a street name account

allows the broker to use the securities for other purposes. T hese may be borrowing money in the

secured money market to obtain the funds he/she lends to margin customers as well as to meet

margin calls.

Cross-margin agreements are used to put in place the net margin position of investors with portfolios

of long and short positions. Cross margin involves transferring excess margin from one account to

another account with an insufficient margin. T his reduces the overall margin to the investor.

Repurchase Agreements (Repos): Repurchase agreements are a form of short-term

collateralized loans sold to buy back at a later date at a higher price (the forward price). Both the

spot and forward prices are agreed upon today, and the difference is the interest rate. Repos

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encompass high-yield bonds and whole loans, and more recently, structured credit products.

Securi ti es Lendi ng: Securities lending involves one party lending security to a counterparty at a

fee, called a rebate. T he lender continues to receive interest cash flows and dividends from the

security. Stock lending involves the borrowing of stocks and it is a common type of securities

lending.

Securities lending is generally carried out by hedge funds and other large institutional equity

investors. T he investor holds the equities through a broker in “street name,” thus making them

available for lending. T hey can then be rehypothecated to a trader who wishes to sell the securities

short. T he investor receives a rebate in exchange. Fixed-income securities’ lending transaction aims

to earn a spread between less and more risky bonds. For example, lending treasury securities and

using the cash to invest in high-risk bonds.

Total Return Swaps: In a total return swap, a fixed payer earns the return (both income and

capital gains) on a reference asset without owning it. T he counterparty providing the return often a

hedge fund establishes a short stock position, which is identical to that of a borrower of stock.

Leverage Ratio and Leverage Effect

T he leverage is the ratio of the firm’s assets to its liabilities. T he leverage ratio, also often called the

debt-to-equity ratio, is given by:

A E+D D
L= = = 1+
E E E

A leverage value of 1 implies that there is no debt. T his is the lowest possible value of leverage.

Leverage ratio increases with an increase in debt.

T he leverage effect is the increase in the return on equity (ROE) that results from increasing

leverage and is equivalent to the difference between the return on assets (ROA) and the cost of

funding. T he leverage effect can be expressed as:

re = Lra − (L − 1)rd

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Where:

ra = Asset returns

re =Equity returns

rd= Cost of debt

L = leverage ratio

T he above formula can also be expressed as:

ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

T he return on equity (ROE) increases with the increase in leverage as long as return on assets

(ROA) is greater than the cost of debt. Although the increase in leverage increases profits in good

times, it can also magnify losses should the ROA prove to be lower than the cost of debt.

For example, if the leverage ratio is 4, 75% of the balance sheet is financed with debt, and only 25%

financed with equity. T hus, for every $4 of assets, $3 is borrowed funds (debt), and $1 in equity. In

the formula expression, we multiply the cost of debt by 3. T he higher the leverage factor, the larger

the multiplier but also the higher the debt costs. Leverage is also referred to as a double-edged sword

because it amplifies gains but also magnifies losses.

T he effect of increasing leverage is equivalent to the proportion of the change in retained earnings

relative to the change in leverage. T his can be expressed as:

∂re
= ra − rd
∂L

Where:

∂re =Change in retained earnings

∂L =Change in the leverage ratio

T his formula implies that increasing assets and taking on an equal amount of additional debt that

increases leverage from an initial value L 0 to L 0 +1 increases ROE by ra − rd.

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T he equity denominator of the leverage ratio depends on the type of entity and the purpose of the

analysis. For example, for a bank, the equity might be the book value or market value of the firm. On

the other hand, hedge funds use net asset value (NAV) of the fund, which is the current value of the

investor’s capital.

Example: Leverage and Leverage Effect

A firm has an ROA of ra = 0.20, while its cost of debt is rd = 0.10. T he firm’s balance sheet is as

given below:

Assets Value
Value of the firm (V) 3
ROA 0.2
Liabilities
Equity € 1.5
Debt (D) 1.5
Leverage 2
Cost of debt(rd) 0.1
ROE 30%

Find the firm's leverage and return on equity (ROE).

Sol uti on

D 1.5
T he firm’s leverage = 1 + = 1+ =2
E 1.5

Its ROE is:

ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

= (0.2 × 2) − [(2 − 1) × 0.10] = 0.30 or 30%

Example: Increasing the amount of debt

Using the previous example and increasing the leverage, by borrowing an extra unit of funds and

investing it in an extra unit of assets, deviates the balance sheet to:

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 Assets
Value of the firm (V) 4
ROA 0.2
Equity and Liabilities
Equity € 1.5
Debt (D) 2.5
Leverage 2.7
Cost of debt(rd) 0.1

Find the firm's ROE.

Solution

D 2.5
T he firm’s leverage = 1 + = 1+ = 2.67
E 1.5

ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

= (0.2 × 2.67) − [(2.67 − 1) × 0.10] = 0.37 or 37%

As we can see, increasing the amount of debt increases the return on equity for shareholders in this

instance.

Example: Hurdle rate

T he firm’s hurdle rate (i.e., required ROE) also influences the leverage. For example, assume a

firm’s hurdle rate (i.e., ROE) is 12%, ROA equals 8%, and its cost of debt equals 4%. T he firm

chooses a leverage ratio of 2.0, as calculated below:

ROE = (2 × 8%) − (1 × 4%) = 12%

Explicit and Implicit Leverage

T here exist two forms of leverage, explicit and implicit leverage. Explicit leverage occurs when

performing margin purchases or issuing bonds to raise capital. T his is because these tasks entail

borrowing. For example, assume that a company’s balance sheet has equity of 50% and a debt capital

of 50%. T he securities are 100% T he Company’s leverage ratio is:

50%
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 50%
= 1+ =2
50%

T herefore, explicit leverage is 2. Increasing the debt capital increases equity and thus increase the

leverage ratio.

Implicit leverage refers to embedded leverage in short positions and derivatives such as options and

swaps. Economic balance sheets can be used to measure implicit leverage.

Margin Loans and Leverage

First, we consider margin loans. T he stock acquired with the margin loan is collateral for the loan.

T he haircut determines the amount of the loan made. At a haircut of h%, (1-h %) is loaned against a

given market value of margin collateral, and h% is the borrower’s equity in the position. A position

with a haircut of h% has a leverage of 1/h.

Example: Margin Loans and Leverage

Suppose that a firm has $200 in cash, following an investment of $200 in equity by its investors.

Assets Value
Cash 200
Stock 0
Total assets 200
Liabilities and Equity
Equity 200
Debt (D) 0
Total liabilities and equity 200
Leverage 1

0
T he leverage ratio will be equal to:1 + =1
200

Assume the firm finances a long position in $200 worth of equity at the Reg T margin requirement of

50 percent. It invests $100 of its own funds and borrows $100 from the broker. Immediately

following the trade, its margin account has $100 in equity and a $100 loan from the broker:

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T he overall economic balance sheet as a result of the borrowed funds is:

Assets Value
Cash 100
Stock 200
Total assets 300
Liabilities and Equity
Equity 200
Margin Loan 100
Total liabilities and equity 300
Leverage 1.5

100
T hus, the leverage ratio has risen to 1.5, i.e., 1 + = 1.5. T he broker retains control of the stock
200

to use as collateral for the loan.

Short Positions and Leverage

Under a short sale, the investor borrows securities from the broker and sells them. T wo

transactions are involved here, one that involves borrowing and the one that involves selling. T he

transaction enlarges the balance sheet because the cash generated from the short sale along with the

value of the borrowed securities appear on the balance sheet.

Example: Short Positions and Leverage

Assume a firm that has a hedge fund with $200 of cash, corresponding to $200 of equity invested by

the owners. T he firm then borrows $200 of stock and sells it short. It has assets equivalent to the

proceeds from selling the stock and a liability equal to the value of the borrowed shares. However,

the firm cannot use the cash for other investments because it is collateral. T he broker uses the cash

to ensure that the short stock can be repurchased and returned to the lender. It remains in a

segregated short account. In case of an increase in the stock price, the firm must also put $100 in a

margin account because the $200 of proceeds would not be enough to cover its returns to the

borrower.

T he immediate impact of this trade is that the firm’s margin and short accounts have $100 in equity

and a $100 loan from the broker as follows:

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 Assets Value
Due from the broker 300
Margin 100
Short sale proceeds 200
Total assets 300
Liabilities and Equity
Equity 100
Borrowed Stock 200
Total liabilities and equity 300

T he firm’s full economic balance sheet given the short sale is:

Assets Value
Cash 100
Due from the broker 300
Total assets 400
Liabilities and Equity
Equity 200
Borrowed Stock 200
Total liabilities and equity 400
Leverage 2

T he firm’s leverage has increased from 1 to 2, i.e.,1/0.50=2. T he leverage is higher in this case than

in the previous example of the long position. T his is because the full value of the securities is

borrowed in creating a short position. Leverage is intrinsic in the short position but is a choice in the

long position. T he firm only borrows half of the balance of the stock in the long position, making the

leverage 1.5. On the contrary, the entire stock position must be borrowed to execute the short in

this case.

Short positions reduce risk if there are long positions with which there is a positive correlation or

other short positions with which they have a negative correlation. If the short position takes part in

hedging a portfolio, the leverage overstates the overall risk since short positions increase leverage,

but reduce market risk. T his reduces the benefits of the short positions. T his leads to contrast

between gross and net l everage. Gross leverage is the proportion of all the assets, including cash

generated by short sales, divided by capital. On the other hand, net leverage is the ratio of the

difference between the long and short positions by capital.

Derivatives and Leverage

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T rading in derivatives involves exposure to an asset or a risk factor without buying or selling it

outright. Since derivatives have a substantial impact on returns, they are included in the economic

balance sheet by finding cash equivalent market value for each one of the derivatives.

Different types of derivatives have different uses and thus very different impact on leverage.

Futures, forwards, and swaps are linear and have symmetric underlying asset price and can be hedged

statically. T hey have a zero NPV at the initiation. T herefore, their cash-equivalent market value can

be represented on an economic balance sheet by the market value of the underlying asset, instead of

the NPV.

On the other hand, options have a nonlinear relationship to the underlying asset price and thus should

be hedged dynamically. Contrary to futures, forwards, and swaps, options have a non-zero NPV at the

initiation. T his is because the value is decomposed into an intrinsic value, which is zero and a time

value that is likely non-zero. T he cash-equivalent market value of options can be represented on an

economic balance sheet by their delta equivalents rather than their market values.

Example: Derivatives and leverage

Suppose that a firm has a hedge fund account with $200 in cash, corresponding to an initial

investment of $200 in equity by investors. T he firm adds the following:

A long one-month euro-denominated bank deposit with an underlying index value of $200, financed by

borrowing $200 for one month. Assume that the one-month forward exchange rate is $1.25 per euro.

Note that $200 equivalent to a $160 bank deposit.

An equity option, with a delta of 50%, which is equivalent to buying $50 worth of the S&P 500 index

with a broker loan of $100:

A short equity position expressed via a three-month equity total return swap (T RS). T he firm pays

the total return on the $200 market value of XYZ Ltd. Stocks and a short rebate or cost of borrowing

XYZ Ltd. stock. If the market price of XYZ Ltd. is $200, we have:

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 Assets Amount($)
Amount due from broker 200
(proceeds from the short sale)
Liabilities and Equity

Borrowed XYZ stock 200

Finally, short protection on XYZ Ltd. via a five year credit default swap (CDS). T he notional amount

of $200. T his position is equal to a long position in a par-value 5-year floating rate note (FRN)

financed with a term loan.

We assume that the counterparty is the same for all positions, i.e., the prime broker or broker-

dealer with which they are executed. Assuming there is no margin, the firm’s combined economic

balance sheet that includes all of the derivatives positions is:

Assets Amount($)
Cash 100
Amount due from broker 300
margin 100
Short sale proceeds 200
Bank deposit (Euro 160) 200
long S&P 500 position 100
XYZ FRN 200
Total Assets 900
Equity and Liabilities
Equity 200
Short-term broker loan 300
Term loan 200
Borrowed stock 200
Total equity and liabilities 900

From the above balance sheet, we can compute the leverage of the long positions of the fund as
900
200
= 4.5. Additionally, it has attained a short position with a magnitude equal to the NAV. It has thus

acquired economic exposure to securities valued at $900, using only $100 in cash.

Computing leverage is sophisticated when derivatives are used. Also, correctly interpreting leverage

is essential since the risk may be reduced if short positions are used to hedge. For example, interest

rate risks can be hedged precisely. However, the positions are of the same magnitude as the

underlying assets. If the positions are carried on the economic balance sheet, leverage will be

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overstated and other material risks in the portfolio may be ignored.

Methods for Measuring and Managing Funding Liquidity Risk

and Transaction Liquidity Risk

We say that a given asset is liquid if it resembles money in that it can be exchanged for other goods

and assets immediately and at a particular value. Money is a liquid asset. On the other hand, non-

money assets have to be liquidated before they can be exchanged for other assets as we do not live

in a barter trade economy. However, liquidating no money assets takes some time and the sale

proceeds are uncertain to some extent.

T ransactions liquidity refers to the ability to buy or sell an asset without moving its price. When an

order to buy an asset is large, it causes a substantial short-term imbalance between the demand and

supply of the asset leading to price changes. T his causes a lack of market liquidity implying that a

market participant may be locked into a losing position.

Causes of Transactions Liquidity Risk

T ransaction liquidity risk is due to costs, including the cost of searching for a counterparty, market

institutions that assist in the search, and inducing someone else to hold a position. T hese market

microstructure fundamentals can be classified as follows:

Trade processi ng costs: T hese are costs associated with finding a counterparty on time.

Although these costs may form a significant part of the transaction costs, it is unlikely to

increase the liquidity risk unless the trading system gets affected either by human-made

circumstances.

Inventory management of the deal ers: Dealers provide trade immediacy to other

market participants. T herefore, dealers must hold short or long inventories of assets.

Holding inventories exposes dealers to price risk and thus requires compensation. T his

risk is a volatility exposure and is analogous to short-term option risk.

Adverse sel ecti on: A dealer is compensated by bid-ask spread for the risk of dealing with

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 uninformed vs. well-informed traders.

Di fferences of opi ni on: When market participants (investors) agree on the correct

price or and about how to interpret new information about specific assets, it becomes

more difficult to find a counterparty relative to when the investors disagree.

Different market organizations have different microstructure fundamentals. For example, in a quote-

driven system, typically found in OT C markets, certain intermediaries are obliged to post two-way

prices publicly and to buy or sell the asset at those prices within known transaction size limits.

T hese intermediaries must hold long or short inventories of the asset and trade heavily to

redistribute inventories of securities and thus ultimately reduce them. On the contrary, order-driven

systems, typically found on regulated exchanges, are more similar to a perfectly competitive auction

model. Usually, the best bids and offers are matched, where possible, throughout the trading session.

Characteristics of Market Liquidity

To better understand the causes of illiquidity, we look at the primary characteristics of asset liquidity

used to measure market liquidity.

Ti ghtness: T his refers to the cost of a round-trip transaction, measured by the bid-ask

spread and brokers’ commissions. T he smaller the spread, the tighter it is, and thus the

higher the liquidity.

Depth: Depth describes how large a transaction it takes to move the market significantly.

If a large institution sells, it is most likely to impact the price adversely.

Resi l i ency: It refers to the length of time it takes a lumpy order to move the market

away from the equilibrium price. In other words, it refers to the ability of the market to

bounce back from temporary incorrect prices.

Both depth and resiliency affect the immediacy of a market participant to execute a transaction.

Illiquidity manifests itself in observable hard-to-measure ways such as the bid-ask spread, which

introduces liquidity risk when it fluctuates. Moreover, adverse price impact is the impact on the

equilibrium price of the trader’s activity. Finally, slippage is the deterioration in the market price

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triggered by the amount of time it takes to get a trade done. If the market is trending, it can go against

the trader, even if the order is not large enough to influence the market.

In summary, we need to focus on the fluctuation of the bid-ask spread, the trader’s actions impact the

price of the asset, and deterioration of the asset price by the time trade happens. Liquidity risk is

complicated to measure. However, since the 2007-2009 financial crisis, more attention is being paid

to measuring liquidity risks in a firm.

Expected Transactions Cost and the Spread Risk Factor

Daily changes in the bid-ask spread can be assumed to follow a normal distribution with a mean of

zero and a constant variance. T he zero-mean assumption is unobjectionable since bid-ask spreads

cannot rise indefinitely or shrink to 0. T he expected transactions cost is half-spread which is

expressed as follows:

s̄
E(P t+1)
2

Where:

P= asset midprice

2(Ask price − Bid price) Ask price − Bid price

s= =
Ask price + Bid price Midprice

s̄= Estimate of the expected Bid-ask spread

P = Asset midprice.

Following the zero mean normality assumption, s = s̄. T he 99% confidence interval on transaction

cost in dollars is then:

1
±P × (s + 2.33σs )
2

Where

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P = estimate of the following day asset midprice, typically set to P, which is utmost price

observation

ask price-bid price

s = expected bid-ask spread calculated as: midprice

σs = sample standard deviation of the spread

1
T he (s + 2.33σs ) component is known as the 99% spread risk factor.
2

Example: Calculating Transactions Cost

XYZ Ltd. traded at an ask price of $150 and a bid price of $149. T he standard deviation (sample) of

the spread is 0.0003. Calculate the expected transaction cost and the 99% spread risk factor for a

transaction.

Solution

150 + 149
Midprice (P) = = 149.50
2

150 − 149
s= = 0.00669
149.5

1
T ransactions cost = 149.50 × (0.00669 + 2.33(0.0003)) = 0.55225
2

1
99% spread risk factor = (0.00669 + 2.33(0.0003)) = 0.003694
2

Measuring the Risk of Adverse Price Impact

Li qui di ty-adj usted VaR is a tool used to measure the risk of adverse price impact. T he trader

begins by estimating the number of trading days (T ) required for the orderly liquidation of a position.

Assuming the position can be divided into equal parts across the number of trading days and liquidated

at the end of the trading day, a trader would face a 1-day holding period on the entire position, a 2-day
T−1 T−4
holding period on a fraction of the position, a 5-day holding period on a fraction of the
T T

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position, and so on.

T he VaR of the 1-day position adjusted by the square root of time is estimated for a given position as:

VaR t × √T

However, the above formula lead to an overstated VaR; the VaR has to be higher than the one-day

position VaR, but less than the one-day position VaR × √T to adjust to the fact that the position could

be liquidated over days, the following formula can be used:

(1 + T )(1 + 2T )
VaR t × ⎷
6T

For example, if the trader estimates that the position can be liquidated in six trading days (T = 6), the

adjustment to the overnight VaR of the position is 1.5899, which means that the trader should

increase VaR by 59%. T his is higher than the initial 1-day VaR but less than the 1-day VaR adjusted by

the square root of T.

Interactions between Various Types of Liquidity Risk and

Impact on Systemic Risk

As discussed in the previous sections, liquidity has two essential forms of risk. Transacti ons (or

mark et) l i qui di ty ri sk is the risk of buying or selling the asset that results in an adverse price

movement. On the other hand, fundi ng l i qui di ty ri sk (balance sheet ri sk ) occurs when a

borrower’s credit position is deteriorating or perceived by market participants to be deteriorating.

Systemic risk is the risk of failure of the entire financial system due to heavy financial stress.

Different types of liquidity risks are interrelated, and this accelerates problems. For example, if a

counterparty increases collateral requirements, the investor may have to unwind it before the full

realization of the expected return. Reducing the trade horizon causes deterioration of funding

liquidity, which increases the transaction liquidity risk.

A key mechanism that links funding and transaction liquidity is leverage. An investor with a long

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position may be forced to sell an asset if it can no longer fetch funding. T his, in turn, decreases the

number of potential asset holders, leading to a reduction in asset valuation. T his depresses the asset

price, regardless of its expected future cash flows. T his decline can be temporary; however, if the

length of the depressed asset price is long, it can adversely impact the solvency of the investor who

initially purchased the asset

A rapid deleveraging of assets causes a “debt-deflation crisis.” T ransactions liquidity could also

constrain funding liquidity. For example, if a hedge fund is facing redemptions, it is forced to raise

cash by selling assets and, therefore, must decide which assets to sell first. T he fundamental trade-

off is that by selling the most liquid assets first, the investor incurs the smallest adverse impact.

However, he/she is left with a more illiquid portfolio with which to face any continuing funding

liquidity pressure. If instead, he sells illiquid assets first, the realized losses increase the real or

perceived risk of insolvency, and may, therefore, worsen the funding liquidity pressure.

T he level of economy-wide liquidity directly impacts the level of systemic risk. When market

conditions deteriorate, liquidity tends to become constrained when investors need it the most.

Problems in payments, clearing, and settlement systems are some of the channels through which

liquidity risk events can become systemic risk events. Severe stress to the financial system would

affect investors simultaneously, suggesting that the illiquidity of one counterparty may have an

economic domino effect on other investors throughout the system.

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Practice Question

T he two types of quantitative liquidity risk measures primarily focus on the available

data that is pertinent to liquidity risk. Which of the following is NOT a type of available

data which are pertinent to liquidity risk?

A. Bid-ask data

B. T ransaction or turnover volume data

C. Position data

D. Data on the size outstanding of securities issues

T he correct answer is C.

T here are different types of transactions liquidity risk measures:

i. T ransaction or turnover volume data;

ii. Bid-ask data; and

iii. Data on the size outstanding of securities issues.

Position data must be verified for it to match the books and records, and it may be

collected from most trading systems and across various geographical locations. However,

this data is not pertinent to liquidity risk.

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 Reading 125: Early Warning Indicators

After compl eti ng thi s readi ng, you shoul d be abl e to:

Evaluate the characteristics of sound Early Warning Indicators (EWI) measures.

Identify EWI guidelines from banking regulators and supervisors (OCC, BCBS, Federal

Reserve).

Discuss the applications of EWIs in the context of the liquidity risk management process.

Characteristics of Early Warning Indicators (EWI) Measures

Internally-focused early warning indicators (EWIs) provide insights on the liquidity profile and health

of a firm. T hese measures are crucial in understanding how the firm’s liquidity position could be

fluctuating over time and the types of vulnerabilities that may emerge due to business and strategic

decisions.

Liquidity risk managers are responsible for identifying and managing underlying liquidity risk factors.

T hey play an integral part in liquidity risk management. Negative trends serve as early indicators that

call for an assessment and a possible response by management to mitigate a firm’s exposure to any

emerging risk.

Since EWIs aid in managing risk, liquidity risk managers should ensure the quality and timelessness of

the data that feeds into EWIs. A relevant and reliable EWI list alerts top management during or ahead

of a crisis. Additionally, it complements the overall risk management capabilities of the institution

For example, management should notice when the bank’s liquidity coverage ratio (LCR) has dropped

below a specified threshold. Additionally, a dramatic increase in call center volumes may portend a

shift in the bank’s liquidity position.

EWIs should be forward-looking, selected to furnish a mix of business-as-usual (BAU), and stressed

environment information. Besides, they should be assessed against limits at predetermined intervals

say, daily, weekly, monthly. Continued deterioration in a single or combined set of EWIs should trigger

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the firm’s emergency response tools, such as the contingency funding plan.

T he Basel Committee on Banking Supervision (BCBS) provided its “Principles of Sound Liquidity

Management and Supervision” (Sound Principles) in September 2008, following the global financial

crisis of 2007-2008. T he following is a non-exhaustive list of EWIs recommended by the BCBS.

Rapid asset growth, especially when funded with probable volatile liabilities

Growing concentrations in assets or liabilities

Increases in currency mismatches

Decrease of the weighted average maturity of liabilities

Recurring incidents of positions approaching or breaching internal or regulatory limits

Negative trends associated with a particular product line

Significant deterioration in the bank’s financial condition

Negative publicity Credit rating downgrade

Stock price declines

Rising debt costs

Widening debt/credit-default-swap spreads

Rising wholesale/retail funding costs

Counterparties requesting additional collateral or resisting entering into new transactions

Drop-in credit lines

Increasing retail deposit outflows

Increasing redemptions of CDs before maturity

Difficulty accessing longer-term funding

Difficulty placing short-term liabilities

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EWI Guidelines from Banking Regulators and Supervisors
(OCC, BCBS, Federal Reserve)

EWIs must align to and be a natural extension of the enterprise liquidity risk management (LRM)

framework. For a bank to adequately capture the banking organization’s exposures, activities, and

risks, the Federal Reserve Board Supervisory Letter (FRB SR) 12-7 requires the bank’s LRM

framework to be end-to-end.

T he following figure summarizes fundamental supervisory guidelines, which should act as one of the

core guiding principles for EWI selection and monitoring at a bank.

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OCC − 2012 2 BCBS − 2008 3 BCBS − 2012 4 SR10 − 6 5
A bank should design Intraday liquidity Institution management
A bank should have
EWIs that signal a set of indicators monitoring indicators should monitor
to pinpoint the emergence include: Daily potential liquidity
whether embedded
triggers in certain of an increased risk maximum liquidity stress events by
of exposure in its requirement using early-warning
products (i.e., call-able
liquidity risk position or indicators and event
public debt, OTC
potential funding needs. triggers. The
derivatives transactions)
are about to be institution should
breached, or whether also tailor these
contingent risks are indicators to its
likely to materialize. specific liquidity
risk profile.
Early recognition of a Early warning Daily maximum
liquidity requirement Early recognition of
potential event indicators can be potential events
allows a bank to quantitative or creates an allowance
enhance a bank’s qualitative and may for the institution
readiness. EWI’s include but are to position itself
may include: not limited to: into progressive
states of readiness
as the event unfolds
while providing a
framework to report
or communicate within
the institution and
to outside parties.
A reluctance of Rapid asset growth, Available intraday Early-warning signals
traditional fund primarily when funded liquidity include, but are
providers to continue with possible volatile not limited to:
funding at historic liabilities
levels
Pending regulatory Growing concentrations Total payments Negative publicity
action (both formal in assets or regarding an asset
and informal) or liabilities class owned by
CAMELS component or the institution
composite rating
downgrade(s)
Widening of spreads Increases in currency Time-specific and Increased likelihood
on senior and mismatches other critical of deterioration in
subordinated debts, obligations the institution’s
credit default swaps, financial condition
and stock price of off-balance-sheet
declines items
Difficulty in accessing Decrease of weighted Value of customer Widening debt or
long-term debt average maturity of payments instead credit default swap
markets liabilities. of financial institutions spreads
customers
Rising funding costs Repeated incidents of Intraday credit lines Increased concerns
in an otherwise the positions approaching expanded to financial over the funding
stable market or breaching internal institution customers
or regulatory limits
Counterparty resistance Negative trends or Timing of intraday
increased risk associated payments
to off-balance
sheet products with a product
or increased margin line
requirements
The elimination of Intraday throughput
committed credit lines
by counterparties

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2OCC: Liquidity booklet of the OCC’s Comptroller’s Handbook (2012)

3BCBS: Basel Committee on Banking Supervision, “Principles for Sound Liquidity Risk Management

and Supervision” (2008)

4BCBS: Basel Committee on Banking Supervision, “Monitoring Indicators for Intraday Liquidity”

(2012)

5Interagency Policy Statement on Funding and Liquidity Risk Management (2010)

Applications of EWIs in the Context of Liquidity Risk

Management Process

T he EWI framework can be summarized as M.E.R.I.T. (Measures, Escalation, Reporting, Integrated

systems, and T hresholds).

1. Measures

To obtain a forward-looking view of liquidity risk, a bank must employ metrics that examine

the structure of the balance sheet in addition to metrics that (b) project cash flows and

future liquidity positions, taking into account (c) off-balance sheet risks. T hese measures

must span vulnerabilities across normal and stressed conditions over various time horizons.

I. Forward-looking bias/view

For prudent risk management, a firm requires these internal and external metrics.

T hese measures ideally need to be leading (forward-looking) and sharp (sufficiently

granular). A leading indicator provides information and signals possible stress before

the occurrence of an actual event. On the other hand, sharp indicators are signals

that do not go unnoticed within the mass of data. For example, detecting a drop in

overall deposit balances is an acceptable EWI. However, detecting drops in deposit

balances of more volatile segments, such as high-net-worth customers or rate-

sensitive products balances, brings into focus that certain crucial classes of

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customers are leaving the bank.

EWIs that is both forward-looking and sharp gives management more time to take

mitigating actions. Additionally, it helps to ensure that managers have a better

understanding of risk drivers and trends than broad, lagging indicators may otherwise

provide.

Liquidity events can start either within a bank or may be influenced by external

elements triggered by the environment in which the bank is set up. EWIs should be

positioned to capture emerging internally-driven stress events before becoming

public knowledge, for example, through monitoring of loan performance, planned

significant accounting adjustments, and operational losses.

Alternatively, a systemic crisis such as a sovereign default or banking system crisis

may trigger liquidity dislocations in parts of the financial market system, disrupting

the funding of any institutions that are exposed to those markets. T he following

figure shows EWI dimensions.

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II. Environments, Both Normal and Stressed

EWIs provide signals for a potential future disaster. It is essential to track

appropriate EWI metrics during a business as a usual environment as any

deterioration in these metrics will alert the bank’s leadership of weaknesses in the

bank’s balance sheet or of the emergence of challenging circumstances in the

markets that the bank operates within.

Including stressed measures and limits into institutions’ EWI lists aids to gauge the

adequacy of the firm’s liquidity buffer for a stressed environment. Finally, stress

testing results may expose previously unidentified or emerging concentrations and

risks that could threaten the viability of the institution.

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 III. Spanning Various T ime Horizon

EWI coverage must reflect various time horizons to match the institution’s unique

balance sheet needs, including the market and economic conditions under which it

operates, the time horizons that match banking forecasts and business operations

can be daily, weekly, or monthly. EWIs may even be monitored on an intraday basis,

as warranted by business conditions or required by regulators.

2. Escalation

Leading firms select and gauge EWIs to transmit meaningful signals to management about the

need for corrective action in light of impending firm-specific distress.

Once an EWI registers a change in status, a robust and well-established escalation process

aids in ensuring that the management reviews the trends to understand the cause better,

identify the potential impacts of evolving business dynamics, and take appropriate measures.

T he firm’s selection of EWIs and their calibration should be reviewed to reflect any changes

to business mix and activities and the changing nature of the macroeconomic and market

environments.

3. Reporting

T he EWI dashboard should be reported daily to provide managers with adequate time to make

adjustments in response to potential crises. Companies with substantial trading focus use

intraday reporting because they are more exposed to external market conditions. Reporting

should be broad enough to provide comprehensive coverage. Additionally, it should be

specific enough to communicate vital information.

4. Integrated Systems

Integrated data and systems provide liquidity managers with the ability to ensure that

reported metrics are accurate and in sync with each other. Automation and integration are

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 crucial as EWI frameworks supplement traditional market-based metrics with a vast array of

internal indicators.

5. Thresholds

T ypically, firms employ the stoplight system to represent and communicate their

performance against the thresholds of their EWIs. A green indicator implies that the

measure is within the normal range. An amber measure should be investigated further while

a red indicator should be an alarm to a significant concern and may warrant an immediate

response. Furthermore, the threshold boundaries for which an EWI moves from green to

amber should not be so broad that movements go undetected, and the metric continually

indicates that the economic and internal environments are healthy.

Industry Practices

Firms, particularly banks, have increased the attention and resources for developing and maintaining

EWI dashboards and their overarching governance. T his can be massively attributed to demands from

supervisory bodies in the form of matters requiring attention (MRAs). In some instances, the firm’s

leadership self-initiatives should be given credit to enhance its liquidity management and solidify risk

reporting.

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Practice Question

You are a financial risk manager at Stanlab Bank. Your supervisor asks you to prepare a

list of early warning indicators for liquidity problems for the bank. Which of the

following is an i naccurate early warning indicator of a potential liquidity problem?

A. Rapid asset growth, primarily when funded with probable volatile liabilities

B. Increase of weighted average maturity of liabilities

C. Significant deterioration in the bank’s financial condition

D. Counterparties requesting additional collateral or resisting entering into new

transactions

T he correct answer is B.

It is the decrease of the weighted average maturity of liabilities that is an early warning

indicator of a potential liquidity problem.

Options A, C, and D are EWIs as recommended by the Basel Committee on Banking

Supervision (BCBS).

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 Reading 126: The Investment Function in Financial Services
Management

After compl eti ng thi s readi ng, you shoul d be abl e to:

Compare various money market and capital market instruments and discuss their

advantages and disadvantages.

Identify and discuss various factors that affect the choice of investment securities by a

bank.

Apply investment maturity strategies and maturity management tools based on the yield

curve and duration.

Money Market and Capital Market Instruments

Nature and Functions of Investments

T he primary function of banks is not to buy and sell bonds but issuing loans. However, most loans are

illiquid as they cannot be readily sold before maturity in case of an emergency. Moreover, loans are

hazardous because of high customer default rates. Besides, for small and medium-sized depository

institutions, loans come majorly from the local area. T his implies that a substantial drop in local

economic activities may weaken the quality of the average lender’s loan portfolio.

Most depository organizations, as well as other nonbank financial service providers such as

insurance companies, pension funds, and mutual funds, invest a significant proportion of their asset

portfolios in securities that are managed by investment officers. T hese investment securities

include government bonds and notes, commercial paper, asset-backed securities arising from lending

activity, domestic and Euro currency deposits, and certain kinds of common and preferred stock.

Investment portfolios play an essential role in the balance sheets of many financial institutions, as

shown in the figure below.

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Investment Securities Available

Financial instruments differ in terms of expected yield, risk, sensitivity to inflation, and sensitivity to

shifting government policies and economic conditions. Financial instruments are split into two

categories:

Money market instruments; and

Capital market instruments.

Money market instruments are low-risk and readily marketable securities which have a maturity

term of one year, whereas capital market instruments have a higher expected rate of return and

capital gains potential with a maturity term of beyond one year.

Popular Money Market Investment Instruments

a. Treasury Bills

U.S. T reasury bill is a debt obligation of the United States government that should mature in

one year following the date of the issue. T-bills are issued in weekly or monthly auctions, and

their high degree of security makes them very attractive. Moreover, they have relatively

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 stable market prices and a ready market. Since T-bills are issued and traded at a discount

from their par (face) value, the investor’s return solely consists of price appreciation as the

bill approaches maturity.

Key advantages

A high degree of security

High liquidity

Serve as good collateral for borrowing

T heir market prices are relatively stable

T hey are readily marketable.

Can pledge behind government deposits

Key disadvantages

T-bills have low yields relative to other financial instruments

Income earned from investing in T-bills is taxable

b. Short-Term Treasury Notes and Bonds

Treasury notes have a relatively long original maturity of 1 to 10 years, whereas treasury

bonds have a maturity term of over 10 years. T hese securities are considered money market

instruments when they have a maturity term of within one year.

Key advantages

Similar to T-bills, they are safe securities and serve as good collateral for borrowing.

However, they offer yields usually higher than T-bills. Additionally, they have a good resale

market.

Key disadvantages

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 Short-term treasury notes and bonds are more sensitive to interest rate risk and less

marketable than T-bills. Moreover, capital gains and income are subject to tax.

c. Federal Agency Securities

T hese are marketable notes and bonds sold by agencies owned by or sponsored by the

federal government. T hey include securities issued by the Federal National Mortgage

Association (Fannie Mae), the Farm Credit System (FCS), the Federal Land Banks (FLBs), and

the Federal Home Loan Mortgage Corporation (Freddie Mac).

Key advantages

Federal agency securities are secure, have a good to the average resale market, and serve as

good collateral for borrowing. Besides, they have higher yields than U.S. government

securities.

Key disadvantages

Similar to short-term treasury notes and bonds, capital gains and income generated from

federal agency securities is subject to tax. However, they are less marketable than T reasury

securities.

d. Certificates of Deposit

A certificate of deposit is short-term security, which has a fixed interest rate and maturity

date issued by a depository institution such as a bank to raise funds from the secondary

money market. T hese securities carry a fixed term and a penalty for default.

Key advantages

Certificates of deposit (CD) are insured to at least $100,000. Furthermore, the yields are

higher than that of T-bills. Finally, security dealers provide a secondary market for large

denominations of CDs.

Key disadvantages

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 Longer-term CDs have a limited resale market. Further, the income generated is taxable.

e. International Eurocurrency Deposits

T hese are typically short-term, fixed maturity deposits issued in million-dollar units by the

world’s largest banks headquartered in financial centers around the globe (not necessarily in

Europe).

Key advantages

T hese are low-risk securities with higher relative to many domestic CDs.

Key disadvantages

International euro currency deposits have volatile interest rates and a taxable income.

f. Bankers’ Acceptances

T hese are money market instruments that represent a bank’s promise to pay the holder a

specified amount of money on a specified future date. T hey are among the most secure

securities. A financial firm may decide to guarantee the credit of one of its customers who is

exporting, importing, or storing goods or purchasing currency. T he institution issuing the

credit guarantee agrees to be the primary obligor. It is committed to paying off a customer’s

debt in return for a fee.

Key advantages

Bank acceptances have a low risk due to multiple credit guarantees.

Key disadvantages

T hese securities have limited availability at specific maturities. Moreover, they are issued in

odd denominations besides having taxable income.

g. Commercial Paper

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 T his is a short-term debt instrument that is unsecured. A financial firm issues it, typically for

the financing of accounts payable and inventories and meeting short-term liabilities. T he

commercial paper sold in the United States is of relatively short maturity—with most of it

maturing in 90 days or less—and generally is issued by borrowers with the highest credit

ratings.

Key advantages

Commercial paper is associated with low risk because it is always issued to borrowers with

the highest credit rating.

Key disadvantage

Commercial paper experience market volatility, have a poor resale market, and the income

earned is subject to tax.

h. Short-Term Municipal Obligations

T hese are a variety of short-term debt instruments issued by state and local governments to

cover temporary shortages.

Key advantages

Municipal notes and bonds enjoy a tax-exempt interest income.

Key disadvantages

T hese securities have a limited resale market as well as taxable capital gains.

Popular Capital Market Investment Instruments

a. Treasury Notes and Bonds

T-notes are investment instruments available in a wide variety of maturities ranging from 1

year to 10 years when issued and in large volumes. On the other hand, T-bonds, with original

maturities of more than 10 years, are traded in a more limited market with wider price

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 fluctuations. Both securities carry higher expected returns than T-bills. However, they

present an investing institution with higher prices and liquidity risk.

Key advantages

T hese securities are secure, have a good resale market, serve as good collateral for

borrowing, and may be pledged behind government bonds.

Key disadvantages

T reasury notes and bonds are low yielding relative to long-term private securities.

Moreover, capital gains and income are taxable. T here is also a limited supply of longest-term

issues.

b. Municipal Notes and Bonds

T hese are long-term debt obligations issued by states, cities, and other local governmental

units. Interest earned on these notes and bonds is exempt from U.S. federal income tax

provided that they are issued to fund public projects.

Key advantages

Interest on the majority of these bonds is exempt from U.S. federal income tax provided

they are issued to fund public, not private, projects.

Municipal notes and bonds are secure because they purchase municipals from security

dealers if their credit ratings are high.

Key disadvantages

Capital gains on municipals are fully taxable. Additionally, they are often not very liquid—

relatively few issues trade on any given day.

c. Corporate Notes and Bonds

Corporate notes are long-term debt securities with a maturity term of within five years

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 issued by corporations. T hey are referred to as corporate bonds when they carry longer

maturities. T heir varieties depend on the types of security pledged, purpose, and terms of

issue.

Key advantages

Corporate notes and bonds generally are more attractive to insurance companies and pension

funds than to banks because of their higher credit risk. Moreover, they usually offer

significantly higher yields than government securities.

Key disadvantages

T hey have a limited resale market. Further, their yield spread over governments widens

when investors become more concerned about credit quality and economic downturns.

Investment Instruments Developed More Recently

a. Structured Note

T his is a debt security issued by financial firms. Its return depends on equity indexes,

interest rates, commodities, or foreign currencies. T hese notes are complicated, thus

resulting in substantial losses for some investing institutions, especially where interest rate

risk is rising.

Key advantages

Coupons may be adjustable to reflect changes in interest rates in the future.

Key disadvantages

T hey are more complex than bonds and the potential for large losses exists.

b. Securitized Assets

Securitization is the procedure of pooling diverse types of contractual debt such as

residential mortgages and commercial mortgages and selling their related cash flows to third-

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 party investors as securities. T hese securities are described as pass-through securities,

collateralized mortgage obligations (CMOs), and mortgage-backed bonds. Repayment to

investors is obtained from the principal, and interest cash flows from the underlying debt.

T he repayments are redistributed via the capital structure of the new financing.

Securities backed by mortgage receivables are known as mortgage-backed securities (MBS),

whereas those backed by other types of receivables are asset-backed securities (ABS).

Key advantages

Asset-backed securities have higher pretax yields than treasury securities. Moreover, they

serve as collateral for borrowing additional funds.

Key Disadvantages

T hey are less marketable and more unstable in price than government securities. Besides,

they carry substantial default risk and have taxable gains and income.

c. Stri pped Securi ti es

A stripped security is a claim against either the principal or interest payments associated

with debt security, such as a T reasury bond. Stripped securities are created by separating

the principal and interest payments from an underlying debt instrument and selling separate

claims to these two promised income streams. T hey offer interest-rate hedging possibilities

to help protect an investment portfolio against loss from interest-rate changes. Each

stripped security is sold at a discount from par, so the investor’s rate of return is based

solely on price appreciation.

Key advantages

Stripped securities offer interest-rate hedging possibilities to help protect an investment

portfolio against loss from interest-rate changes.

Key disadvantages

T hey are sensitive to price fluctuations.

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Factors Affecting the Choice of Investment Securities by a
Bank

Investment Securities Held by Banks

T here are a few types of investment securities that dominate bank investment portfolios. T hese

include:

U.S. government (especially treasury) securities.

Obligations of different federal agencies such as the Federal National Mortgage Association

(FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC).

State and local government obligations (municipal).

Nonmortgage-related asset-backed securities, for example, the obligations backed by credit

cards and automobile loans.

Equities (common and preferred stock).

Mortgage-loan-backed securities make up more than half of all U.S. bank investment holdings because

of their relatively higher yields. T he largest banks in the industry hold the highest concentration of

these mortgage-related instruments. T he smallest banks tend to invest more heavily in government

securities than larger banks as expected. T hese instruments are the lowest-risk securities. Since the

smallest banks tend to be more heavily exposed to the risk of loss from economic problems in their

local areas, they use lower-risk securities to offset the high risk often inherent in their loans.

On the other hand, the largest banks invest more heavily in foreign securities and private debt and

equity obligations, i.e., corporate bonds and commercial paper, all of which carry a higher exposure

to risk relative to government securities.

Overall, investment securities account for only about a fifth of total assets. However, this

proportion varies depending on the size and location of the bank. Banks located in areas with low loan

demands typically hold a substantial, more significant proportion of investment securities relative to

their total assets.

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Moreover, smaller size banks hold a higher proportion of investment securities while larger banks

hold a smaller proportion of their assets in investment securities, reflecting the relatively heavy loan

demand most large banks face. It is crucial to note that after loans, the most significant source of

revenue for most banks around the world is interest and dividends on investment securities.

Factors Affecting Choice of Investment Securities

When deciding on the investments to hold, investments managers must weigh multiple factors: (a)

the goal of the investment portfolio; (b) expected rates of return; (c) tax exposure; (d) risks

associated with changing market interest rates, with possible default by security issuers, with the

possible need for cash at any time, with the impact of inflation and business cycle upon the demand

for financial services, and with the prepayment of loans that can reduce expected returns. Here, we

discuss these factors in detail.

a. Expected Rate of Return

T he investment manager must determine the rate of return expected from investing in a

given security, expected interest payments, and potential capital gains or losses. T he

manager does this by calculating the yield to maturity (YT M) for a security to be held to

maturity or the holding period yield (HPY) between the point of purchase and the point of

sale.

T he yield to maturity formula determines the rate of discount (or yield) on a loan or security

that equities the market price of the loan or security with its expected stream of cash flows

(interest and principal). For example, suppose an investor wants to purchase an $800 par-

value treasury note that has a 6% coupon rate (i.e., 0.06×800=$48) and is expected to

mature in 6 years. If the current price of the T reasury note is $500, the yield to maturity is

determined as follows:

48 48 48 48
500 = + + +
(1 + YT M)1 (1 + YT M)2 (1 + YT M)3 (1 + YT M)4
48 (48 + 800)
+ +
(1 + YT M)5 (1 + YT M)6

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 Solving the above equation gives a YT M of 16.24%. T he YT M should be compared with the

expected yields on other loans and investments to determine the range of the best possible

return.

For investments that are not held to maturity, the investments manager should work out the

holding period yield (HPY). T he HPY refers to the rate of return (discount factor) that

makes a security’s purchase price equal to the stream of income expected until it is sold.

For example, suppose an investor wants to purchase an $800 par-value treasury note that

has a 6% coupon rate (i.e., 0.06×800=$48) and is expected to mature in 6 years. T he

current price of the T reasury note is $500. T he investor decides to sell the security at the

end of 3 years for $600 to another investor. Its holding period yield could be calculated as

follows:

48 48 (600 + 48))
500 = + +
(1 + HPY)1 (1 + HPY)2 (1 + HPY)3

In this case, the security’s HPY is 13.07%.

b. Tax Exposure

Interest and capital gains income from most investments are taxed as ordinary income for

tax purposes. Banks are focused more on the after-tax rate of return on loans and securities

than on their before-tax return because of their relatively high tax exposure. T his is

contrary to other institutions such as credit unions and mutual funds, which are tax-exempt.

Tax Status of the State and Local Government Bonds

Banks in the upper tax brackets, tax-exempt state and local government (municipal) bonds,

and notes can be attractive, depending on their status in tax law and market conditions. An

investments officer for a financial firm subject to the corporate income tax may compare

potential yields of different bonds using the formula:

After-tax gross yield = Before-tax gross yield × (1 − Firm's marginal income tax rate)

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For example, suppose that Aaa-rated corporate bonds have an average gross yield to maturity

of 6%, the prime rate on top-quality corporate loans is 5%, and Aaa-rated municipal bonds

have a 4.5% gross yield to maturity.

From the above formula, we can compare each of these potential yields, the expected after-

tax gross returns for a taxed financial firm in the top 35% federal income tax bracket is

computed as follows:

Aaa-rated corporate bonds: 6% × (1 − 0.35) = 3.9% .

Prime-rated loans: 5% × (1 − 0.35) = 3.3% .

Aaa-rated municipal bonds: 4.5% × (1 − 0) = 4.5% .

T he municipal bond is the most attractive investment in gross yield under the assumption

given.

Given municipal or tax-exempt security, an investment manager can calculate tax-equivalent

yield (T EY). T his measure indicates that the before-tax rate of return on a taxable

investment provides the investor with a similar after-tax return as a tax-exempt investment

would.

After-tax return on a tax-exempt investment

T EY =
(1 − Investing firm’s marginal tax rate)

In the above example, the Aaa-rated corporate bond and the prime-rated loans would have to

have a before-tax yield of 6.92% to match the Aaa-municipal bond’s after-tax yield of 4.50%.

The Impact of Changes in State Laws

Tax reforms have a significant effect on the relative attractiveness of state and local

government bonds as investments for banks. Since the federal tax reform legislation in the

United States, banks' share of the municipal market has fallen substantially due to:

Declining tax advantages.

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 Lower corporate tax rates.

Fewer qualified tax-exempt securities.

Bank qualified bonds

Bank-qualified bonds are those issued by smaller local governments, i.e., governments issuing

no more than $10 million of public securities per year. Banks buying bank-qualified bonds are

allowed to deduct 80% of any interest paid to fund these purchases. T his tax advantage is not

available for nonbank-qualified bonds.

Financial institutions evaluate the attractiveness of municipals by calculating the net after-

tax returns or tax-equivalent yields. T his enables comparisons with other investment

alternatives. T he net after-tax return of bank-qualified municipals is worked-out as follows:

Net after-tax return on municipals(%) =(Nominal return on municipals after taxes

(%) − Interest expense incurred
in acquiring the municipals(%)
+ Tax advantage of a qualified bond

Where:

Tax advantage of a qualified bond = T he bank’s marginal income tax rate(%)

× Percentage of interest expense
that is still tax deductible
× Interest expense acquiring the municipals(%)

The Tax Swapping Tool

In a tax swap, the lender sells lower-yielding securities at a loss to reduce its current taxable

income, while at the same time purchasing new higher-yielding securities to boost future

returns. T ypically, larger lending institutions are in the top income-tax bracket and have the

most to gain from security portfolio trades that minimize tax exposure.

The Portfolio Shifting Tool

Financial firms may shift their portfolios to substitute new, higher-yielding securities for old

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 security holdings whose yields may be below current market levels. T his may be to take

substantial short-run losses in return for the prospect of higher long-run profits.

c. Interest Rate Risk

Increasing interest rates have various effects, including lowering the market value of

previously issued bonds and notes and surging loan demand. T he longest-term issues

experience the most massive losses. Investment officers often find themselves purchasing

investment securities when interest rates and loan demand are decreasing. T herefore, the

prices investments officers must pay for desired investments are higher. Financial futures,

options, interest-rate swaps, gap management, and duration are some of the financial tools

used to hedge interest rate risk.

(c) Risk Associated with changing Market Interest Rates (d. to i.)
d. Credit/Default Risk

Credit risk refers to the risk that the other counterparty will default (i.e., fail to repay) on

its loan payments or meet contractual obligations. Credit risk has led to regulatory controls

that prohibit the acquisition of speculative securities. Speculative securities are those rated

below Baa by Moody’s or BBB on Standard & Poor’s bond-rating schedule and below BBB on

Fitch’s Rating Service as shown in the following figure:

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 Credit Moody’s Standard Fitch Inc.
Quality Rating and Ratings
of Securities Category Poor's Category
Rating
Category
Investment quality
or investment
grade/deemed
Best quality/
suitable for investment
smallest Aaa AAA AAA
by most banks
investment risk and other highly
regulated financial
institutions.
High grade or
Aa AA AA
high quality

Upper medium
A A A
grade

Medium grade Baa BBB BBB

Medium grade
and somehow Ba BB BB
speculative
Speculative quality
and junk bonds/deemed
Lower medium not suitable for banks
B B B
grade and other highly
regulated financial
institutions.
Poor standing/
Caa CCC CCC
may be in default

Speculative/often
Ca CC CC
in default

Lowest grades
speculative securities/ C C C
poor prospects
Defaulted and
bankrupt-company Bankrupt or defaulted
Not rated DDD RD security issuers
securities DD D
D

To protect depositors against excessive risk, U.S.

banks generally are allowed to buy only investment-
grade securities, rated at least Baa or BBB. Many
state and local governments seem to face an even
greater risk of loss because of factors like high

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 unemployment, depressed government revenues,
declining support from the federal government for
welfare programs, health services, and infrastructure
needs, higher energy costs, and strong taxpayer
resistance to higher taxes.
Credit options and swaps can be used to protect the expected yield on investment securities.

For example, investment officers may find another financial institution willing to swap an

uncertain return on securities held for a lower but more certain return based on a standard

reference rate, such as the market yield on T reasury bonds. Credit options also help to

hedge the value of a corporate bond, for example. If the bond issuer defaults, the option

holder receives a payoff from the credit option that at least partially offsets the loss.

Moreover, investment officers can also use credit options to protect the market value of a

bond in case its credit rating is lowered.

e. Business Risk

Business risk is the exposure of the economy of the market area in a firm that operates,

which may turn down, leading to falling sales and rising unemployment. T he business risk

may lead to a rise in delinquent loans as borrowers struggle to generate enough cash flow to

pay the lender. Out-of-market security purchases may be used to balance risk exposure in

the loan portfolio. For example, a bank located in Alaska may purchase a substantial quantity

of municipal bonds from cities and other local governments outside the Midwest (e.g., Los

Angeles or New York debt securities).

f. Liquidity Risk

Liquidity risk is the risk of losses due to the need to liquidate positions to meet funding

requirements. T his occurs when financial firms are forced to sell investment securities in

advance of their maturity due to liquidity needs. Liquid securities such as T reasury

securities, which are the most liquid, have a ready market, relatively stable price over time,

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 and a high probability of recovering the original amount invested.

Unfortunately, the purchase of a large volume of liquid securities tends to lower the average

yield from a financial institution’s earning assets and reduce its profitability. T herefore,

there is a trade-off between profitability and liquidity that must be reevaluated daily as

market interest rates and exposure to liquidity risk fluctuate.

g. Call Risk

Call risk refers to the risk that the issuer of callable bonds redeems them before their

maturity date. Callable bonds are related to call options, where the issuer has the right to

redeem (call) the bond before maturity. Since these calls typically occur when the interest

rates decline, meaning that the borrower can get lower interest costs, the institution

investing in such bonds faces the risk of earnings loss since it should reinvest its recovered

funds at lower interest rates. Call risk can be reduced by purchasing callable securities

bearing longer call deferments or only by avoiding the purchase of callable securities.

h. Prepayment Risk

As the name suggests, prepayment risk is the risk of early repayment of a loan by the

borrower. It is specific to asset-backed securities that arise since the realized interest and

principal payments from a pool of securitized loans may be different from the originally

expected cash flows.

Mortgage-backed securities are a class of securities where the underlying is a pool of

mortgages (home loans). In addition to the credit risk of a borrower defaulting on the loan,

mortgages also have prepayment risk because the borrower has the option to repay the loan

early (at any time), usually due to favorable interest rate changes. Investors in these

securities collect interest payments made by the underlying home loans. T herefore, when

the homeowners repay their loans earlier than expected, the investors face the risk of

lower interest payments obtained from the underlying home loans.

For example, suppose that a homeowner takes out a mortgage at an interest rate of 12%. At

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 the time of taking out a mortgage, the market interest rate was 12%. T wo years later, the

market interest rate is 9%. In this case, the lender faces prepayment risk on the mortgage

due to the change in market interest rates from 12% to 9%. Assuming that there is no

prepayment penalty, the homeowner has an incentive to refinance the mortgage from an

interest rate of 12% to an interest rate closer to the current market interest rate of 9%.

T herefore, the lender foregoes the interest payments (at the higher interest rate) that the

homeowner will have made over the life of the mortgage.

Prepayment risk in this case can be reduced by imposing prepayment penalties on

homeowners who repay their mortgage loans earlier than expected.

i. Inflation Risk

Rising prices of goods and services distort the purchasing power of interest income and

repaid principal from security or loan. Moreover, inflation can erode the stockholders’ net

worth.

Inflation risk can be mitigated by the use of short-term securities and those with variable

interest rates, which usually grant the investment officer greater flexibility in responding to

any flare-up in inflationary pressures. T reasury Inflation-Protected Securities are used to

hedge inflation risk in the United States. Both the coupon rate and the principal (face) value

of a T IPS are adjusted annually to match the fluctuations in the consumer price index.

Unfortunately, T IPS does not protect investors from all the effects of inflation, such as

moving into higher tax brackets. Moreover, they carry market risks like regular bonds but

tend to be less liquid.

j. Pledging Requirements

A Pledging requirement refers to any legal requirement for securities to be pledged as

collateral for specific deposits. Depository institutions, for example, in the United States,

reject deposits from federal, state, and local governments unless they post collateral, which

is acceptable to these governmental units.

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 State and local government deposit pledging requirements differ widely from state to state,

though most allow a combination of federal and municipal securities to meet government

pledging requirements

If a financial institution uses repurchase agreements (RPs) to raise money, it must pledge

some of its securities (usually T reasury and federal agency issues) as collateral to receive

funds at the lowest RP rate.

Investment Maturity Strategies

After the investment officer has chosen the types of securities the financial firm should hold, the

next step is to determine the maturities of the securities that the investing institution must hold.

T hese may either be short-term bills and notes, only long-term bonds, or a combination of the two.

Maturity distribution strategies that can be employed here include:

a. The Ladder, or Spaced-Maturity, Policy

Under this approach, the strategy is to divide the investment portfolio equally among all

maturities acceptable to the investing firm. Smaller institutions apply this approach.

T he advantages of the ladder method are that it reduces income fluctuations, requires little

expertise to carry out, and tends to build in investment flexibility. However, it fails to

maximize investment income.

For example, suppose the management decides to purchase bonds or notes with maturities

no longer than 5 years. It might then decide to invest 20% of the investment portfolio in

securities one year or less from maturity, another 20% in securities maturing within two

years but no less than one year, another 20% in the interval of two to three years, until the

five-year point is reached. T his can be demonstrated in the following chart.

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b. The Front-End Load Maturity Policy

T his strategy involves purchasing short-term securities only and placing all investments

within a short interval of time. T he method has the advantage of strengthening the liquidity

position of a financial institution and avoids significant capital losses in case of a rise in the

market interest rates.

For example, the investment officer may decide to invest 100% of the institution’s funds not

needed for loans or cash reserves in securities not more than 3 years from maturity.

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c. The Back-End Load Maturity Policy

T his approach stresses the investment portfolio as a source of income, and all security

investments are long term contrary to the front-end load maturity policy approach. An

investing firm following the back-end load approach might decide to invest only in bonds that

have a maturity range of 5-10 years. T his firm is most likely to rely heavily on borrowing in

the money market to help meet its liquidity requirements. T his strategy applies when the

interest rates are believed to increase. T he following chart illustrates the back-end load

maturity policy.

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d. The Barbell Strategy

T he barbell strategy is a combination of front-end and back-end load approaches, and smaller

financial firms often use it. T he investing institution places most of its funds in a short-term

portfolio of highly liquid securities at one extreme and in a long-term portfolio of bonds at

the other extreme, with minimal investment holdings in intermediate maturities. T his

strategy has the advantage of helping to meet liquidity needs with short-term securities and

to create income using the long-term portion of the portfolio.

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e. The Rate Expectations Approach

T he largest financial firms use this strategy. T he rate expectations approach continually

shifts maturities of securities in line with current forecasts of interest rates and the

economy. When interest rates are expected to rise, this strategy shifts the investments

towards the short end of the maturity spectrum and toward the long end when interest rates

are expected to fall. T his approach maximizes the potential for earnings. However, it raises

the specter of substantial losses. Moreover, it requires in-depth knowledge of market

forces, presents a higher risk if expectations turn out to be wrong, and carries higher

transaction costs because it may require frequent security trading and switching.

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Liquidity Management Tools

T he yield curve and duration are essential maturity tools that help the investment officer to

understand the consequences and potential impact upon earnings and risk from any particular

maturity mix of securities fully.

a. The Yield Curve

T he yield curve refers to a curve that demonstrates the relation between the interest rate

and the term to maturity. More specifically, it shows how market interest rates differ across

loans and securities of different terms to maturity. T he curve assumes that all the yields

(interest rates) included along the curve are measured at the same time. Additionally, all the

other rate-determining factors are held fixed.

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Forecasting Interest Rates and the Economy

T he yield curve acts as a guideline for other loans in the market, such as bank lending rates

or mortgage rates. Moreover, it is used to predict changes in economic output and growth.

Yield curve shapes have critical implications for the decisions an investment officer must

make.

Positively sloped yield curves imply that the future short-term interest rates are expected

to be higher than they are today.

Investors expect an upward movement in the interest rates; therefore, they shift their

investment holdings from longer-term securities, which are expected to incur capital losses

when market interest rates rise.

On the other hand, a downward-sloping yield curve implies that the investor expects a

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decline in the short-term interest rates in the period ahead. T herefore, he/she lengthens the

portfolio maturity because falling interest rates imply substantial capital gains income from

the longer-term investments.

Furthermore, yield curves give a clue about overpriced and underpriced securities. A

security whose yield lies above the yield curve implies that its price is too low with a

temporary high yield. Conversely, a security whose yield lies below the curve represents a

‘don’t buy’ situation because its yield is too low for its maturity, and thus its price is too high.

Yield curves rise in economic expansions and fall in recession. T herefore, they can be used

to determine the stage of the business cycle the economy presently occupies.

Risk-return Trade-offs

T he yield curve’s shape determines the additional yield the investments officer can earn by

replacing shorter-term securities with longer-term issues or vice versa. Longer-term

securities have higher price volatility relative to shorter-term securities; thus, an investor

must be willing to accept a higher risk of a capital loss for longer-term security if interest

rates rise.

Additionally, longer-term bonds have a thinner market when cash needs to be raised urgently,

leading to a liquidity crisis (cash-out) or capital losses if interest rates go in an unexpected

direction.

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Pursuing the Carry Trade

A carry trade is an investing strategy that entails borrowing short-term money (at a low-

interest rate) using the safest and most liquid investment securities in the firm’s portfolio as

collateral and then investing the borrowed funds in income-generating assets farther out

along the curve (provides a higher rate of return). T he difference between these two return

rates is called carry income and tends to be highest when the yield curve has an upward

slope, which is steep.

Riding the Yield Curve

T his is an investment strategy in which the investment firm buys a long-term bond and sells

it before maturity. Riding the yield curve allows the investing firm to profit from the

declining yield that occurs over the life of the bond. For example, the investment officer

identifies a situation in which some securities are soon to approach maturity, and their

prices have risen significantly while their yields to maturity have fallen.

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 If the yield curve’s slope is steep enough to cover transaction costs more than adequately,

the investing firm can sell those securities, reaping a capital gain due to the recent rise in

their prices, and reinvest the proceeds of that sale in longer-term securities carrying higher

rates of return. If this maneuver works (i.e., the slope of the yield curve does not fall), the

investing institution reaps both higher current income and greater future returns.

b. Duration

Duration is a present-value-weighted measure of the maturity of an individual security or

portfolio of securities. It measures the average amount of time needed for all of the cash

flows from a security to reach the investor who holds it. In other words, it measures a

security’s price sensitivity to interest rate changes.

A critical relationship exists between duration, market interest rates, and investment

security prices, as depicted in the following formula.

Change in interest rate)

Percentage change in price = −Duration ×
1 + ( m1 )(Initial rate)

Where m is the number of times in a year that the security pays interest. For example, if

bonds pay interest semiannually, m = 2.

Given an investment, the investment officer must decide how much chance there is that

market interest rates rise, whether this degree of price sensitivity is acceptable, and

whether other investments would better suit the institution’s current investment needs.

Immunization

Immunization is a risk-mitigating strategy that matches the duration of an investment’s assets

and liabilities. T his reduces an institution’s exposure to interest rate risk. It suggests a

formula for minimizing interest rate risk:

Duration of an individual security or a security portfolio = Length of the investor’s planned

holding period for a security or a security portfolio

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Portfolio immunization is a strategy that involves protecting securities purchased from loss

of return, no matter which way interest rates go. T he investment officer should focus on

the tradeoff between price risk and reinvestment risk in an investment portfolio.

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Practice Question

T he investment strategy that involves purchasing short-term securities only and placing

all investments within a short interval of time is known as?

A. T he ladder or spaced-maturity policy.

B. T he front-end load maturity policy.

C. T he back-end load maturity policy.

D. T he barbell investment portfolio strategy.

T he correct answer is B.

T he front-end load maturity policy involves purchasing short-term securities only and

placing all investments within a short interval of time. T he method has the advantage of

strengthening the liquidity position of a financial institution and avoids significant capital

losses in case of a rise in the market interest rates.

A i s i ncorrect. T he ladder or spaced-maturity policy entails dividing the investment

portfolio equally among all maturities acceptable to the investing firm.

C i s i ncorrect. T he back-end load maturity policy is an investment maturity strategy

that requires the bank to hold all its investment assets in long term maturities.

D i s i ncorrect. T he investment maturity strategy, which requires the bank to have one

half of its investment portfolio in short term assets and one half of its investment

portfolio in long term assets, is known as the barbell investment portfolio strategy.

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 Reading 127: Liquidity and Reserves Management: Strategies and
Policies

After compl eti ng thi s readi ng, you shoul d be abl e to:

Calculate a bank’s net liquidity position and explain factors that affect the supply and

demand for liquidity at a bank.

Compare the strategies that a bank can use to meet demands for additional liquidity.

Estimate a bank's liquidity needs through three methods (sources and uses of funds, the

structure of funds, and liquidity indicators).

Summarize the process taken by a US bank to calculate its legal reserves.

Differentiate between factors that affect the choice among alternative sources of

reserves.

Bank’s Net Liquidity Position and Factors Affecting the Supply

and Demand of Liquidity at a Bank

Financial institutions depend upon public confidence to survive and prosper. Additionally, liquidity can

quickly get distorted when the public loses its faith with one or more institutions.

The Demand for and Supply of Liquidity

Here, we discuss various activities that give rise to the demand for liquidity and the sources that can

be relied upon to supply liquidity.

For most financial firms, demand for liquidity come from a few primary sources:

Customers withdrawing money from their accounts;

Credit requests from customers the financial firm wishes to keep, either in the form of

new loan requests or drawings upon existing credit lines;

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 Paying off previous borrowings; and/or

Periodic payment of income taxes or cash dividends to stockholders.

Financial firms cover the demand for liquidity by drawing upon potential sources of supply:

Receipt of new customer deposits customers repaying their loans and from sales of assets,

especially marketable securities, from the investment portfolio;

Revenues (fee income) generated by selling non-deposit services; and/or

Borrowing in the money market.

T he combined sources of demand and supply determine a financial firm's net liquidity position at any

given time.

A financial firm’s net liquidity position = Supplies of liquidity flowing into the financial firm –

Demands on the financial firm for liquidity

T he following formula gives a financial firm's net liquidity position:

Net liquidity position = Incoming deposits (inflows) + Revenue from the sale of deposit services +

Customer loan repayments + Sales of assets + Borrowing from the money market – Deposit

withdrawals (outflow) – Volume of acceptable loan requests – Repayments of borrowings – Other

operating expenses – Dividend payments to stockholders.

A l i qui di ty defi ci t occurs when the demand for liquidity exceeds its supply. I.e., L t < 0. On the

other hand, l i qui di ty surpl us occurs when the supply for liquidity exceeds the demand for

liquidity, i.e., L t > 0. When there is a liquidity deficit, the management must decide when and where

to raise additional funds. Also, when there is a liquidity surplus, the management decides when and

where to invest surplus liquid funds until they are required to meet future cash needs and earn a

profit.

Example: Calculating the Net Liquidity Position for a Bank

Suppose that a bank has the following cash inflows and outflows during the coming week:

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 Cash Inflows Amount in Million Dollars
Customer loan repayment 123
Sales of bank assets 32
New deposits 683
Money-market borrowings 55
Non-deposit service fees 38
Total cash inflows 931

Cash Outflows Amount in Million Dollars

Deposit Withdrawals $61
Operating Expenses $68
New Loan Requests $307
Repayment of Previous Borrowings $32
Dividend to Stockholders $145
Total Cash Outflows $606

T he bank’s projected net liquidity position for the coming week is calculated as:

Net Liquidity Position Projected = Total cash inflows– Total cash outflows
= $931 − $606 = $318 million

T he management of liquidity is subject to the risks that interest rates changes (interest rate risk) and

that liquid funds are unavailable in the volume needed (availability risk).

A rise in the market interest rate causes a decline in the value of the assets that the financial

institution intends to sell to raise liquid funds. T hus, these assets are sold at a loss. T he losses

incurred reduces earnings and lead to fewer liquid funds raised from the sale of the assets.

Furthermore, raising liquid funds by borrowing costs more. T his is because as interest rates

increase, some forms of borrowed liquidity may no longer be available. If lenders perceive a financial

firm to be riskier than before, it is forced to pay higher interest rates to borrow liquidity.

Strategies for Liquidity Managers

Strategies that experienced liquidity managers have developed for dealing with liquidity problems

include:

i. Providing liquidity from assets (asset liquidity management)

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 ii. Depending on borrowed liquidity to meet cash demands (liability management)

iii. Balanced (asset and liability) liquidity management.

i. Asset Liquidity Management (or Asset Conversion) Strategies

T he asset conversion strategy entails storing liquidity in assets, mainly in cash and marketable

securities, so that when liquidity is needed, selected assets can be easily converted into cash to meet

all demands.

Characteristics of a liquid asset include:

It has a ready market, making it easily convertible into cash;

It has a reasonably stable price, implying that the market is deep enough to absorb the sale

without a substantial price decline regardless of the speed at which the asset is sold or the

size of the sale; and

It is reversible. T he seller can recover his/her original principal with little risk of loss.

Since every institution’s liquidity is influenced by demands for liquidity made against it, holding more

liquid assets does not necessarily make it a liquid institution. T he most popular liquid assets include

T reasury bills, federal fund loans, certificates of deposit, municipal bonds, federal agency securities,

and euro currency loans.

T his method has the advantage that smaller financial firms find it less risky for liquidity management

relative to borrowing. However, it is a costly approach. T here is an opportunity cost of storing

liquidity in assets when they must be sold. Moreover, transaction costs or commissions paid to

security brokers are involved. Furthermore, the assets in question may need to be sold in a market

experiencing declining prices and increasing risk. Finally, liquid assets generally carry the lowest

rates of return of all assets. Investing in liquid assets means forgoing higher returns on other assets

that might be acquired.

ii. Borrowed Liquidity (Liability) Management Strategies

A liability management (purchased liquidity) strategy is an approach extensively used by the largest

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firms, i.e., which often borrow close to 100% of their liquidity needs. It entails borrowing

immediately spendable funds to cover all anticipated demands for liquidity. T he number one advantage

of this approach is that it calls for borrowing funds only when the firm needs to contrast to storing

liquidity in assets where a storehouse of liquid assets should be held at all times, lowering potential

returns. It also allows the firm to leave the volume and asset composition of its portfolio the same if

it is satisfied with the assets it currently holds. However, liquidity management comes with an

interest rate offered to the borrowed funds. If the borrowing firm needs additional funds, it merely

raises the offer rate until it generates the required amount of funds. T he firm may lower its offer

rate if it requires few funds.

T he primary sources of borrowed liquidity for a depository institution include jumbo ($100,000+)

negotiable CDs, federal funds borrowings, repurchase agreements, Euro currency borrowings,

advances from the Federal Home Loan Banks, and borrowings at the discount window of the

country's central bank.

T his strategy offers the highest expected returns with more significant uncertainty.

iii. Balanced Liquidity Management Strategies

T he balanced liquidity management strategy entails combining both asset and liability management. It

entails storing a portion of the expected demands for liquidity in assets while backstopping other

anticipated liquidity needs by advance arrangements for lines of credit from potential suppliers of

funds. Near-term borrowings are used to meet unexpected cash needs, while short-term and medium-

term assets are used to meet longer-term liquidity needs. It must, therefore, raise funds from the

cheapest and most timely sources available.

Estimating Liquidity Needs

Four approaches are employed to estimate a financial firm's liquidity requirements. T hese include

(1) sources and uses of funds approach, (2) the structure of funds approach, (3) the liquidity indicator

approach, and (4) the market signals (or discipline) approach.

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1. The Sources and Uses of Funds Approach

T his approach rests on two simple facts;

For a depository institution, liquidity rises as deposits increase, and loans decrease; and

Liquidity decreases when deposits decrease, and loans increase.

A l i qui di ty gap arises when the sources and uses of liquidity do not match. A positive liquidity gap

(surplus) arises when the sources of liquidity exceed the uses of liquidity. On the other hand, a

negative liquidity gap (deficit) emerges when the uses exceed sources.

T he crucial steps for the sources and uses of funds approach for a bank are as follows:

1. Forecasting loans and deposits for a given planning period;

2. Calculating the estimated change in loans and deposits for the same period; and

3. Estimating the net liquid funds’ surplus or deficit for the planning period by comparing the

estimated change in loans (or other uses of funds) to the estimated change in deposits (or

other funds sources).

T he bank’s liquidity manager might prepare the following forecasting model:

T he estimated change in the total loans for the coming period is a function of:

Projected growth in the economy;

Projected quarterly corporate earnings;

T he current rate of growth in the money supply;

Projected prime loan rate or CD rate; and

T he estimated rate of inflation.

T he estimated change in total deposits for the coming period is a function of:

Projected growth in personal income in the economy;

T he estimated increase in retail sales;

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 T he current growth rate of the money supply;

T he projected yield on the money market deposits; and

T he estimated rate of inflation.

T he bank can then estimate its needs for liquidity by calculating;

Estimated liquidity deficit (-) or surplus (+) for the coming period
=Estimated change in deposits − Estimated change in loans

Future deposits (other fund sources) and loans (other fund uses) can also be calculated by dividing

the forecast of future deposit and loan growth into three components:

A trend component: estimated by constructing a trend (constant-growth) line using

reference points year-end, quarterly, or monthly deposit and loan totals established over a

base period sufficiently long to define a trend growth rate (at least 10 years).

A seasonal component: measuring how other funds sources and other funds use is

expected to look like in each week or month due to seasonal factors, relative to the most

recent year-end deposit or loan level. T he seasonal component compares the average level

of deposits and loans for each week over the past 10 years to the average level of deposits

and loans for the final week of December over the preceding 10 years.

A cycl i cal component: reflects the difference between expected deposit and loan levels

each week during the preceding year (measured by the trend and seasonal elements) and

the actual volume of total deposits and total loans the bank posted that week.

Example: The Sources and Uses of Funds Approach

A bank estimates its total deposits and loans for the next 6 months in millions of dollars to be as given

in the following table. Using the sources and uses of funds approach, we can establish when this bank

faces a liquidity deficit or surplus.

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 Month Estimated Total Deposits Estimated Total Loans
January $120 $100
February 136 $105
March 128 $114
April 156 $129
May 161 $116
June 145 $138

We focus ls on the liquidity deficit (-) and surplus (+) as follows:

Month Estimated Deposit Estimated Loan Estimated Liquidity

Change Change Deficit(−) or
Surplus(+)
January $0 $0 $0
February $16 $5 $11
March ($8) $9 ($17)
April $28 $15 $13
May $5 ($13) $18
June ($16) $22 ($38)

Evidently, the bank has projected liquidity surpluses in three out of six months. T hese surpluses

should be invested profitably. T here is also a liquidity deficit estimated for the third and sixth months.

T he deficit must be covered by borrowing or selling liquid assets.

2. The Structure of Funds Approach

Suppose that we have a bank that frequently faces substantial liquidity demands. Under this

approach, we first divide the deposits and other fund sources into categories based on their estimated

probability of being withdrawn, therefore lost to the financial firm. T he resulting categories might

include:

Hot money l i abi l i ti es (vol ati l e l i abi l i ti es): T hese include deposits and other

borrowed funds (such as federal funds borrowings) that are very interest-sensitive or that

management is sure to be withdrawn during the current period.

Vul nerabl e funds: T hese consist of customer deposits, of which a significant portion,

perhaps 25% to 30%, is probably withdrawn sometime during the current period.

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 Stabl e funds (core deposi ts or core l i abi l i ti es): T hese consist of funds that

management considers unlikely to be removed.

In the second step, the liquidity manager sets aside liquid funds according to some desired operating

rules for each of the above funding categories. For example, the manager may choose to set up a

90% liquid reserve for hot money funds (less the required legal reserves held behind the hot money

deposit).

For vulnerable deposit and non-deposit liabilities, a common rule of thumb is to hold a fixed

percentage of their total amount—say, 30%—in liquid reserves. For stable (core) funds sources, a

liquidity manager may decide to place a small proportion—say at most 15%—of their total in liquid

reserves. T hus, the liquidity reserve behind deposit and non-deposit liabilities would be:

Liability Liquidity Reserve=0.95 × (Hot money deposits and non-deposit funds

− Legal reserves held)
+ 0.30 × (Vulnerable deposit and non-deposit funds
− Legal reserves held)
+ 0.15 × (Stable deposits and non-deposit funds
− Legal reserves held)
+ 1.00 × (Potential loans outstanding
– Actual loans outstanding)

Example: The Structure of Funds Approach

Suppose that a bank's liquidity division estimates that it holds $30 billion in hot money deposits and

other IOUs against which it holds 80% liquidity reserve, $65 million in vulnerable funds against

which it plans to hold a 15% reserve, and $123 million in stable funds against which it holds a 5%

liquidity reserve. T he bank expects its loans to grow by 10% annually. Its loans are currently

standing at $129 million, but have recently reached $144 million. Assuming that the reserve

requirements on liabilities currently stand at 2.5%, what is the bank’s total liquidity requirement.

Total Liquidity Requirement=0.80 × (30 − 0.025 × 30)

+ 0.15 × (65 − 0.025 × 65)
+ 0.05 × (123 − 0.025 × 123)
+ (144 + 0.10 × 144 − 129)
= $68.3025 million (held in
liquid assets and additional borrowing capacity)

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3. Liquidity Indicator Approach

Many financial institutions use liquidity indicators to estimate their liquidity needs based on

experience and industry averages. T he ratios are employed to estimate liquidity needs and to monitor

changes in the liquidity position. T he following liquidity indicators are often used for depository

institutions:

Cash and cash deposits due from depository institutions

Cash position indicator =
Total assets

A higher proportion of cash implies that the institution is in a stronger position to handle immediate

cash needs.

The l i qui di ty securi ti es i ndi cator compares the most marketable securities an institution can

hold with the overall size of its asset portfolio.

Government securities
Liquidity Securities Indicator =
Total assets

T he higher the proportion of government securities, the more liquid the depository institution's

position tends to be.

Net federal funds and repurchase agreements posi ti on measures the comparative

importance of overnight loans relative to overnight borrowings of reserves.

(Fs − Fp )
Net federal funds and repurchase agreements position =
Total assets

Where:

Fs =Federal funds sold and reverse repurchase agreements

Fp=Federal funds purchased and repurchase agreements

A rise in this ratio increases liquidity.

Capaci ty rati o is a negative liquidity indicator because loans and leases are the most illiquid of the

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assets.

Net loans and leases

Capacity Ratio =
Total assets

Pl edged securi ti es rati o is also a negative liquidity indicator. T his is because the higher the

proportion of securities pledged to back U.S. government deposits, the less the securities available

to sell when liquidity needs arise.

Pledged securities
Pledged securities ratio =
Total security holdings

Hot money rati o shows whether the institution has balanced the volatile liabilities it has issued

with the money market instruments that it holds that could be sold quickly to cover the liabilities.

Money market (short-term) assets

Hot money ratio =
Volatile liabilities

or could be rewritten as:

=(Cash and due from deposits held at other depository institutions

+ Holdings of short-term securities
+Federal funds loans + Reverse repurchase agreements)
(Large CDs+Eurocurrency deposits
+ Federalfunds borrowings+repurchase agreements)

and

Brokered deposits
Deposit brokerage index =
Total deposits

Where brokered deposits consist of packages of funds (usually at most $100,000 to obtain the

advantage of deposit insurance) arranged by securities brokers for their customers with firms paying

the highest yields, brokered deposits are interest-sensitive and may be withdrawn quickly. T he more

a depository institution holds, the higher the chance of a liquidity crisis.

Core deposits
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 Core deposits
Core deposit ratio =
Total assets

Where core deposits are typically small-denomination checking and savings accounts that are treated

as unlikely to be withdrawn on short notice, thus have lower liquidity requirements.

Deposi t composi ti on rati o measures how stable a funding base each institution possesses. A

decline suggests more excellent deposit stability and a lesser need for liquidity.

Demand deposits
Deposit composition ratio =
T ime deposits

Where demand deposits are prone to immediate withdrawal via check writing, on the other hand,

time deposits carry fixed maturities with penalties for early withdrawal.

Loan commi tment rati o measures the volume of promises a lender has made to its borrowers to

provide credit up to a prespecified amount for a specified period.

Unused loan commitments

Loan commitments ratio =
Total assets

Example Liquidity Indicator Approach

ABC Bank Ltd.’s excerpt of balance sheet entries as of today’s date is given in the following table:

Item Amount in Million Dollars

Assets
Net loans and leases 3, 681
Cash and deposits held at 807
other depository institutions
Federal funds sold 217
Government securities 349
Total assets 4, 605
Liabilities 154
Federal funds purchased 211
Demand deposits 1, 132
T ime deposits 2, 766

Using these entries, we can compute various liquidity indicators for ABC Bank Ltd, as shown in the

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following table:

Liquidity Indicator Value

Cash position indicator 17.52%
Liquidity securities indicator 7.58%
Net Federal funds position 0.13%
Capacity ratio 79.93%
Deposit composition ratio 40.93%

4. The Standard for Assessing Liquidity Needs: Signals from the

Marketplace

No financial institution can confidently tell if it has sufficient liquidity until it has passed the market's

test. Notably, the management should look at the following signals:

Publ i c confi dence: T he firm’s customers may lose confidence in it if they believe there is

expected danger making the firm unable to meet its obligations.

Stock pri ce behavi or: If the investors perceive that the institution is experiencing a liquidity

crisis, the firm's stock prices decline.

Ri sk premi ums on CDs and other borrowi ngs: T he market imposes a risk premium in the

form of higher borrowing costs if it believes the institution is headed for a liquidity crisis.

Loss sal es of assets: T his arises when the firm is pushed to sell its assets in a hurry, with

significant losses, to meet demands for liquidity.

Meeti ng commi tments to credi t customers: Here, we focus on the firm's ability to meet all

possible profitable requests for loans from its esteemed customers. Further, we establish if liquidity

pressures may have compelled management to turn down some otherwise acceptable credit

applications.

Borrowi ngs from the central bank : We consider if the firm has been forced to borrow in larger

volumes and more frequently from the central bank in its home territory (such as the Federal

Reserve or Bank of Japan). Additionally, we examine if the central bank officials have begun to

question the institution's borrowings.

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Legal Reserves and Money Position Management

The Money Position Manager

T he money position manager makes quick decisions that have potential long-run consequences on

profitability. Smaller banks and thrifts often hand this job over to more significant depositories with

whom they have a correspondent relationship (that is, that hold deposits to help clear checks and

meet other liquidity needs).

Legal Reserves

T he money position manager ensures that his/her financial firm maintains an adequate level of legal

reserves. T hese are the assets that law and the central bank regulation set to be held during a period.

T he legal requirements also make sure that an institution holds not more than the minimum legal

requirements since excess legal reserves yield no income for the bank.

T hese requirements apply to all qualified depository institutions. T hese include commercial and

savings banks, credit unions, savings and loan associations, and agencies and branches of foreign

banks offering transaction deposits or business time deposits or borrow through Eurocurrency

liabilities.

Calculating Legal Reserve Requirements

T he lagged reserve accounting (LRA) current system of accounting is the accounting standard for

legal reserves. To derive the bank's total legal reserve requirements, each reservable liability item

is multiplied by the expected reserve requirement percentage set by the Federal Reserve Board.

Total required legal reserves

= Reserve requirement on transaction deposits
× Daily average amount of net transaction deposits over a designated period
+ Reserve requirement on nontransactional reservable liabilities
× Daily average amount of nontransaction reservable liabilities

Non-transaction liabilities currently have a reserve requirement of zero.

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Example: Calculating Legal Reserve Requirements

T he legal reserve requirements in the United States are as follows:

T he first $10.7 million of net transaction deposits are subject to a 0% legal reserve requirement

(known as the “exemption amount”). T he volume of net transaction deposits over $10.7 million up to

$58.8 million carries a 3% reserve requirement (known as the “low reserve tranche”), while the

amount over $58.8 million is subject to a 10% reserve requirement (the “high reserve tranche”).

Non-transaction reservable liabilities (including nonpersonal time deposits and Eurocurrency

liabilities) are subject to a 0% reserve requirement.

Assume that ABC Bank Ltd.’s net transaction deposits averaged $152 million over the latest reserve

computation period. Its non-transaction reservable liabilities had a daily average of $210 million over

the same period.

ABC Bank Ltd.’s daily average requires a legal reserve level computed as follows:

Required
legal reserves = 0.0 × 10.7
+ 0.03 × [ First 58.8
− 10.7 of transaction deposits]
+ 0.10(152 − 58.8)[Amount of transaction deposits in excess of $58.8M]
= $10.763M

Assume that ABC Ltd. held a daily average of $9 million in vault cash over the required latest reserve

computation period. T herefore, it must hold an additional amount of legal reserves over its latest

reserve maintenance period as follows:

Daily average level of additional legal reserves. ABC Bank Ltd. Must raise:

= Total required legal reserves-Daily average vault cash holdings

= $10.763 million − $9.000 million = $1.763 million

Management must plan on how to invest the excess reserve taking into consideration any expected

drain on funds shortly and considering any reserve deficit in the previous period.

Factors Influencing the Money Position

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A depository institution’s money position can be influenced by various factors, with some of these

factors mostly controllable by management, while others are fundamentally non-controllable. T he

management needs to anticipate and react to them quickly. T hese factors are shown in the following

table:

Controllable Factors Increasing Controllable Factors Decreasing

Legal Reserves Legal Reserves
Selling securities Purchasing securities
Receiving interest Making interest payments
payments on securities to investors holding
the bank’s securities
Borrowing reserves from Repaying loans from the
the Federal Reserve bank Federal Reserve bank.
Purchasing federal funds Selling federal funds
from other banks to other institutions
that need reserves
Selling securities under Security purchases under a
a repurchase agreement (RP) repurchase agreement (RP)
Selling new CDs, Receiving currency and
Euro currency deposits, or coin shipments from
other deposits to customers the Federal Reserve bank

Noncontrollable Factors Noncontrollable Factors

Increasing Legal Reserves Decreasing Legal Reserves
Surplus position at the local Deficit position at the local
clearinghouse. T his is due to receiving clearinghouse. T his is as a result of
more deposited checks in its favor more checks drawn against the
than checks drawn against it bank than in its favor
Credit from cash letters sent to the Calls of funds from the bank’s
Federal reserve bank, listing drafts tax and loan account by
received by the bank the U.S. T reasury
Deposits made by the government Debits received from the Federal
treasury into a tax and loan Reserve bank for checks drawn
account held at the bank against the bank’s reserve account.
Credit received from the Federal Withdrawal of large deposit accounts,
Reserve bank for checks previously often immediately by wire
sent for collection

Clearing Balances

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Besides holding a legal reserve account at the central bank, many depository institutions also have a

clearing balance with fed to cover any checks or other debit items drawn against them. T he amount

is decided by its estimated check clearing needs and the record of overdrafts. T he clearing balance

can be beneficial since the firm earns credits from holding this balance with the Federal reserve

bank, and this credit can be used to settle the fees the Fed charges for services.

For example, suppose a bank has a clearing balance averaging $1.5 million during a most recent

maintenance period, and the federal funds' interest rate over this same period averaged 6%. T hen it

would earn a Federal Reserve credit of:

14 days
Reserve credit = Average clearing balance × Annualized federal funds rate × ( )
365 days
14
= $1,500, 000 × 0.06 × = $3,452.05
365

Sweep Accounts

A sweep account is a contractual agreement between bank and customer that permits the bank to

move funds out of a customer checking account (such as a savings account with zero reserve

requirement) overnight to generate higher returns for the customer and lower reserve

requirements for the bank.

Sweep accounts help in lowering the overall cost of the bank’s funds while allowing the customer to

access their deposits for payments. T hese services account for nearly $200 billion in current

deposit balances and therefore have significantly reduced the total reserve requirements of banks.

Factors in Choosing the Different Sources of Reserves

Several factors must consider by the money position manager when deciding on the sources of

reserves to choose from. T hese include the immediacy of need, duration of need, access to the

market for liquid funds, current and expected interest rates, and outlook for central bank monetary

policy. Additionally, relative costs and risks of alternative sources of funds, as well as the rules and

regulations applicable to a liquidity source, are crucial when choosing different sources of reserves.

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Practice Question

T he following are attributes of a liquid asset. Which one is NOT ?

A. Readily marketable

B. Reasonably stable price

C. Reversible

D. Relatively high rate of return

Sol uti on

T he correct answer is D.

Liquid assets provide a reasonably low level of return.

A i s i ncorrect: A liquid asset has a ready market, making it easy to be convertible into

cash

B i s i ncorrect: A liquid asset has a reasonably stable price, implying that the market

has the appropriate depth to absorb the sale without a substantial price decline

regardless of the speed at which the asset is sold or the size of the sale.

C i s i ncorrect: Liquid assets are reversible. In other words, the seller can recover

his/her original principal with little risk of loss.

XYZ Bank has the following forecasts for its checkable deposits, time and savings

deposits, commercial loans, and consumer loans over the next eight months as follows.

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 Reading 128: Intraday Liquidity Risk Management

After compl eti ng thi s readi ng, you shoul d be abl e to:

Identify and explain the uses and sources of the Intraday liquidity

Discuss the governance structure of the intraday risk liquidity management

Differentiate between methods for tracking intraday flows and monitoring risk levels.

Intraday liquidity refers to cash funding that can be accessed at any point during the business day to

enable banks to continue processing transactions. T his can include the interbank fund markets,

wholesale money markets, and intraday credit lines provided by central banks or financial market

utilities (FMUs). On the other hand, intraday liquidity ri sk is the risk that a bank or FMU is unable

to cover a payment or settlement obligation at the expected time due to inadequate liquid funds

(cash), also known as settl ement ri sk .

Banks may face a shortage of liquidity during the day. T his is because certain market conditions serve

to institutionalize intraday overdrafts. For example, a bank can borrow fed funds in the inter-bank

market any time within the business day with a delivery of funds occurring almost immediately, but

the return of borrowed funds usually takes place as a first-order item the following morning. Even

though the transaction is priced as a one-day loan, the borrower has the use of the funds for less than

twenty-four hours. Moreover, the provision of intraday credit to clients causes a shortage in the

bank’s liquidity.

Uses and Sources of Intraday Liquidity

Uses of Intraday Liquidity

Outgoi ng wi re transfers: T hese are typically the essential use of intraday liquidity. Payment lasts

the entire business day and follows a reasonably predictable pattern. Large banks “throttle” outgoing

payments and closely monitor incoming credits to ensure that they do not exceed their debit cap.

Most large-value payment systems (LVPSs) and some other payment, clearing, and settlement

systems (PCSs) have hard controls that prevent participants from exceeding their intraday credit

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limits.

Settl ements at Payment, Cl eari ng, and Settl ement (PCS) Systems: Most PCS systems

have a single settlement per day, which is done majorly in the late after-noon timeframe. T hese

systems may either serve as a source or use of funds reliant on the net position of a participant on

any given day. T hey can be forecast for securities that have multi-day settlements (e.g., T +3) and are

more difficult for same-day settlement activity.

Fundi ng of Nostro accounts: T his entails transferring cash to a correspondent bank to services

provided. Banks manage the cash they place in a correspondent bank account to a target average

monthly balance as part of the return for providing banking services. T he account funding position

may serve as a basis or use of funds to the bank’s overall liquidity profile. However, this depends on

the net position of the activity flowing in the account that given day. Nostro account balances are

restocked or drawn down every day.

Col l ateral pl edgi ng: T his pertains to banking activities that require a bank to earmark and set

aside collateral. Such activities include over-the-counter capital markets trading and deposits of

certain public funds. Everyday use of intraday funding is to acquire extra collateral to care for an

increasing liability or as a result of a mark-to-market induced margin call. T hese collateral positions

are adjusted daily.

Asset purchases/fundi ng: Intraday liquidity is also utilized to fund other balance sheet assets.

T hese assets may include securities purchases for the investment portfolio, client loans, and fixed

asset purchases.

Sources of Intraday Liquidity

T here are several sources of intraday funding accessible to the bank treasurer. However, each of

these sources differs in its contribution to overall funding from day-to-day. Nevertheless, each

source is instrumental in the overall funding landscape.

T he typical sources of intraday liquidity include:

Cash bal ances: T his is the most common source of intraday liquidity; it is the starting cash held on

the bank’s balance sheet at the beginning of the day. T his cash includes deposits at the central bank

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and a correspondent bank Nostro accounts. Unlike bank clients, the bank treasury determines the

level of closing/start of day cash balances. T he bank activity can be forecasted with 1 to 2 days’

notice, whereas the client payment activity is more difficult to predict.

Incomi ng funds fl ow: Incoming flows from payments and FMU settlements form the largest

source of intraday funding during the normal market function. Some of these inflows, including LVPS

payments, are real-time while credits are batch-oriented; an example is the net settlements with

clearinghouses, retail payment systems, among others. We can forecast bank activity with 1 to 2

days’ notice. However, client payment activity is more difficult to predict. FMU credit can be

forecast for securities that have multi-day settlements (e.g., T +3). Forecasting is relatively tricky

for same-day settlement activity

Intraday credi t: T his refers to a credit line or overdraft permitted during business hours and

covered by close of business. Lines are often uncommitted and provided without interest charges.

Central banks are the largest sources of intraday credit for the banking system, and their borrowing

terms change across jurisdictions. Additionally, FMUs and other banks may also provide intraday

credit.

Li qui d assets: T hese are assets that can be converted quickly into cash. T hey include cash,

money market deposits, and short-term government debt (e.g., T-Bills). T he clients may be sources

of liquidity in converting liquid assets into cash, for example, in a repo transaction.

Overni ght borrowi ngs: T hese borrowings provide quick intraday liquidity for a bank. T hey

include Fed funds, London Interbank Offered Rate (LIBOR), and Eurodollar deposits. Note that these

kinds of borrowings are not repaid on the same day. Hence, they remain on the borrower’s balance

sheet overnight. T he bank treasury must gauge the possible cost of having excess liquidity at the end

of the day versus the risk of being unable to complete the current day’s business or even

experiencing reputational risk exposure from delayed transactions due to breaking a daylight

overdraft limit.

Other term fundi ng: A bank can tap into other funding sources such as Federal Home Loan Banks

(FHLB) borrowings and term repos if the lenders are in a capacity to offer funding at a time of day

that is appropriate for the bank’s intraday funding needs.

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Furthermore, the bank does this only if it needs longer-term funding, like for one week, one month,

and so on. Client supply of term funding tends to be reasonably predictable, with low volatility. T his

type of borrowing is generally viewed as an incremental factor to include in each day’s liquidity

positioning ledger rather than a consistent source of intra-day funding.

Governance Structure of the Intraday Risk Liquidity

Management

In this section, we look at an overview of the leading practices for managing intraday liquidity risk at

large banks.

Governance of Intraday LRM

All risk management contexts begin with a governance structure that outlines the roles and duties of

various banks. T he characteristics of a sound governance structure for overseeing intraday liquidity

risk include the following:

Acti ve ri sk management: Intraday liquidity risk is recognized as a cost and is not as actively

managed strictly as other kinds of enterprise risk or liquidity risks. T he leading banks with vast

volumes of PCS have mastered the art of understanding and working to decrease their intraday

liquidity risks. Such banks categorize settlement and systemic risks as part of their risk arrangement;

they further include them critically into the firm’s risk appetite framework.

Integrati on wi th ri sk governance: T his involves the integration of the oversight of intraday risk

management into the bank’s overall risk oversight structure.

Ri sk assessment: Intraday liquidity risk is combined into the risk classification at major

institutions and is treated as a factor of risk self-assessments — this analysis aids in identifying and

evaluating settlement risks about existing and potential new products and operational processes. T he

line of business and risk management committee reviews the soundness of controls in mitigating

settlement risk.

Ri sk measurement and moni tori ng: Leading institutions monitor their intraday liquidity risk

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using two perspectives:

T he amount of intraday credit the institution is extending to clients; and

T he amount of intraday credit the institution utilizes.

For the first perspective, systemically important financial institutions (SIFIs) with huge transaction

banking and capital markets, businesses have invested substantially in recent years to elevate their

capacity to compile and monitor real-time cash positions for their clients. Institutions with these

capacities can pass on the intraday overdraft charges they get from central banks onto clients, given

that the industry moves in that direction. T he second perspective should give a complete view of all

intraday credit used by an institution. However, the unavailability of data and data aggregation makes

this perspective more challenging.

Methods for Tracking Intraday Flows and Monitoring Risk

Levels

Measurement of Intraday Liquidity

In this subsection, we delve into the commonly used measures significant for apprehending and

monitoring the bank’s intraday liquidity risk. Institutions need to set risk limits and do consistent

tracking against these measures.

Measures for Understanding Intraday Flows

Total payments

A bank should store crucial information following a transaction in a data warehouse. Information

regarding a payment transaction, such as payment amount, time received or originated, times for

each processing step in the payment workflow, routing information, payer, and payee, among others,

is essential for analysis.

Compiling this information aids in drawing insights such as the trend in payment volumes overtime

for doing correlation analysis, the net position in the settlement account at any time of day, filtered

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by payment type, total payments sent, and received for bank activity among others.

Other cash transactions

A bank should monitor intraday and end-of-day settlement positions at every financial market utility in

which it participates. Furthermore, the bank should maximize the volume of transaction-level detail

taken and stored for further analysis.

Settlement positions

If a bank has no complete data for reconstructing account positions at any time of the day, it should at

least keep data on its settlement positions with all its FMUs. T hese critical, deadline specific

payments are critical to managing intraday liquidity and systemic risk. T herefore, banks should track

trends in settlement positions and correlate them with external market factors to enhance its

capacity to predict future liquidity requirements in time.

Time-sensitive obligations like settlement positions

T hese transactions need completion at a time of the day, just like settlement positions. Failure to

settle time-sensitive obligations can lead to a financial penalty or other negative consequences.

T herefore, a bank should track the volume and settlement patterns of these time-sensitive

obligations by recording the amounts and deadline times.

Total intraday credit lines to clients and counterparties

A bank risk manager must look after the bank’s intraday liquidity risk needs to understand the

potential and actual amounts of intraday credit the bank is extending to clients and counterparties.

T hese intraday credit lines can be committed and disclosed to the client in some cases, while in other

cases the lines are uncommitted and undisclosed. In addition to the credit lines, the bank should have

data on average and peak usage, and the ability to model activity at the client and portfolio levels.

Total bank intraday credit lines available and usage

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Regulators anticipate financial institutions to understand and control the size of systemic risk they

pose to the overall financial system among risks posed to taxpayers and industry-funded insurance

plans. In that analysis, the amount of intraday credit that a bank depends on and the maximum amount

of intraday borrowing it can draw down is very crucial. T his data takes the amount of committed and

uncommitted intraday credit an institution has at its disposal, and preferably across all its cash and

settlement accounts.

Measures for Quantifying and Monitoring Risk Levels

Daily maximum intraday liquidity usage

Daily maximum intraday liquidity usage is a measure of the bank’s usage of an intraday credit

extension. It is the ratio of the day’s most significant net negative balance relative to the size of the

committed or uncommitted credit line. T he peak and average of this metric are monitored over some

time. At a minimum, this measure should be tracked for every cash account held at the central bank,

FMUs, and correspondent banks. A bank should also track its consolidated position across all

accounts between which liquidity can be readily transferred intraday without restrictions to get an

accurate picture of its intraday liquidity usage. T his is done for accounts with the same currency and

connected to a standard payment system but can be done for several currencies and in different

jurisdictions if cash and collateral are freely transferred between the jurisdictions intraday.

Intraday credit relative to tier 1 capital

T his measure is a broad representation of the intraday settlement risk caused by a bank. It should be

tracked for both total intraday credit and unsecured intraday credit, existing and used, according to

the perception that posting high-quality collateral mitigates intraday settlement risk. Moreover,

available unsecured intraday credit relative to an institution’s tier 1 capital is also a measure of the

unintended systemic risk that the institution causes to the financial system.

However, it is a weak measure. Using time-series analysis on such measures as well as horizontal

comparisons to other institutions would provide bank risk managers with an understanding of the

relative systemic risk of their business model as well as fluctuations in their risk profile over time.

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Client intraday credit usage

T his measure is obtained by comparing a client’s peak daily intra-day overdraft to the established

credit line. It is essential in tracing the total intraday credit exposures as it furnishes a bank with an

indicator of the necessary liquidity required to support its clients’ business activities. Besides,

tracking the averages, volatility, and correlation of these measures to other money market indicators

gives useful information for establishing how client activity affects its capacity to manage its intraday

liquidity.

Payment throughput

It is a measure that tracks the percentage of outgoing payment activity relative to the time of day.

For FMU participating banks, it is useful to actively-measure and to track the flow of outgoing

payment transactions relative to total payments or time markers for reasons such as:

1. T racking its volume patterns aid in ensuring that all the day’s payments are processed on a

timely basis;

2. Meeting FMU requirements for submitting a target percentage of payments by a deadline;

and

3. Helping the bank identify and track its peak periods over time and the correlation of this

activity with its intraday liquidity on hand and intraday credit usage.

Additionally, a bank can monitor its top intraday credit usage concerning the total volumes with an

FMU to get an indicator of the effectiveness of the FMU’s usage of daylight credit. Different system

rules and operating models are used by FMU, leading to disparities in how effectively they use

intraday liquidity. For a bank to redirect payment flows as a tool to manage intraday liquidity needs, it

should understand these differences, assuming it has the essential operational skills.

Role of stress testing

T he previous indicators are significant in understanding and tracking a bank’s need for and use of

intraday credit under business as usual. It’s worth noting that intraday liquidity requirements and

usage can vary significantly during periods of market stress. Consequently, a bank that frequently

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depends on intraday credit should model the effect of various events on its requirements and the

availability of intraday liquidity.

Despite that, the banking industry has, over time, established useful stress tests of overall liquidity

management that have helped in developing liquidity contingency plans; still, the industry through

moderators need to extend these capabilities to intraday position modeling. Stress testing of intraday

liquidity risk management may result in numerous advantages for a bank. Apart from the empirical

results gained from these advantages, interactions and discussions, brainstorming, and other critical

thinking that senior management engages in when stress testing may be useful.

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Practice Question

Lending institutions use two perspectives in monitoring their intraday liquidity risk.

Which of the following options correctly states the two perspectives?

A. T he amount of intraday credit the institution is extending to clients and the amount of

intraday credit the institution utilizes.

B. T he amount of intraday credit the institution is extending to clients and the risk

assessment.

C. Active risk management and the amount of intraday credit the institution utilizes.

D. T he amount of intraday credit the institution is extending to clients and the amount of

debts the institution pays.

T he correct answer is A.

T he perspectives for monitoring intraday liquidity risk are the ones outlined in choice A.

B i s i ncorrect: T he first part of option B is one of the perspectives. However, risk

assessment is none of the two perspectives.

C i s i ncorrect: T he first part of choice C is incorrect, while the second one the

“amount of intraday credit the institution utilizes” is correct.

D i s i ncorrect: T he first part of choice D is correct, but the second one is incorrect.

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 Reading 129: Monitoring Liquidity

After compl eti ng thi s chapter, you shoul d be i n a posi ti on to:

Distinguish between deterministic and stochastic cash flows and provide examples of each.

Describe and provide examples of liquidity options and explain the impact of liquidity

options on a bank’s liquidity position and its liquidity management process.

Describe and apply the concepts of liquidity risk, funding cost risk, liquidity generation

capacity, expected liquidity, cash flow at risk.

Interpret the term structure of expected cash flows and cumulative cash flows.

Discuss the impact of available asset transactions on cash flows and liquidity generation

capacity.

In monitoring liquidity, it is essential to understand the identification and taxonomy of cash flows that

occur during the business activities of a financial institution and, importantly, the deterministic and

stochastic cash flows. T hese cash flows help in building practical tools to monitor and manage

liquidity risk. T ime and amount are the two dimensions used to classify a cash flow as either

deterministic or stochastic.

Deterministic and Stochastic Cash Flows

1. Cl assi fi cati on based on ti me

Determi ni sti c cash fl ows are cash flows that occur at future instants that are

predictable or known with certainty at the reference time of their appearance. On the other

hand, stochasti c cash fl ows are those that manifest themselves at some random instants

in the future in an unpredictable manner.

2. Cl assi fi cati on based on the amount

Under classification based on the amount, determi ni sti c cash fl ows occur in an amount

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 known with certainty at the reference time. On the contrary, stochasti c cash fl ows are

those whose amount cannot be fully determined.

Examples of Stochastic and Deterministic Cash Flows

a. Stochastic cash flows

When the amount is stochastic, we recognize four possible subcategories:

Credi t-rel ated: T his is when the uncertainty of the amount is due to credit events, such

as the default of one or more of the bank’s clients. An example is the missing cash flows

after the default of the contracting stream of fixed interests and capital repayment of the

loan.

Indexed/conti ngent: T he stochastic cash flow amount depends on market variables, such

as Libor fixings. An example is floating rate coupons that linked to market fixings (e.g., Libor)

and the payout of European options, which also depend on the level of the underlying asset at

the expiry of the contract.

Behavi oral : T his is when the cash flows are dependent on decisions made by the bank’s

clients or counterparties: these decisions are roughly predicted according to some rational

behavior based on market variables, and sometimes they are based on information the bank

does not have. Examples include when a bank’s clients decide to prepay the outstanding

amount of their loans or mortgages and credit lines that are open to the client’s withdrawals

occurring at any time until the expiry of the contract and in an uncertain amount, although

within the limits of the line. Another example under this category is withdrawals from sight

or saving deposits.

New busi ness: T his is when cash flows originated by new contracts that are dealt with in

the future and planned by the bank, such that their amount is stochastic. An example is when

a bank plans to deal new loans to replace precisely the amount of loans expiring in the next

two years, this produces a stochastic amount of cash flows since it is unsure whether new

clients will want or need to close such contracts.

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 b. Deterministic cash flows

When the amount is deterministic, cash flows can be labeled as fixed due to being set in such

a way by the terms of a contract. T hey are related to financial contracts such as fixed-rate

bonds or fixed-rate mortgages or loans, bonds issued, and loans received by the bank held in

its liabilities. T hese cash flows are produced by payments of periodic interests and periodic

repayment of the capital installments if the asset is amortizing.

It is crucial to note that the bond issuer should be risk-free for cash flows to be classified as

deterministic, so that credit events cannot affect the cash flow schedule provided in the

contract. An example is the payout of one-touch options where the buyer of this type of

option receives a given amount of money when the underlying asset breaches some barrier

level.

Risk factors such as interest rates, the yield curve, and credit quality can make deterministic

cash flows shift to stochastic cash flows.

Liquidity Options

Liquidity option is defined as the right of a holder to receive cash from or to give cash to the bank at

predefined times and terms. A liquidity option does not involve a profit or a loss implication in

financial terms, but it is as a result of a need for or a surplus of liquidity of the holder.

Liquidity options differ from standard options as the latter are profit-oriented, independent of the

cash flows following exercise, although typically, they are positive. On the other hand, a liquidity

option is exercised because of the cash flows produced after exercise, even if it is sometimes not

convenient to exercise it from a financial perspective. An example of a liquidity option is sight and

saving deposits whereby the bank’s clients can typically withdraw all or part of the deposited amount

with no or short notice. T he withdrawal incentive might be due to the potential of investing in assets

with higher yields.

Additionally, the prepayment of fixed-rate mortgages or loans is another example of a liquidity option.

Fixed-rate mortgages or loans can be paid back before the expiry for exogenous reasons, due to

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events in the life of the client such as divorces or retirements; more often prepayment is triggered

by a financial incentive to close the contract and reopen it under the current market conditions if

the interest rate falls. In the first case, the bank would not suffer any loss if market rates rose or

stayed constant. It could even reinvest at better market conditions those funds received earlier than

expected. In the second case, prepayment would cause a loss since replacement of the mortgage or

closure of the loan before maturity would be at rates lower than those provided for by old contracts.

Impact of Liquidity Options on a Bank’s Liquidity Position

Even though liquidity options can be prompted by factors other than financial convenience, the

impact on the bank may be considered twofold as follows:

A l i qui di ty i mpact on the bal ance sheet: Usually given by the amount withdrawn or

repaid.

A (posi ti ve or negati ve) fi nanci al i mpact: T his results from the disparity between

the contract’s interest rates and credit spread and the market level of the same variables at

the time the liquidity option is being exercised, applied on the withdrawn or repaid amount.

T he financial impact is sometimes quite small, for example, when a client closes a savings account,

the bank’s experiences a financial loss due to the missing margin between the contract deposit rate

and the rate it earns on the reinvestment of received amounts (usually considered risk-free assets),

or by the cost to replace the deposit with a new one that yields a higher rate.

On the other hand, the liquidity impact can be quite substantial if the deposit has a big notional.

Although the financial effects of liquidity options can be directly hedged by a mixture of standard and

statistical techniques, the liquidity impact can only be managed by tools involving cash reserves or a

constrained allocation of the assets in liquid assets or easy access to credit lines. All of these imply

costs that should be accounted for when pricing contracts to deal with clients. Moreover, models for

pricing long and short liquidity options have also to be designed.

Liquidity Risk, Funding Cost Risk, Liquidity Generation

Capacity, Expected Liquidity, and Cash Flow at Risk

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Liquidity Risk

Liquidity risk is the risk that in the future, the bank receives smaller than expected amounts of cash

flows to meet its payment obligations. T he liquidity risk definition involves both funding liquidity risk

and market liquidity risk.

Fundi ng l i qui di ty ri sk occurs if a bank is not able to fund its future payment obligations because

it is receiving fewer funds than expected from clients, from the sale of assets, from the interbank

market or the central bank. T his risk may cause an insolvency situation if the bank is unable to settle

its obligations, even by resorting to very costly alternatives. On the other hand, mark et l i qui di ty

ri sk is the result of the bank’s inability to sell assets, such as bonds, at a fair price, and with

immediacy. It causes the bank to receive smaller than expected amounts of positive cash flows.

Liquidity risk is the number of economic losses that occur when the algebraic sum of positive and

negative cash flows and existing cash available at a given date, differ from some projected desirable

level. From this definition, liquidity risk is:

T he inability to raise enough funds to meet payment obligations forcing the bank to sell its

assets, hence causing costs related to the non-fair level at which they are sold or to

suboptimal asset allocation.

T he ability to raise funds only at costs above those expected. T hese costs refer to the

cost dimension of liquidity risk.

T he ability to invest excess liquidity at only rates which are below the expected rates. It is

an infrequent risk for a bank since business activity typically hinges on assets with longer

durations than liabilities. T hese (opportunity) costs also refer to the cost dimension of

liquidity risk.

Quantitative Liquidity Risk Measure

T hese are the set of measures used to monitor and manage quantitative liquidity risk. T he measures

aim at tracking the net cash flows that a bank might expect to receive or pay in the future to stay

solvent. Based on this taxonomy, cash flows are classified as to have been produced by two factors,

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namely, the causes of liquidity and sources of liquidity.

Causes of l i qui di ty: T hese are factors referring to existing and forecast future

contracts originated by the ordinary business activity of a financial institution.

Sources of l i qui di ty: T hese comprise of all factors able to generate positive cash flows

to manage and hedge liquidity risk and can be disposed of promptly by the bank to

determine the liquidity generation capacity of the financial institution.

T he sum of expected positive cash flows occurring at time ti from the reference time ti is given as:

+
Cf +
e (t0 , ti ) = E[Cf (t0, ti)]

Similarly, the sum of expected negative cash flows occurring on the same date is given by:

−
Cf −
e (t0 , ti ) = E[Cf (t0, ti)]

Since the cash flows are expected, their distribution at each time should be determined to recover

measures other than the expected (average) amount, to increase the effectiveness of liquidity

management.

Assume we are at the reference time t0: we define by Cf(t0, tj) the cumulative amount of all cash

flows starting from the date ta to tb as:

b
Cf(t0, ta, tb) = ∑ cf + −
e (t0 , ti ) + cf e (t0, ti)
i=a

Expected cash flows and cumulated cash flows allow us to construct the term structure of expected

cash flows, which is the primary tool for liquidity monitoring and management:

Funding Cost Risk

Funding cost risk occurs when the bank must pay higher than expected cost (spread) above the risk-

free rate to receive funds from sources of liquidity that are available in the future.

Liquidity Generation Capacity

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Liquidity generation capacity (LGC) is the primary tool used by a bank to handle the negative entries

of the term structure of expected cash flows (T SECF). It refers to the bank’s ability to generate

positive cash flows, beyond contractual ones, from the sources of liquidity available in the balance

sheet and off the balance sheet at a given date.

Expected Liquidity

Expected liquidity is a measure to use to check whether the financial institution can cover negative

cumulated cash flows at any time in the future, calculated at the reference date t0.

Cash Flow at Risk

Cash flow at risk (CFaR) is a measure that defines the extent of vulnerability of an institution's

future liabilities and assets to the possible market variations. A firm can, therefore, employ this

measure to examine the changes in its market value.

The Term Structure of Expected Cash Flows and Cumulated

Cash Flows

The Term Structure of Expected Cash Flows (TSECF)

T he term structure of expected cash flows (T SECF) refers to the collection, ordered by date, of

positive and expected cash flows, up to expiry referring to the contract with the longest maturity,

say tk:

T SECCF(t0 ,tk )
= {Cf + − + − + −
e (t0 ,t0 ),Cf e (t0, t0 ),Cf e (t0, t1), Cf e (t0 , t1), … … , Cf e (t0 ,tk ), Cf e (t0 ,tk )} .

At the end of a T SECF, with an unspecified expiry corresponding to the end of business activity,

there is reimbursement of the equity to stockholders. T SECF is often referred to as the maturity

ladder: we reserve this name for the first part, up to one-year maturity, of the T SECF. Additionally, it

is a standard practice to determine short-term liquidity (up to one year), and structural liquidity

(beyond one year).

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When assets expire, positive cash flows accrue to the bank, and when liabilities expire, the bank

pays negative cash flows. T he quantity of the cash flows is just the notional of each contract in the

assets and liabilities. T herefore, these amounts are deterministic both under a time and amount

perception; collecting them and ordering them based on the date we obtain the T SECF.

The Term Structure of Cumulated Expected Cash Flows (TSECCF)

T he T SCECF is the collection of expected cumul ated cash flows, from time t0 to tk, ordered by

date:

T SECCF(t0, tk) = {CF(t0, t0 , t1 ), CF(t0 , t0, t2), . .. , CF(t0, t0, tk)} .

T he T SECCF is essential because besides monitoring the net balance of cash flows on a given date,

banks also need to know how the past evolution of net cash flows affects its total cash position on

that date.

Example: The Term Structure of Expected Cash Flows and Cumulated

Cash Flows

Given the assets, liabilities, and their respective expiry terms of a financial institution, we can build

the T SECF. We can first order the assets and the liabilities according to their maturity, disregarding

which kind of contract they are.

Assets and Liabilities Classified According to Maturity

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 Expiry Assets Liabilities
1 20.00 −
2 − (10.00)
3 − −
4 − −
5 50.00 −
6 − −
7 − (70.00)
8 − −
9 − −
10 30.00 −
> 10 − (20.00)
100.00 (100.00)

T he following graph illustrates the above:

Positive cash flows are received by the bank whenever assets expire, whereas when liabilities

expire, the bank must pay negative cash flows.

Assuming further that the interest rate (yield) of the assets and liabilities is as shown below:

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 Expiry Assets Liabilities
1 5% 0%
2 0% 4%
3 0% 0%
4 0% 0%
5 6% 0%
6 0% 0%
7 0% 0%
8 0% 0%
9 0% 0%
10 7% 0%
> 10 0% 0%

We can calculate the term structure of cash flows and cumulated cash flows, as shown in the table

below:

Assets and Liabilities Reclassified According to Maturity

Expiry Notional Interest Notional Interest T SECCF

1 20 6 0 −4 22
2 0 5 −10 −4 14
3 0 5 0 −3 16
4 0 5 0 −3 17
5 50 5 0 −3 69
6 0 2 0 −3 68
7 0 2 −70 −3 −3
8 0 2 0 0 −2
9 0 2 0 0 0
10 30 2 0 0 32
> 10 0 − −20 0 12

Note that we use the ordinary method given as

T SECCF(t0 , tk ) = {CF(t0 , t0 , t1), CF(t0, t0, t2 ),. . ., CF(t0, t0 , tk )}

A graphical representation is as shown:

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Additionally, the cash flows of the T SECF are those produced by all the causes of cash flows. It

hence means that the T SECF:

Includes the cash flows from all current contracts that include the assets and liabilities.

Cash flows are stochastic in many cases because they link to market variables, such as

Libor or Euribor fixings.

Cash flows in T SECF are adjusted to consider credit risks, and therefore credit models

must be used to include defaults on an accumulative basis by also considering the

correlation existing amongst the bank’s counterparties.

Cash flows are adjusted to include liquidity options, and hence behavioral models are used

for typical banking products such as sight deposits, credit link usage, and prepayment of

mortgages.

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 Cash flows originated by new business increasing the assets are included; they are typically

stochastic in both the amount and time dimensions, so they are treated employing models

that consider all related risks.

T he rollover of maturing liabilities by similar or different contracts, and new bond

issuances (which could also be included in the new business category) to fund the increase

in assets, are included.

Both the T SECF and the T SECCF do not include the flows produced by the sources of cash flows.

T he sources of cash flows are apparatus to manage the liquidity risk originated by the causes of cash

flows.

Liquidity Generation Capacity

Liquidity generation capacity is the ability of a bank to generate positive cash flows, beyond

contractual ones, from the sources of liquidity available on the balance sheet and off the balance

sheet at a given date.

Ways in which LGC manifests itself:

1. Bal ance sheet expansi on: from secured or unsecured funding; or

2. Bal ance sheet shri nk age: which results from selling assets.

When aiming to expand a balance sheet, we consider the following factors:

Borrowing through an increase of deposits, typically in the interbank market (retail or

wholesale unsecured funding);

Withdrawal of credit lines the financial institution has received from other financial

counterparties (wholesale unsecured funding); and/or

Issuance of new bonds such as wholesale and retail unsecured funding.

A similar classification within LGC depends on the link between the generation of liquidity and the

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assets on the balance sheet so that we have:

1. Securi ty-l i nk ed l i qui di ty: the inclusion of secured withdrawals of credit lines received

from other financial institutions, secured debt issuance, and selling of assets and repo; and

2. Securi ty-unl i nk ed l i qui di ty: the inclusion of unsecured borrowing from new clients

through new deposits, withdrawals of credit lines received from other financial institutions

and, the unsecured bond issuance.

T he security-linked liquidity is a bit more than the balance sheet liquidity (BSL) liquidity, or the

liquidity obtained by balance sheet reduction.

The Term Structure of Liquidity Generation Capacity (TSLGC)

T he T SLGC is the collection, a reference time t0, of liquidity that can be generated at a given time ti,

by the sources of liquidity, up to an ending time tk referred to as a terminal time expressed as

follows:

T SLGC(t0, tk)
= {AS(t0 , t1 ), RP(t0 , t1), USF(t0, t1), … , AS(t0 , tk ), RP(t0, tk), USF(t0, tk )} .

In the equation, AS(t0 , t1 ) is the liquidity that can be generated by the sale of assets at the time ti,

computed at the reference time t0. Similarly, RP(t0, t1) refers to secured funding (repurchase

agreements, or repos) and USF(t0 , t1 ) refers to unsecured funding.

The Term Structure of Cumulated Liquidity Generation Capacity

(TSCLGC)

T he term structure of cumulated LGC is the collection, at the reference time t0, of the cumulated

liquidity generated at a time ti up to a terminal time tk, using the sources of liquidity.

1 2 k
T SCLGC(t0 , tk ) = ∑ T SLGC(t0, ti ), ∑ T SLGC(t0, ti), . , ∑ T SLGC(t0 , tk ).
i=0 i=0 i=0

T he sources of liquidity contributing to the T SLGC belong either to the banking or the trading book.

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The Term Structure of Available Assets

At the end of the loan or repo, cash flows produced by a bond are typically given back to the

borrower by the counterparty, although the contract may sometimes provide for various solutions.

When an asset, such as a bond, is purchased by a bank, a corresponding outflow equivalent to the

price is recorded in the cash position of the bank. All cash flows should be considered contract-

related and included in the T SECF and the T SECCF. T he possibility of the issuer defaulting is

considered.

T ransactions such as purchases, repo transactions, reverse repo transactions, sell/buyback

transactions, and security lending affects cash flows and liquidity generation capacity, as discussed

below.

Repo Transactions

During the repo agreements, the payments on the asset belong to the bank as it is the owner.

T herefore, T SECF and T SECCF are not affected in any way. T he T SAA of the asset is reduced by an

amount equal to the notional of the repo agreement, whereas the cash flow received by the bank at

the start and the negative cash flow at the end are both entered in the T SLGC. Repo transactions are

viewed as liabilities on the balance sheet for the bank

Reverse Repo Transactions

In a reverse repo, the payments produced by the asset are not included in T SECF or the T SECCF as

they don’t belong to the bank. However, we include the cash flow paid by the bank at the start and

the cash flow received at the end of the contract, but only once. T he T SAA of the asset is increased

by an amount equal to the notional of the repo agreement while the T SLGC is not affected. Reverse

repo transactions are viewed as assets on the balance sheet since they are collateralizable loans to

the counterparty.

Sell/Buyback Transactions

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In this transaction, the cash flows between the start and end of the contract should be taken from

the T SECF and the T SECCF. Furthermore, the T SAA of the asset decreases by an amount equal to

the notional of the sell/buyback contract. T he T SLGC is affected in the same way as in the repo

agreement since sell/buyback transactions are ways of generating balance sheet liquidity (BSL).

Sell/buyback transactions represent a commitment to the bank at the end of the contract.

Buy/Sell-Back Transactions

In this transaction, the payments received for the asset before the sell-back belong to the bank so

that they enter the T SECF and the T SECCF, along with the cash flows at the start and end that relate

to the purchase and sale, since they are contract flows. T he T SAA of the asset is increased by an

amount equal to the notional of the buy/sell-back agreement. T SLGC is not affected, but the asset

can be repoed until the end so that it can be altered until this date. Buy/sell back transactions

represent an asset for the period of the contract.

Security Lending

In the security lending, both the payments received for the asset before the end of the contract and

the interest paid by the counterparty at expiry belong to the bank, and they enter the T SECF and the

T SECCF. T he T SAA of the asset decreases by an amount equal to the notional of the lending since

the bank cannot use it as collateral or sell it. T he T SLGC is not affected, and the asset cannot

produce any liquidity until the end of the contract. T he transaction represents an asset on the bank's

balance sheet for the period of the contract.

Security Borrowing

In this transaction, the T SECF and the T SECCF are not affected besides the interest paid by the bank

at the expiry of the borrowing. T he T SAA of the asset increases by an amount equal to the notional

of the borrowing since the bank can use it as collateral if it returns it to the counterparty at expiry.

T he T SLGC is not affected, but the asset can produce liquidity until the end of the contract. T he

transaction represents a liability of the bank.

Assets such as stocks have no definite expiry date. In this case, contract cash flows entering the

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T SECF and the T SECCF is simply the initial outflow representing the price paid to purchase the

asset and the periodic dividend received. Note that T SLGC is continuously affected either because

the contract is dealt to generate balance sheet liquidity (BSL) or because Liquidity generation

capacity (LGC) is possibly increased over its lifetime. T he only contract that does not increase the

T SLGC is security lending, which decreases LGC related to BSL.

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Practice Question

Nicolas Young is a client at ABC bank who has defaulted on a contract stream of fixed

interests extended to him by the bank. Jane Fancy, an FRM intern, has been asked to

classify the stochastic cash flow accruing from this default.

Which of the following choices most accurately defines the choices Fancy gave,

assuming she gave the correct answer?

A. Indexed/contingent

B. Behavioral

C. New business

D. Credit-related

T he correct answer is D.

Credit-related stochastic cash flows occur when the uncertainty of the amount is due to

credit events, such as the default of one or more of the bank’s clients, just like in Young’s

case.

A i s i ncorrect: Indexed/contingent stochastic cash flow amount depends on market

variables, such as Libor fixings.

B i s i ncorrect: Behavioral stochastic cash flows are dependent on decisions made by

the bank’s clients or counterparties.

C i s i ncorrect: New business stochastic cash flows originate by new contracts that are

dealt with in the future and planned by the bank.

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 Reading 130: The Failure Mechanics of Dealer Banks

After compl eti ng thi s readi ng, you shoul d be abl e to:

Compare and contrast the main lines of business in which dealer banks operate and the risk

factors they encounter in each of the lines.

Identify circumstances that can cause a liquidity crisis at a dealer bank and explain

responses that can alleviate these risks.

Assess policy measures that can alleviate firm-specific and systemic risks related to large

dealer banks.

Main Lines of Business in which Dealer Banks Operate and the

Risk Factors they Encounter

A bank is an intermediary between depositors desiring short-term liquidity and borrowers seeking to

finance projects. An unexpected surge in depositors' cash withdrawals or borrowers showing signs

of not being able to repay their loans makes depositors concerned over the solvency of the bank.

T he following standard policy tools can be sources of bank failures:

i. Regul atory supervi si ons: and the requirement for risk-based capital reduces the chance

of solvency-threatening capital losses.

ii. Deposi t i nsurance: which lowers individual depositors' incentives; and

iii. Regul atory resol uti ons mechani sms: through which the authorities acquire powers to

liquidate or restructure a bank efficiently.

Major dealer banks in the recent financial crisis suffered from the new forms of bank runs. Dealer

banks are often considered too big to fail since they are mostly parts of large, sophisticated

organizations, and their failures can damage the economy.

Major Lines of Business in Which Dealer Banks Operate

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T he main lines of a dealer banks' business are:

a. Securities dealing, underwriting, and trading;

b. OT C derivatives;

c. Prime brokerage and asset management; and

d. Off-balance sheet financing.

For simplicity, large dealer banks are treated as members of a distinct class despite there being many

significant disparities in many aspects. T he most insignificant lines of businesses of these dealer

banks include securities markets, securities lending, repurchase agreements, and derivatives.

Besides, proprietary trading is engaged in by dealer banks when they speculate on their accounts.

Various other dealer banks operate internal hedge funds and private equity partnerships as part of

their asset management businesses, by effectively acting as a general partner with limited-partner

clients.

a. Securities Dealing, Underwriting, and Trading

T here is always an intermediation by dealer banks between securities issuers and investors in the

primary market, and among investors in the secondary markets. Sometimes acting as an underwriter,

a dealer purchases equities or bonds from an issuer and, over time, sells them to investors in the

primary markets.

Sellers hit the dealer's bid prices, while buyers hit the dealer's ask prices in the secondary markets.

T he intermediation of OT C securities markets is dominated by dealer banks, covering bonds issued

by corporations, municipalities, specific national governments, and securitized credit products.

Furthermore, interdealer brokers and electronic trading platforms intermediate trade between

dealers in some securities. Dealers are also active in secondary equity markets despite public

equities being easily traded on exchanges. Speculative investing is popular among banks with dealer

subsidiaries and can partly be aided by the ability to observe inflow and outflow of capital from

certain securities classes.

Repos markets are likewise good intermediation points for securities dealers. A counterparty posts

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government bonds, corporate bonds, government-sponsored enterprises’ securities, or other

securities like CDOs as collateral against the performance of a borrowed or lent loan.

Most repos are short-term, typically overnight, and are commonly renewed with the same dealer. A

haircut that reflects the securities' risk or liquidity mitigates a repo's performance risk.

Some repos are tri-party for counterparty risk requiring mitigation. T ri-party repos are contracts

where a third entity (apart from the borrower and lender) acts as an intermediary between the two

parties to the repo. T ypically, the third party is a clearing bank holding the collateral and returns the

cash to the trader, thereby facilitating the trade and somewhat insulates the lender from the

borrower’s default risk.

b. Over-the-Counter Derivatives

T he contracts involving transferring financial risk from one investor to another are called

derivatives. T hey are traded OT C on exchanges. OT C derivatives can be customized to suit a client's

needs since they can be privately negotiated. For most OT C derivatives trades, one counterparty

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must be the dealer. It usually lays off most or all the risk of its client's inflated derivatives positions

by running a matched book, profiting on the differences between bid and offer terms.

Proprietary trading is conducted in OT C derivatives markets by dealer banks as in their securities

business. T he market value measures the notional amount of an OT C derivatives contract, and for

bond derivatives, the measure is the face value of the asset whose risk is transferred by the

derivative.

All derivatives contracts must have a total market value of zero as an accounting identity, which

implies that there should be an equal number of positive and negative positions. Wealth is transferred

by derivatives from one counterparty to another rather than directly added or subtracted from the

total stock of wealth.

Fractional costs of bankruptcies can lead to net losses caused by derivatives. Also, the risk is socially

transferred from those ill-equipped to bear it to others who are well equipped to bear the risk.

T here is also a further risk of the counterparty failing to meet its promised payments.

T he amount of exposure to default as a result of counterparties failing to perform their contractual

obligations is a useful gauge of counterparty risk in OT C markets. Collaterals reduce these

exposures.

Under normal circumstances, the trades of various OT C derivatives between a given pair of

counterparties are legally combined between the two counterparties under a master swap

agreement and being in line with the standards set by the International Swaps and Derivatives

Association.

T here was a reduction in the range of acceptable forms of collateral that dealers took from their

OT C derivatives counterparties, as the 2007 financial crisis deepened. According to statistics, cash

was the form of collateral for over 80% of collateral for these agreements.

An example of an OT C derivative is a call option whereby an investor buys an asset at a prearranged

price, protecting the investor from risks related to the cost of acquiring the asset.

c. Prime Brokerage and Asset Management

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Numerous large dealers are active prime brokers for hedge funds and other large investment firms.

T hey provide customers with a variety of services ranging from securities holding management,

clearing, and cash management services to securities lending, financing, and reporting.

By lending securities from prime brokerage customers, additional revenue gets generated by the

dealer bank.

T he large asset-management divisions often found in dealer banks are for the institutional and

wealthy individual clients' needs. T he divisions hold securities for clients, oversee cash, and provide

alternative investment vehicles like private equity partnerships often managed by the same bank.

A limited partner in an internal hedge fund perceives a large dealer bank to be more stable as

compared to a stand-alone hedge fund because the dealer bank might voluntarily support an internal

hedge fund at a time when the hedge fund needs financial support.

d. Off-Balance Sheet Financing

Dealer banks have made an extensive application of off-balance-sheet financing. A good example is a

financial institution originating or buying residential mortgages and other loans financed by the sale of

the loans to a financial corporation set up for this express purpose. T he proceeds of the debt issued

by the special purpose entity to third-party investors pay the sponsoring bank for the assets.

Due to minimal regulatory requirements and accounting standards, dealer banks do not have to treat

assets and debt obligations of special purposes entities as if they were on the bank's own balance

sheet, since the debt obligations of such entities are usually contractually remote from the

sponsoring bank.

Circumstances that can Cause Liquidity Crisis at a Dealer

Bank and Responses that can Alleviate these Risks

If the solvency of a dealer bank gets threatened, there can be a rapid change in the relationship

between the bank and its derivatives counterparties, prime brokerage clients, and other clients.

T here are similarities between the concepts at play and those of a depositor run at a commercial

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bank.

T here is also a lack of default insurance by most of the insured depositors exposed to dealer banks as

compared to those at a commercial bank, or still, they do not wish to bear the frictional costs of

getting involved in the bank's failure procedures even if they have insurance. T he main fundamental

mechanisms that lead to the failure of a dealer bank are as follow:

a. T he flight of short-term creditors;

b. Prime brokerage clients' departure;

c. Various cash-draining undertakings by derivatives counterparties designed to lower their

exposures to the dealer bank; and

d. T he loss of clearing-bank privileges.

a. The Flight of Short-term Creditors

One of the forms through which the assets of larger dealer banks tend to be financed by the banks is

the issuing of bonds and commercial paper. T he short-term repurchasing agreements have recently

financed the purchasing of their securities inventories. T he money-market funds, securities

borrowers, and other dealers are often the counterparties to these repos.

In case of a failure by the repo creditors of dealer banks to renew their positions en masse, there

are doubts about the ability of the dealer banks to finance their assets with enough amounts of new

private sector banks. T herefore, the dealer sells its assets hurriedly to buyers aware of the need for

a quick sale. T his situation is called a fire sale and can lead to lower and lower prices for the assets.

In case the dealer's initial solvency concerns were prompted by declines in the market values of the

collateral asset themselves, an asset fire sale's proceeds could be insufficient to meet the dealer's

cash needs.

Fatal inferences by participants in other markets of the dealer's weakened condition could be as a

result of a fire sale. During a financial crisis, the financing problems of a dealer bank could be

exacerbated. Besides, the fire-sale prices could lower the market valuation of the unsold securities

hence lowering the volume of cash that could accrue from repurchase agreements collateralized by

those securities, leading to a "death spiral" of further fire sales. Consequently, fire sales by one large

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bank could set off fire sales by other banks, resulting in systemic risk.

T he dealer bank can alleviate the risk of a liquidity loss in the following ways due to a run by short-

term creditors:

Establishing lines of bank credit;

Dedicating a buffer stock of cash and liquidity securities for emergency liquidity needs; and

Laddering the maturities of its liabilities to refinance only a small portion of the debt within

a short period.

Teams of professionals are always present for major dealer banks to manage liquidity risk by

controlling the distribution of liability maturities and managing the availability of pools of cash and

other noncash collateral acceptable to secured creditors.

Broad and flexible lender-of-last-resort financing to large banks is a popular response by central

banks to the systemic risk created by the potential for fire sales. T he time needed for financial

claims to be liquidated bought by such financing on time.

T he U.S. Federal Reserve has always provided secured financing to regulated commercial banks

through its discount window. However, the discount window is not accessible to dealers, since they

are not as regulated as banks.

For the cash that was lost by the exit of repo counterparties and other less suitable funding sources

to be replaced, there may be lessening of the extent to which traditional insured bank deposits

finance a dealer bank during a solvency crisis.

b. Prime Brokerage Clients' Departure

T he cash and securities left by customers in their prime brokerage accounts are sometimes partly

used by prime brokers to finance themselves. In the U.K., securities and cash in prime brokerage

accounts are generally commingled with assets of prime brokers and are, therefore, available to the

prime brokers for their business.

A prime broker in the U.S. must aggregate its clients' free balances in safe areas of the broker

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dealer’s business-related activities to servicing its customers or deposit the funds in a reserve bank

account to prevent the comingling of customer and company funds.

T he financing provided by prime brokers to their clients is typically secured by the assets of those

clients’ prime brokers. In the U.S., the asset of a client can also be used as collateral to finance a

dealer bank's margin loans through re-hypothecation.

T he weakening of a dealer bank's financial position may lead hedge funds to move their prime

brokerage accounts elsewhere. T he cash liquidity problems of a prime broker in the U.S. can be

exacerbated by its prime brokerage business with or without clients running away from the dealer

bank.

T he dealer could continuously demand a hedge fund cash margin loans backed by securities left by

the hedge fund in its prime brokerage account, under its contract with the prime broker.

T he prime broker may have to use its cash to meet the demands of other customers on short notice

since the running away of prime brokerage customers can leave them with insufficient cash to be

pulled from their free credit balances to meet the said demands.

c. Various Cash-draining Undertakings by Derivatives Counterparties

designed to Lower their Exposures to the Dealer Bank

If a dealer bank is perceived to have some solvency risk, the counterparty of an OT C derivative

looks for opportunities to reduce its exposures to that of the dealer bank. T he following are the

mechanisms that are possible in this case scenario:

i. Borrowing from the dealer reduces the counterparty's exposure;

ii. Entering new trades with the dealer causing the dealer to pay out cash for a derivatives

position; and

iii. Cash can be harvested by the counterparty from any derivatives positions, having swung in

its favor over time.

Novation to another dealer is also a feasible way for a counterparty to reduce its exposure to the

dealer, just like in the case of Bear Stearns in 2008, whereby its counterparties sought for novation

from other dealers. Often, a collateral posting call is necessary for the OT C derivatives agreement.

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Furthermore, the increase in collateral is frequently called from a counterparty whose credit rating

gets downgraded below a stipulated level.

Terms for the early termination of derivatives are included in the master swap agreements, and this

includes one of the counterparties defaulting.

Most OT C derivatives are exempted by law as "qualifying financial contracts" from the automatic

stay at bankruptcy, holding up other creditors of a dealer. A significant post-bankruptcy drain on the

defaulting dealer is the impact of unwinding the derivatives portfolio of the dealer.

To minimize the incentive of counterparties fleeing from a weak dealer bank, derivatives contracts

are granted through a central clearing counterparty, which intervenes between original buyers and

sellers of OT C derivatives. T he central clearing counterparty protects all lose accruing from

defaults by amassing capital from members and collateral against derivatives exposures to its

members.

d. The Loss of Clearing-bank Privileges

T he refusal of the clearing bank to process transactions marks the final step of the collapse of a

dealer bank's ability to meet its daily obligations. A clearing bank extends daylight overdraft privileges

to its creditworthy clearing clients in the normal course of business.

T he right to offset a contractual right to discontinue making cash payments, thus reducing the

account holder's cash below zero during the day, is always in possession of a clearing bank in case

the cash liquidity of the dealer is under scrutiny. T his process results after accounting for the value

of any potential exposures by the clearing bank to the account holder.

Policy Measures that can Alleviate Firm-Specific and Systemic

Risks Related to Large Dealer Banks

For many years, there have been developments in the policies for prudential supervision, capital

requirements, and traditional commercial banks’ failure resolutions, and they have been relatively

settled. Policies for reducing the risks possessed by large systematically important financial

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institutions (SIFIs) have had significant new attention brought to them due to the financial crisis.

In both the U.S. and Europe, increased capital requirements, new supervisory councils, and special

abilities to resolve the financial institutions as they approach insolvency are the currently

envisioned regulatory changes for financial institutions that are critical for the banking system.

T he leading cause of systematic risk in the market is the effect of a dealer bank fire sale on market

prices and investor portfolios. To alleviate a financial crisis, lender-of-last-resort financing and capital

injections such as those provided by central banks have been used. Such injections can be provided

by the Bank of England or the U.S. T reasury Department's T roubled Asset Relief Program (TARP).

T he policy responses have further taken care of the challenges related to short-term tri-party repos,

which are unstable financial sources to a dealer bank. T ri-party clearing banks have incentives that

cover their exposures to a dealer bank, limiting the dealers' access to repo financing and account

function clearance. According to Ben Bernanke, who served two terms as Chair of the Federal

Reserve, there are possible benefits of a tri-party repo, with less discretion in rolling over a dealer's

repo positions.

Additionally, there is a development of an emergency bank usually financed by repo participants. T he

bank has direct access to discount-window financing from the central bank, protecting the

systemically critical clearing banks from losses in the event of unwinding their positions.

Further, the threat caused by the flight of over-the-counter derivatives counterparties is alleviated

through central clearing. Nowadays, several OT C derivatives, such as equities, commodities, and

foreign exchange, are centrally cleared.

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Practice Question

Which of the following standard policy tools is NOT applicable in the treating of the

social costs of bank failures?

A. Regulatory supervisions and the requirements for risk-based capital

B. Deposit insurance

C. Regulatory resolutions mechanisms

D. Regulatory requirements guiding the departure of prime brokerage customers

T he correct answer is D.

When treating the social costs of bank failures, the standard policy tools that are used

include: regulatory supervision and requirements for risk-based capital, deposit

insurance, and regulatory resolutions mechanisms.

T here are no such things as regulatory requirements guiding the departure of prime

brokerage customers when treating the social costs of bank failures.

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 Reading 131: Liquidity Stress Testing

After compl eti ng thi s readi ng, you shoul d be abl e to:

Differentiate between various types of liquidity, including funding, operational, strategic,

contingent, and restricted liquidity.

Estimate contingent liquidity via the liquid asset buffer.

Discuss the matters about the liquidity stress test design, such as scope, scenario

development, assumptions, outputs, governance, and integration with other risk models.

T his chapter discusses the critical factors that underpin a bank's liquidity risk management

framework. Liquidity stress testing aims to determine the level of liquidity that should be kept for

the institution to meet financial obligations under stressed conditions. A reliable liquidity stress test

should project cash flows from assets, liabilities, and other off-balance sheet items for a diverse,

systemic, and idiosyncratic scenario in different time horizons.

In an attempt for the banks to keep a robust stress testing framework, consider the following two

factors:

i. T he industry should expand the integration level and consistency between such factors as

the liquidity stress test, performance measurement, the capital stress test, risk

measurement and monitoring, and regulatory reporting.

ii. Banks should ensure a sustainable technology infrastructure to guarantee liquidity stress

testing in an effective and controlled way.

T he liquidity problem caused by an inadequate liquidity risk management framework is as challenging

for a financial institution as the actual incapability to meet financial obligations.

We consider the main components of stress testing, which include:

i. T he suitable scope and structure of the liquidity stress test across the enterprise;

ii. Scenario development; and

iii. T he development of critical assumptions.

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Types of Liquidity, including Funding, Operational, Strategic,
Contingent, and Restricted Liquidity

A liquidity stress test aims to measure the level of liquidity the institution must maintain to ensure a

continuous ability to meet financial obligations in stressed conditions. A useful liquidity framework

starts with defining "liquidity" for liquidity stress testing purposes. For this context, liquidity refers

to fundi ng l i qui di ty ri sk , which is the risk that the institution is unable to meet its contractual

obligations without suffering unacceptable economic losses. Asset liquidity risk, which involves an

institution incurring losses due to the difficulty of converting assets into cash, should further be

considered as it has an impact on the level of funding created from the sale of assets.

Liquidity is used for four purposes, namely operational, contingent, restricted, and strategic liquidity,

as discussed below:

Operational Liquidity

Operational liquidity involves the cash needed for daily funding of the business and orderly clearing of

payment transactions. T here is a high level of volatility associated with operational liquidity hence

necessitating an additional cushion to account for unpredictable daily settlements. During a liquidity

stress test, operational liquidity is unavailable to meet financial obligations.

Restricted Liquidity

Restricted liquidity entails liquid assets maintained to be used mainly for specifically defined

purposes. During a liquidity stress test, restricted liquidity is unavailable to meet general financial

obligations; however, it applies to any assumed outflows which they support.

Contingent Liquidity

Contingent liquidity characterizes the liquidity available to meet general financial obligations under a

stress scenario. T he liquidity is in the form of the institution's liquid asset buffer, which entails

access to high-quality financial assets that are readily convertible to cash without incurring a fire

sale price. T he principal objective of the stress test inclines towards the contingent liquidity

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measurement.

Strategic Liquidity

Strategic liquidity involves the cash an institution holds for future business needs that may arise

without the course of normal operations such as funding future acquisitions or capital, but it's not to

support the bank during times of stress.

Estimation of Contingent Liquidity via the Liquid Asset Buffer

Overview of the Model

For an institution to measure the liquidity stress, it should target to measure the level of required

contingent liquidity, which involves constructing a cash flow model that precisely and accurately

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measures components such as the liquid asset buffer, stressed outflows, stressed inflows, and the

stressed liquid asset buffer. T he following sections give a further discussion of these components.

Liquid Asset Buffer

Liquid asset buffer refers to a stock of unencumbered high-quality liquid assets usually held to

protect against failure under liquidity stress. It represents the contingent liquidity that is currently

available for an institution.

Before the inclusion of a security is in the asset buffer, the necessary market and operational

characteristics that it should meet must be explicitly defined, and the framework should ensure that

their liquidity-generating capacity remains intact even during adverse idiosyncratic and market

stress. T hese characteristics should include low credit and market risk, trading in an active and

sizable market, ease and certainty of valuation, and low concentration of buyers and sellers.

Stressed Outflows

Stressed outflows occur during stressed scenarios and results from the need to prematurely settle

non-contractual maturity obligations and incapability to refund contractual maturity obligations that

could roll over under normal conditions. T he outflows to be modeled should be explicitly defined in

the framework and should belong to the categories of retail deposit outflows, derivative transaction

funding, unsecured wholesale funding outflows, loss of funding on asset-backed issuances, secured

funding runoff, and drawdown of credit and liquidity facilities.

Stressed Inflows

Stressed inflows offset the stressed outflows but partially. T hey include secured funding transaction

maturities, drawdowns on liquidity facilities available to the institution, and loan repayments from

customers. Market conditions may reduce the level of inflows according to the assumptions

employed in a given stress scenario.

Stressed Liquid Asset Buffer

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T he current liquid asset buffer is the sum of (stressed outflows - stressed inflows) and the liquid

asset buffer considering the underlying assumptions in a stress scenario.

Liquidity stress testing components can be demonstrated as shown in the following figure:

Design of the Model

T he model process of the liquidity stress testing begins with identifying the risk and doing event

analysis to ensure that the list of scenarios captures material liquidity appropriately.

Organization Scope

Although the consolidated stress test should be the fulcrum of any liquidity risk framework, it may be

necessary to conduct stress testing on subsidiary entities within the organization. An institution

should perform a separate liquidity stress test on organizational levels such as parent, service

business unit, subsidiary legal entities, lines of business, and shared service centers. For less

material entities or entities with manageable risk assessment, simple entity-level liquidity risk

reporting might be appropriate.

An institution should consider the organizational level whereby the liquidity is commingled, and the

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management does liquidity control. Combining the legal entities and operating units exemplifying both

of the above characteristics provide the building blocks of the enterprise-level liquidity stress test.

Liquidity Transfer Restrictions

Sometimes liquidity may be trapped in given legal entities creating a distorted view of the

consolidated liquidity position of an institution due to certain restrictions. In such scenarios, the bank

should assess the effect of the restrictions on enterprise-level liquidity for both typical operating

environment and stressed conditions.

T he presence of liquidity transfer restrictions does not guarantee a rise to the need for an extra

stress test in cases that are demonstratable to show that there is no subsidiary requirement to

upstream cash to the parent. For instance, an institution may stress the consolidated entity and the

holding company but fail to test individual banking subsidiaries assuming that cash movements from

the parent to the subsidiary would be unrestricted.

Currency

T he liquidity stress test is performed based on the currency of the tested entity using the home

country currency for the consolidated test. T here should be further considerations of the liquidity

impact of currency conversion requirements to avoid currency mismatch for offshore subsidiaries.

Regulatory Jurisdiction

Individual stress test for foreign subsidiaries is necessary for institutions that operate in several

foreign jurisdictions under several regulatory oversight regimes. For instance, according to U.S.

regulations, specific foreign banking organizations should conduct liquidity stress tests for

intermediate holding companies and branches to address cases of foreign banks operating in the

country been over-reliant on offshore funding.

Planning Horizon

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For an institution to maintain adequate contingency funding through a period of extended stress, the

time horizon for the stress test should be at least 12 months. Cash flow projections that run beyond

twelve months are acceptable, albeit longer-term projections may be affected by forecast error

according to the baseline balance sheet and statement of income budgeting time horizon. Besides, it's

not feasible for a bank to continue its operations indefinitely under stress without employing a

recovery or resolution process.

A bank may decide to forecast beyond twelve months in a case where the calculation of survival

horizon depends on the stress test. T he survival horizon may even extend beyond this period for

banks with sufficient liquidity.

Determination of the cash flow frequency measurement is done within the overall time horizon, and

the decision to estimate periodic cash flows should balance the benefits of improved precision

against the reduced forecasting accuracy beyond a specific time frame. In this connection, stress

models forecasting daily over a short time frame such as a month and a weekly or monthly transition

of cash flows for the remaining time horizon usually offer the best balance.

It is recommendable to do daily forecasting during the early stage of forecasting because of the

relatively higher predictability of these cash flows, and also because a critical period of stress for

the institution may occur during the first few days.

Testing Techniques

T he liquidity stress test involves three approaches, namely historical statistical techniques,

deterministic models, and Monte Carlo simulation.

Hi stori cal stati sti cal approach: T his stress testing technique models an institution's

historical pro forma cash flow subject to the observed cash flow volatility of the

institution. An example is the cash flow at risk approach (CFaR).

Determi ni sti c model s: Deterministic models model the liquidity effect of a forward-

looking or historical-based scenario that has been developed by the institution. An example

of such a model is the development of hypothetical liquidity stress scenarios.

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 Monte Carl o si mul ati on: T his statistical technique is based on simulation modeling and

applies in assessing the liquidity risk done by stress testing specified variables over a

future time frame.

Stochastic techniques that depend on observations of the historical volatility of cash flow variables,

either using the historical statistical models such as CFaR or Monte Carlo simulation techniques that

depend on historical observations of volatility, are less favorable in time of financial crisis.

Deterministic scenarios are the most effective tools for assessing liquidity risk since the liquidity

stress is an extreme "tail event." T he disadvantage of stochastic approaches is in their incapability to

accurately predict the management countermeasures that would occur during a liquidity crisis event.

Developing a Deterministic Liquidity Stress Test Framework

The Baseline Scenario

T he baseline balance sheet funding and a liquidity plan is the starting point for building a liquidity

stress test. A banking organization should ensure that it enhances the structure of the baseline plan

as well, ensuring that the base case is consistently structured and at the same level of detail as the

stress scenarios when building its liquidity stress test framework.

Scenario Development

Liquidity failure is a high-impact and low-frequency event by nature. However, few banks have fallen

as a result of a liquidity crisis, and for that matter, there is little data reliable for building dependable

and predictive models that can accurately evaluate the minimum level of liquidity that an institution

should expect to remain within a confidence interval.

Due to these challenges and the highly complex, interconnected nature of liquidity behavior, the best

approach in stress testing is based on developing a discrete and deterministic scenario. Additionally,

banks should carefully consider their idiosyncratic material risk when designing their scenario

framework.

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Liquidity stress scenarios are of two types, namely historical scenarios and forward-looking

(hypothetical) scenarios.

Hypothetical Scenarios

Hypothetical scenarios depend on a forward-looking view in which the financial institution

experiences adverse liquidity stress. Banks develop multiple scenarios with the following

characteristics:

Di sti ngui sh between systemi c and i di osyncrati c ri sk : Systemic stress such as a decrease in

the market liquidity of securities may cause stress impacts. However, other stress impacts result

from bank-only stress, such as a deposit run. In this case, the bank should develop scenarios for each

of the cases of systemic, idiosyncratic, and for both to capture these fluctuating impacts.

Di sti ngui sh between l evel s of severi ty: For an institution to widen its view of liquidity risk and

applicable limits, it should undertake graduating levels of severity, such as developing adverse and

severely adverse variations of the idiosyncratic scenario.

Cl earl y defi ne the scenari os: Establishing the specific and detailed description of the business

and market events related to each scenario offers the basis of assumption development and link

stress testing with early warning indicators in contingency funding plans. A good scenario description

should include:

1. T he overall level of stress (e.g., high) due to market, economic, and credit conditions;

2. Conditions secured and unsecured wholesale funding markets;

3. Changes in counterparty haircut necessities by collateral type;

4. Liquidity effects on securities in the liquidity buffer and other assets when selling;

5. Credit grade downgrade details;

6. Deposit runoff assumptions based on product and customer type, considering other factors

such as insurance coverage;

7. Description of impacts on specific counterparty relationships;

8. Assessment of trigger effects on derivative margin and collateral calls;

9. Effects of regulatory actions and limit breach in jurisdictions of overseas;

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 10. Drawdowns assumed on unfunded credit and liquidity facilities; and

11. T he assumed debt calls and buybacks.

More Holistic Approaches to Scenario Development

A bank should consider a model that is holistic in terms of capturing systematic and independent risk

behavior rather than developing isolated liquidity assumptions. In this case, liquidity stress test

scenarios based on the standard industry such as those needed by regulators in the Basel III Liquidity

Coverage Ratio (LCR) are very prescriptive.

Together with the assumption-based hypothetical scenarios, the bank may also perform a reverse

liquidity stress test to determine which conditions' existence given the bank's current liquidity level

would cause its current business plan to fail. Developing such a reverse stress test scenario creates

several problems due to the existence of many factors that could be combined to destroy the

institution. Reverse stress testing is not performed collectively among financial institutions due to

the challenges of identifying the associated problems. However, to enhance an understanding of the

priority risks the institution should be testing its's wise to think through a reverse stress test in

developing traditional stress test scenarios.

Development of Assumptions

Valid assumptions are crucial in liquidity stress testing as the process depends on both historical and

hypothetical scenarios. T here have been an inadequate market and historical data to create a

baseline for stress testing assumptions; however, the available segmentation frameworks that enable

differentiation of assumptions across different levels of cash flow risk improves the precision of the

liquidity stress test.

T he Basel III Liquidity Coverage Ratio (LCR) is an essential factor an institution should consider

when developing internal views of stressed liquidity behavior.

Necessary Factors in the Development of Assumptions

1. An institution should do a qualitative assessment of the expected liquidity behavior for each

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 type of cash flow to identify where there is significant liquidity risk.

2. Based on the assessment of the behavioral differences, an institution should identify the

significant level of segmentation relating to each cash flow, considering the existing

limitations in ongoing data availability.

3. Institutions should do a qualitative assessment and orderly rank different levels of liquidity

risk for each segmentation factor, possibly applying a scoring system.

4. Undertake quantitative modeling assumptions based on any existing historical data.

5. An institution should build matrices of relative modeling assumptions based on scored risk

levels and historical baseline data.

6. Appropriate changes of the assumption matrices for each stress scenario, such as reflecting

variations in relative overall severity or assumptions about idiosyncratic or systemic risk.

T he following table gives a breakdown of crucial liquidity stress impacts:

Category Key Liquidity Stress Impacts

Deposit runoff Depositors accelerate demand deposit withdrawals
Deposit runoff Term depositors exercise early withdrawal rights
Loss of wholesale funding Inability to roll over short-term, maturing unsecured
wholesale
Loss of wholesale funding Early termination of unsecured wholesale funding credit lines
and/or early redemption of wholesale fundings
Loss of secured funding Loss of willing counterparties for secured funding
Limitation of security types available for secured funding
Loss of secured funding
and/or increased collateral haircuts
Loss of secured funding Loss of access to asset-backed funding facilities due to lack of
funding embedded options, or lack of eligible assets
Reduced investment Increased liquidity haircuts and/or reduced valuations
portfolio liquidity of liquidity portfolio securities
Derivative cash flows Increased derivative margin/collateral calls due to increased
market volatility of underlying position
Derivative cash flows Increased collateral calls due to reduction in collateral value
Ratings downgrades Collateral or other liquidity impacts due to ratings triggers
Credit/liquidity facilities Accelerated drawdown of credit and liquidity facilities
by customers/counterparties

T he following section discusses the considered assumptions:

Investment portfol i o hai rcuts: T he available sources of liquidity and haircut pose a critical

impact on available liquidity under stress. For systematic stress scenarios, the haircut widens, just

like in times of liquidity crisis. For this reason, the model should include different haircut

assumptions for securities with different liquidity characteristics. It should further include

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anticipated haircut disparities between secured financing channels used by the institution such as

Federal Home Loan Bank funding, and repo facilities.

T he institution should develop an orderly scoring system rank of the relative liquidity along the

different segmentation dimensions and allocate specific haircuts to each security type and funding

channel based on assessed liquidity risk. Developing the haircuts starts with a review of the current

market conditions assuming the conditions are normal. T hese advance rates are compared to the

experiences of the bank during the financial crisis, and if such information is unavailable, peer

comparisons can provide it.

Deposi t outfl ows: T hese outflows creates a substantial threat to both liquidity and the behavioral

dynamic of the model. For banks with a high level of deposit funding, liquidity stress test models

developed on simplistic assumptions about deposit behavior probably yields meaningless results

irrespective of how accurately calibrated are other factors.

Institutions should build a set of complete deposit runoff assumptions relative to behavioral

segmentation framework capturing variations in stressed deposit behavior.

T he historical behavior of a deposit portfolio at the account rather than the portfolio level should be

analyzed to develop a suitable internal segmentation framework. During a hypothetical crisis, an

empirical analysis may yield an imperfect experiment indicative of behavior. However, the analysis

suggests customer "stickiness," offering a more rigorous foundation compared to high-level,

qualitative assumptions.

Unsecured whol e sel l fundi ng: During the idiosyncratic stress period, unsecured whole sell

funding is hardly available. Banks need to review funding channels to differentiate them subject to

overnight and term funding.

Col l ateral requi rement: Collateral requirements increase during stress period due to valuation

impacts on existing collateral and amplified amount of collateral required due to changes in derivative

positions. Assumptions for collateral call levels are developed depending on the level of required

detail. Historical collateral call levels during times of stress are reviewed, selecting the most

substantial liquidity requirement experienced during a historical period.

Other conti ngent l i abi l i ti es: T he developed model should address every material source of

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contingent liquidity outflow, such as drawdowns of customer credit lines, letters of credit, trade

financing arrangements, liquidity facilities, securitization facility runoff, and other contractual

arrangements. T he institution should review the contingent liabilities' behavior during the financial

crisis, and if no available data from the past crisis, conservative assumptions can be employed. Note

that the model should also incorporate non-contractual agreements.

Busi ness di al back : All feasible assumptions about the institution's capacity to reduce liquidity-

draining business activities like new loan origination should be incorporated in the model. In the

development of these assumptions, the business management should discuss the appropriate reduced

funding activity that can occur without substantial reputational problems.

Outputs of the Model

T he output of a stress testing model is very substantial in assessing tactical and structural liquidity

based on internally established limits and regulatory expectations. Furthermore, the liquidity risk

escalation process of an institution depends on model output. T he bank should develop its liquidity

limit structure, and notably the contingency funding plan based on the results of the liquidity stress

test. T he output of a stress testing model is as below:

Stress testing assumptions

T he following are the four key assumptions:

1. T he assumption on the overall stress level represented by the scenario;

2. T he indication of the nature of the scenario, e.g., systemic, idiosyncratic, or both systemic

and idiosyncratic;

3. Documentation of the general macroeconomic, market, and company-specific events causing

the stress scenario; and

4. Discussion of the impact of the scenario on cash flows.

Liquidity Position Metrics

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T he amount of available liquidity concerning net cash outflows under every scenario is the key

output of a stress testing model. T his metric structure varies depending on the institution; some

differentiate between tactical and structural liquidity while measuring the results of the liquidity

stress test. For instance, the Basel III Liquidity Coverage Ratio (LCR) provides a thirty-day view into

available liquidity under stress.

Prospective Liquidity Position Metrics

An institution should gauge the potential liquidity profile of the bank during the stress horizon. T he

leading indicators of liquidity risk comprise of prospective existing liquidity, ratios indicating

wholesale funding dependence, and metrics indicating possible overconcentration in given funding

channels.

Capital and Performance Metrics

A balance sheet should be thoroughly measured, gauging the economic impact of the investment

portfolio. An institution may gauge the tradeoff between low-yielding, low-haircut instruments and

higher performance, less liquid instruments by computing yield net of a regulatory/economic capital

charge. In confirming whether the model captures the impact of any capital actions that are

necessary for supporting liquidity over the stress period, it is necessary to track the significant

capital metrics for each entity. T he stress test is advisably conducted at least quarterly to assist the

asset-liability management team to do a review.

Governance and Controls

T he stress test purpose is to effectively oversee the process to ensure the liquidity risk profile

satisfies the bank's risk appetite and capacity. Governance and control roles include:

Asset-liability Committee (ALCO) – First line of defense

T his committee, together with the management risk committee and executive management, is

responsible for the liquidity stress testing. T he functions of the committee include:

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 Undertaking the establishment, review, and approval of a liquidity stress testing policy. T he

policy should comprise of the details of the scenarios to be run, significant assumptions,

roles and responsibilities, reporting requirements, and limits. T he renewal of the policy

plan for liquidity stress testing should take place annually.

Identifying and approving liquidity risk scenarios, comprising of main changes to liquidity

scenarios and assumptions.

Designing liquidity risk policy limits relative to stress test results and escalating

exceptions.

Treasury – Second line of defense

T he treasury is responsible for the following activities:

1. Maintaining the liquidity stress testing procedures.

2. Recommending stress testing scenarios.

3. Reviewing and monitoring components of the institution's assets and liabilities and

recommending to the ALCO on matters relating to stress testing assumptions.

4. Making stress-test liquidity reports which reconcile to the liquidity stress test data of the

baseline balance sheet. For large banks, the treasury performs a liquidity stress test for

their particular entities.

Risk Management

Risk management is accountable for providing independent oversight of liquidity stress testing

together with other programs relative to components of the liquidity risk management program. T he

risk management is accountable for:

1. Administering the policy regarding liquidity stress testing.

2. Reviewing and providing a practical challenge of the scenario design and assumptions.

3. Ensuring the institution's method of liquidity stress testing follows acceptable industry

practices and regulatory rules and guidance.

4. Reviewing and approving the liquidity stress test-based limits.

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 5. Monitoring liquidity stress test-based limits.

6. Ensuring the ALCO is informed on the bank's liquidity risk profile.

Internal Audit – Third line of defense

Internal audit undertakes the liquidity stress testing framework periodical review, procedures, and

controls to keep compliance with policy, regulatory, and control requirements.

Model Risk Management

T he committee provides independent validation and control over the management governance of the

liquidity stress testing model concerning the institution's model risk management policy.

Liquidity Optimization

T he liquidity stress test aims to get the appropriate level of liquidity buffer. In maximizing the

efficiency of the liquidity portfolio, the composition of the liquidity buffer is designed based on the

liquidity stress test.

Liquidity versus Yield

Higher yielding instruments usually have less favorable liquidity components and increase

investment portfolio duration. A maximization in either the yield or period of the portfolio would be

suboptimal for the institution's return on asset performance as a whole.

A yield maximizing portfolio is ineffective due to the extra balance level needed to offset stress test

haircuts and the disparity between the portfolio's inflows and the stress test outflows. Additionally,

maximizing the liquidity profile of the portfolio instead of the yield may be likewise ineffective.

Liquidity versus Capital

T here exists a similar trade-off for incorporating the capital impact of various portfolio alternatives

depending on the institution's economic and regulatory capital framework. T he maximization of the

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investment allocation of liquidity and capital may be suboptimal due to the extra regulatory and

possibly economic capital requirements related to the instruments. Banks in which additional asset

amount leads to an extra equity capital necessity under leverage ratio limits experience challenges

due to the new haircut required for higher-risk instruments. Linking liquidity versus capital

necessitates a funds transfer pricing (FT P) framework to accurately incorporates the stressed

liquidity profile of diverse business segments across the enterprise.

Funding Optimization

T he impact of different funding sources with varying liquidity characteristics is one of the vital

information provided by the liquidity stress testing. Since the financial crisis, attempts are made to

provide financial institutions with an incentive to promote reliable funding sources like retail branch

deposits rather than money from wholesale sources. T he treasury should establish a target funding

profile by modeling the liquidity impacts of the available alternatives.

For instance, linking the liquidity profile of commercial deposits to treasury management services

bolsters the business' case investment in the desired industry segments characterized by more

intensive working capital requirements. Establish such a link needs a funds transfer pricing (FT P)

framework to incorporate the stressed liquidity profile of different business segments across the

enterprise appropriately.

Establishing a Sustainable Infrastructure

An institution should keep an information technology system that automatically collects, aggregates,

captures market data, generates reports, and does data analytics. Developing such an infrastructure

for liquidity stress data is a challenge to complex financial institutions as it requires substantial

amendments to the existing data warehouse capabilities built from the general ledger and

transactional customer data. T he following conditions are vital for consideration in establishing a

sustainable infrastructure:

Position data collection and aggregation

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A data management model development is necessary to ensure that the required liquidity position

data are captured automatically. T he specific architecture used by an institution could include the

use of standardized templates or data hub structures. For the automated development of model

inputs, there is an association between the necessary liquidity characteristics and each position data

which should conform to the institution's granularity.

Regulatory report generation

T he development of an automated position capture should start with generating regulatory reports

such as the Basel III Liquidity Coverage Ratio (LCR) with less manual intervention.

Analytics

A good model should capture all necessary features and functions required in any robust analysis tool.

Such features include the capacity to perform sensitivity analysis on stress test assumptions, the

capacity to save scenarios, and the capacity to produce different legal entity views. T he model

should further include analytic functionality that measures the economic capital impact of different

liquidity portfolio allocations.

Liquidity dashboard

Monitoring of significant risk indicators and performance drivers on a predetermined basis should be

done, distributing the results to risk managers. In this connection, liquidity stress test outcomes may

be included in a current risk dashboard or distributed separately.

Integration of Liquidity Stress Testing with Related Risk

Models

Liquidity stress testing is integrated with other related risk frameworks like asset-liability

management (for interest rate risk), recovery and resolution planning, and capital stress testing. T he

model may be using a related assumption framework about the balance sheet behavior of given

accounts, which, when developed independently, may lead to an overall risk management framework.

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Banks should consider correlations between risk types that may create a systemic or idiosyncratic

stress scenario.

T heoretically, an institution should keep a complete risk model that gauges the impact on liquidity,

capital, and balance sheet structure based on a standard set of scenarios. Practically, this strategy

may be challenging since it's complicated and needs an institution to develop exceptional stress

scenarios for each risk type.

Liquidity Stress Testing and Capital Stress Testing

To link liquidity stress testing and capital stress testing requires an institution to incorporates any

essential capital infusions of subsidiary entities. For every liquidity stress test scenario, the

institution should develop capital impact assumptions based on the general market and idiosyncratic

conditions that occur under the scenario. T he extent of detail for developing these assumptions

differ from a high-level capital infusion assumption to complete credit loss and pre-provision net

revenue modeling for victim subsidiaries.

Additionally, the capital stress testing framework should comprise of a liquidity stress evaluation

aimed at gauging the impact of any required liquidity impacts on capital adequacy. Finally, a liquidity

impact analysis should be done to establish if extra capital impacts may arise through investment

portfolios and necessary funding actions that would raise additional worsening in capital adequacy.

Liquidity Stress Testing and Asset-liability Management

Interest rate risk models are made to gauge the interest expense and economic value of equity

impacts of adverse changes in interest rates. Liquidity impact analysis is not run concomitantly

stress testing for interest rate risk as done for capital stress testing. However, we employ a

consistent behavioral framework in both the interest rate and liquidity stress testing models. For

instance, in an event where the liquidity stress test model assumes that there is no runoff in given

operational deposits, the interest rate risk model has to segment these deposits and treat them as

non-operational deposits.

In the liquid stress model, consideration of interest rate impacts is essential. T he combination of the

liquidity stress test scenario framework, liquidity risk dash-boards, and liquidity risk early warning

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indicators should comprise the likelihood of an interest rate shock and its possible impact on general

liabilities.

Liquidity Stress Testing and Funds Transfer Pricing

Funds transfer pricing is an essential tool for driving business decision making, despite that it's not a

risk model. T he purpose of the FT P framework is to price liquidity appropriately, irrespective of

whether provided for lending by the treasury center or credited to liability-generating activities. T his

framework should leverage and be consistent with the contingent liquidity necessities for assets and

liabilities measured by the liquidity stress test model. All costs of carrying a buffer should pass

through FT P framework.

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Practice Question

Which of the following most accurately defines liquidity in the context of liquidity stress

testing?

A.T he funding liquidity risk

B. Intraday liquidity

C. Market liquidity risk

D. Credit risk

T he correct answer is A.

Liquidity in the context of liquidity stress testing refers to funding liquidity risk, which is

the risk that an institution is unable to fund its obligations without suffering unacceptable

economic losses

B i s i ncorrect: Intraday liquidity is a source of liquidity

C i s i ncorrect: T he market liquidity is the ability of buyers and sellers of assets to

transact efficiently and is gauged by the speed with which large purchases and sales can

be performed, and the transaction costs incurred.

D i s i ncorrect: Credit risk is just a manifestation of funding liquidity risk

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 Reading 132: Liquidity Risk Reporting and Stress Testing

After compl eti ng thi s readi ng, you shoul d be abl e to:

Identify best practices for the reporting of a bank’s liquidity position.

Compare and interpret different types of liquidity risk reports.

Explain the process of reporting a liquidity stress test and interpret a liquidity stress test

report.

Best Practices for the Reporting of a Bank’s Liquidity Position

In the UK, quantitative liquidity reporting is a core part of the regulatory regime. T he full

requirement applies to individual liquidity adequacy standards (ILAS) firms. Some smaller institutions

and foreign branches are not ILAS firms. As such, the regulatory authority will agree on the format

and frequency of liquidity reporting on a case-by-case basis. T he following is a summary of the

reporting requirements for UK standard ILAS firms:

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 Report Description Frequency Deadline of
submission
FSA047: Daily Daily cash flows out BAU: Weekly BAU: end-of-
Flows to analyses survival firm-specific day Monday
of 3 months and the market- Stress: end of the
wide liquidity day in the
stress, done following
daily business day
FSA048: Enhanced ILAS risk drivers/ BAU: Weekly BAU: end-of-
mismatch report contractual cash firm-specific day Monday
flows across the full and the market- Stress: end of the
maturity spectrum wide liquidity day the
stress, done on following
daily business day
FSA050: Liquidity Granular analysis of Done monthly Submitted in 15
Buffer qualifying the firm’s marketable business days
securities asset holdings after month-end
FSA051: Funding Unsecured wholesale Done monthly Submitted in 15
concentration funds borrowings business days
(excludes primary after month-end
issuance), by
counterparty class
FSA052: Wholesale Daily transaction Done weekly submitted in the
liabilities prices and the end-of-day
transacted level for T uesday 15
wholesale unsecured business days
liabilities after month-end
FSA053: Retail, T he firm’s retail and Done quarterly Submitted in 15
SME and large corporate funding business days
enterprises profile and the retail after month-end
corporate funding deposits stickiness
FSA054: Currency T he analysis of Done quarterly Submitted in 15
analysis foreign exchange business days
(FX) exposures on a after month-end
firm’s balance sheet
Off-balance sheet Total undrawn Done monthly Submitted in 15
report committed facilities business days
after month-end

Treatment of Cashflows

How different specific types of cashflow are treated is a fundamental question in liquidity reporting.

Take for example the following items:

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 1. Non-maturity items in liquidity/interest rate sensitivity analysis, i.e., demand deposits; or

2. Off-balance sheet items such as options and undrawn commitments in a liquidity gap analysis.

T he treatment of these cash flows may vary for regulatory purposes. For instance, callable and

demand deposits are treated as one-day money for regulatory purposes. However, certain regulatory

authorities allow “behavioral” modifications of retail deposits in cases where they remain relatively

stable over time. For instance, in such a case, 50% of deposits can be treated as long-term funds.

UK FSA Treatment for Off-Balance Sheet Items

T he off-balance sheet items are treated as follows:

i. T he derivative's values/notional is not included in the calculation of the liquidity ratio.

However, coupons receivable or payable are included on their pay dates.

ii. 10% of commitments, as specified by the UK's Financial Conduct Authority (FSA), which is

undrawn, is included as a cash outflow (at sight) and included in the ratio calculations.

Bank liquidity models usually apply the following:

i. Derivatives are included to the extent of collateral payable or receivable under an ISDA/CSA

agreement; though, coupons receivable or payable are included but only on their pay dates.

ii. For commitments, all committed but undrawn lending is included as a cash outflow (at sight)

and included in liquidity calculations.

Generally, treating expected cash outflows conservatively, whether as derivative collateral or

undrawn commitments, is a recommended business practice.

Types of Liquidity Risk Reports

A bank produces several liquidity reports during its normal business course, either weekly, monthly,

or at any other specified duration. T he format of liquidity management information (MI) is supposed

to be accessible and transparent. We demonstrate a sample of reports that provide a benchmark

framework for reporting in the following section.

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Deposit Tracker Report

Deposit tracker report is a weekly/monthly report of the current amount of deposits as well as a

forecast of deposits anticipated in the future. It provides an idea about the loan-to-deposit (LT D) ratio

in the immediate short term. T he information provided by the deposit tracker report include:

1. Month-end actuals for deposits by customer type;

2. Each month-end change;

3. Aggregate customer assets and the LT D ratio; and

4. Each month-end forecast for the position to the end of the year.

T he following graph represents a simple example of the first part of the deposit tracker report as of

31/05/2019 for a medium commercial bank. From the report, the month-end actual is provided based

on customer type, the change from the month-ends, total customer assets, and LT D ratio, and then

the month-end position forecast for the whole year.

Note that forecasting in this report is based basically on the objective judgment. T he historical trend

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up to the current date may assist in making the forecast.

T he following is a graph of the deposit tracker report that represents customer deposits by type of

account and tenor. In this case, the current accounts and rolling deposits make a significant

contribution to the retail bank deposits while there is little fixed-term deposit. For regulation, these

funds are treated as short-term liabilities and don’t assist the bank’s regulatory liquidity metrics,

which emphasizes long-term funds. However, the local regulator can allow the bank to treat

overnight balances as longer-term if they are demonstratable to be acting as long-term in

“behavioral” terms.

T he bank should undertake a marketing exercise to establish whether customers are interested in

transferring their deposits into fixed-term or notice accounts. Any increase in the size of the fixed-

term accounts improves the firm’s liquidity metrics.

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Daily Liquidity Report

Daily liquidity report gives the bank’s liquid and marketable assets and liabilities in a straightforward

spreadsheet up to 1-year maturity and beyond. It provides an end-of-day of the bank’s liquidity

position for the T reasury and Finance departments. Each branch and subsidiary complete one,

although a bank that has only a branch structure (and no subsidiaries) may aggregate the report.

T he following table represents a simple daily liquidity report for a commercial bank showing a list of

liquid securities.

List of Liquid Securities: Input to Daily Liquidity Report

Securities and CDs

Classification marketable Input Data

securities CDs
Bank CDs: non-ECB eligible, liquid at 265,896
the maturity date
Bank CDs: ECB eligible, liquid same day 0
ECB eligible securities, liquid in 1-week 43, 908
tender
Non-ECB eligible securities, can be sold over 56, 876
4 weeks
Government securities 81, 900
Total marketable securities and CDs 182, 684 265,896
Non-marketable
Non-ECB eligible CD summary
Average remaining tenor Amount
2 weeks 34,600
1 month 65,800
2 months 56,890
3 months 51,900
6 months 61,679

Funding Maturity Gap (“Mismatch”) Report

T he funding maturity gap report, also called to as a mismatch report, reflects the maturity gap for all

assets and liabilities per time bucket and with an adjustment for liquid securities. T he report

comprises the cumulative liquidity cash flow of the daily liquidity report. T he report is also used to

generate a cash flow survival horizon report.

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T he following figure shows a graphical representation of cash flow survival horizon:

Funding Concentration Report

T his report is crucial management information (MI) for senior T reasury and relationship managers.

T he funding diversity, a fundamental principle in liquidity management, requires financial institutions

to avoid overreliance on one source of funds such as intraday group funds. A funding concentration

report is as illustrated below:

Large Depositor Concentration Report Summary

Group T reasury Large Depositors by Country as

a Percentage of Total Funding

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 Country Total large deposits % of external country % of external group
'000s funding funding
F 5, 600, 000 10% 7.20%
G 6, 890, 450 43.67% 4.30%
H 7, 567, 890 21.00% 3.89%
I 5, 890, 500 12.54% 2.80%
J 3, 783, 900 3.89% 4.78%
K 4, 783, 870 23.84% 2.63%
Total 34, 516, 610 25.6%

T he above table represents an example of a hypothetical large depositor concentration report for a

banking group. In this case, “large” is defined as someone that deposits USD 50 million or more;

however, a bank may define it in the percentage of total liability terms rather than absolute amounts.

Generally speaking, a deposit of 5% of total liabilities should be treated as large by ALCO.

Undrawn Commitment Report

Off-balance sheet items such as liquidity lines, letters of credit, revolving credit facilities, and

guarantees are potential stress points for a bank’s funding. Unutilized liquidity and funding lines are

expected to be drawn down in a stress scenario since customers experience their own funding

challenges. T he presence of undrawn commitments may cause funding shortages at wrong times;

hence liquidity metrics must include undrawn commitments.

T he following figure shows an undrawn commitment report, showing trend over time:

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Liability Profile

T he liability profile is a simple breakdown of the share of each type of liability at the bank. T he

liabilities of a bank comprise the following categories:

Customer individuals

Large customer enterprises

Highly liquid security repo

High-quality securities repo

Asset-backed securities

Other unsecured wholesale, other assets repo

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 Conditional liabilities.

T he share of each of the components is shown in the following pie chart:

Other types of funding sources by product type that may be included in the liquidity profile include

covered bonds, client free cash, structured deposit products, unsecured credit institution, unsecured

government and central banks, net derivative margin, and primary issuance.

Wholesale Pricing and Volume

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Together with liquidity cash flow metrics, the liquidity position of an institution can be gleaned by

banks funding costs and the components of its funding by product. T he regulatory authority usually

obtains early warnings of a given bank experiencing funding stress through the funding yield curve. If

the curve rises significantly beyond the curves for its peers, it indicates a funding stress. For

individual bank senior management, an idea of a peer group average can be obtained from the

regulator. A comparison to one’s own funding level is a worthwhile exercise and should be

undertaken on at least a quarterly basis.

A yield curve for a hypothetical bank may look like this:

T he following graph represents the breakdown of the same bank’s wholesale funding by volume and

product type.

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Summary and Qualitative Reports

Senior management liquidity report management information is presented as a one-page summary of

the vital metrics of liquidity. T hese reports are kept in one side of A4 to increase their chances of

been noticed and read by the senior management. T he following is an example of a hypothetical

monthly liquidity snapshot for senior management.

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 1 2 1 2 1 2 3 6 1
Day Day Week Week Month Months Months Months Year
Cumulative Net 180 180 (1, 160) (1, 160) (1, 080) (1, 308) (1, 050) (750) (750)
Cash Balance
Other Forecast
Inflows
Other Forecast
Outflows
Cumulative Cash 180 180 (1, 160) (1, 160) (1, 080) (1, 308) (1, 050) (750) (750)
Gap
Counterbalancing 280 280 735 740 848 848 1, 338 1, 338 1, 338
Capacity
Liquidity Gap 460 460 (425) (420) (232) (460) 288 588 588
Limit
Variance 460 460 (425) (420) (232) (460) 288 588 588

* Cash gap turns negative between 2-day and 1-week

* Liquidity gap turns negative between 2-day and 1-week

Current Previous Change

month month
Liquidity Risk Factor 20.2 23.1 Decrease
Loan-To-Deposit Ratio 86% 84% Increase
Net Inter-Group Lending −1, 220 −1, 550 Increase

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From the above report, it is notable that the cash gap becomes negative between the first and

second week, while the liquidity gap turns negative between the first and second day.

A qualitative monthly report should be prepared and send to the head office group treasury for the

banking groups operating across country jurisdictions or multiple subsidiaries for a better

understanding of the liquidity position in the respective countries.

Regular Liquidity Highlights for Group Treasury Qualitative Reporting

A group treasury qualitative reporting provides a report on liquidity highlights through templates for

subsidiaries and branches. Summarizing the main liquidity changes for the previous month, usually

produced weekly at specific dates. T he points considered in regular liquidity qualitative reporting are

the following:

T he report should explain:

i. Substantial changes in the 1-week and 1-month liquidity ratios;

ii. Any changes in cash and liquidity gap in the Cumulative Liquidity mode;

iii. T he essential changes to the Liquidity Risk Factor;

iv. Shrinkage or growth of asset books;

v. Any changes to inter-group borrowing or lending position; it should further detail the

counterparties for large-size deals;

vi. Any increase or decrease in corporate deposits, this should be accompanied by a detail of

large dated transactions with a projected roll-over confidence level;

vii. Any increase or decrease in retail deposits; and

viii. T he average daily opening cash position.

Liquidity Stress Test Reporting

As discussed in the previous chapter, the main objective of the liquidity stress testing is to gauge the

level of funding difficulties a bank may experience in times of idiosyncratic or market stress. T he

stress test output reports are, therefore, significant in providing the senior management with the

understanding of a bank’s liquidity position to take mitigation actions when necessary.

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T he cashflow survival report is the primary output of a stress test process. T his is followed by a

stressed cumulative cash flow forecast considering the immediate sale or repo of marketable

securities. T he standard FSA-specified stresses that can be applied include wholesale funding, retail

liquidity, intra-day liquidity (3- and 5-day stresses), cross-currency liquidity, intra-group liquidity, off-

balance sheet liquidity, market-able assets, non-marketable assets, and funding concentration.

A line-by-line stress test result report is produced every quarter as a requirement by the regulators.

T he following stress test report shows the results of individual shocks on the liquidity ratio, and the

probability of each result occurring. T he following categories are included:

Reduction in liquid assets

Decrease in liabilities

Fx mismatch

Combined shocks.

T his report would be produced as part of routine stress testing, undertaken either by T reasury or

risk management.

Stress-
test
combined
shocks Sight- Sight- Probability Impact
8 Day 1 Month

Stress
test
individual
shocks light A rating category 8% 1% 45 % 20
of 1 notch downgrade
moderate A rating category 2% 0.25 % 22 % 30
of 2 notch downgrade
severe A rating category −15 % −20 % 2% 80
of 3 notch downgrade
Market to
market light 8% 1% 50 % 45
reduction
in asset moderate 2% 0.25 % 22 % 55
value severe −15 % −20 % 3% 88
Asset
increased
haircut light 8% 1% 55 % 30
moderate 2% 0.25 % 30 % 37

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 % % %
severe Treat all marketable −15 % −20 % 8% 45
securities as illiquid
Absence
of repo
facilities light Reduction of customer 8% 1% 45 % 30
deposits by 5%, replace
with o/night funding
moderate Reduction of customer 2% 0.25 % 29 % 70
deposits by 10%,
replace
with o/night funding
severe Reduction of customer −15 % −20 % 3% 120
deposits by 15%,
replace
with o/night funding
Intragroup
deposit
withdrawal light Reduction in net group 8% 2% 43 % 35
liability to EUR500 mm,
withdrawals to replace
funding
moderate Reduction in net group 2% 0.25 % 22 % 45
liability to EUR250 mm,
replace with overnight
funding
severe Reduction in net group −15 % −20 % 10 % 90
liability to nil, replace
with overnight funding
Interbank
deposit
withdrawals light Reduction in deposits from 8% 1% 50 % 33
“ relationship banks ”
(correspondent banks) by
5%, other inter-bank
deposits by 25%, replace
with o/night funding
moderate 2% 0.25 % 22 % 50
Reduction in deposits
from
“relationship banks”
(correspondent banks) by
25%, other inter-bank
deposits
by 50%, replace
with o/night funding
severe Reduction in deposits −15 % −20 % 4% 75
from
“relationship banks”
(correspondent banks) by
50%, other inter-bank
deposits by 100%, replace
with o/night funding
Changes
in FX
rates light Stresses the GBP and 8% 1% 45 % 20
USD FX rates by 15%
moderate Stresses the GBP and 2% 0.25 % 26 % 35
USD FX rates by 15%
severe −15 −20 2 65
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 severe Stresses the GBP and −15 % −20 % 2% 65
USD FX rates by 25%
FX swap
market
withdrawals light Withdrawal of less 8% 1% 43 % 35
liquid swap markets
moderate Withdraws of swap markets 2 % 1% 30 % 60
(excl. USD, EUR, GBR
severe Withdrawal of all swap −15 % −20 % 5% 75
markets
Stress
test-
combined
shocks Sight- Sight- Probability Impact
8 day 1 Month
Slow-
burn
liquidity
crunch Balance sheet shocks −32 % −38 % 2% 110
description in details
Severe
reputational
damage Balance sheet shocks −38 % −54 % 0.25 % 180
description in details

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Practice Question

Which of the following details would NOT be obtained from a deposit tracker report?

A. Month-end actuals for deposits by customer type

B. Each month-end change

C. Each month-end forecast for the position to the end of the year

D. Annual liability to deposit ratio

T he correct answer is D.

T he deposit tracker only reports on a weekly/monthly basis, hence annual liability to

deposit ratio included in the deposit tracker report.

A i s i ncorrect: T he deposit tracker report provides the details on deposit month-end

actuals organized by customer type.

B i s i ncorrect: T he deposit tracker report usually provides the details on month-end

changes.

C i s i ncorrect: T he month-end position forecast for the whole year is provided in a

deposit tracker report basically on the objective judgment.

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 Reading 133: Contingency Funding Planning

After compl eti ng thi s readi ng, you shoul d be abl e to:

Discuss the relationship between contingency funding plan and liquidity stress testing.

Evaluate the key design considerations of a sound contingency funding plan.

Assess the key components of a contingency funding plan (governance and oversight,

scenarios and liquidity gap analysis, contingent actions, monitoring and escalation, data, and

reporting).

The Relationship Between Contingency Funding Plan and

Liquidity Stress Testing

Actions in a Liquidity Crisis

A contingency funding plan (CFP) is a liquidity management tool that links the stress test results and

other related information as inputs to the CFP governance, decision framework, and menu of

contingent liquidity actions.

Institutions manage low-impact and high-probability events as part of their business-as-usual (BAU)

funding and liquidity risk management activities. On the other end, they use CFPs to address high-

impact low-probability events. Institutions use CFPs to develop and implement their financial and

operational strategies for effective management of contingent liquidity events.

The Key Design Considerations of a Sound Contingency

Funding Plan

While smaller institutions have included CFPs as part of their broader business continuity plans,

larger institutions have created more formal CFPs. T here is no universality related to establishing

CFPs. However, firms should consider the following factors when designing or refreshing their

CFPs.

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 i. Alienated to business and risk profiles

ii. Integrated with broader risk management frameworks

iii. Operational and actionable, but flexible playbook

iv. Inclusive of relevant stakeholder groups

v. Supported by a communication plan

i. Alienated to Business and Risk Profiles

When designing or refreshing a CFP, institutions should envisage their specific business and

risk profiles. Specific business profiles include the scope of business activities, geographic

and foreign exchange (FX) coverage, legal entity structures, and products/asset classes.

Moreover, institutions should have a consistent alignment of their risk appetite statement to

the CFP framework, through quantifiable early warning indicators, limits, and escalation

levels.

ii. Integrate with Broader Risk Management Frameworks

Similar to enterprise risk management (ERM), capital management, and business continuity

and crisis management, CFP is an integrated part of an institution’s risk management and the

broader risk management framework. CFP should be blended with other ERM components

to increase its effectiveness and consistency. T his is so because there is an allowance for a

CFP to leverage and reference existing controls and processes.

Additionally, it is essential to link a CFP to the business continuity and crisis management as

it reinforces significant operational and communication protocols during a financial crisis.

iii. Operational, Actionable, but Flexible Playbook

A valid CFP is operationally ready and in a position to strike a balance between specifying

recommended contingency actions while giving the management enough flexibility and

discretion to make informed decisions as the crisis emerges.

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 T he CFP needs to include a menu of possible contingency actions that management can

undertake in various stress scenarios and at graduated levels of severity, which are alienated

to EWIs, triggers, and contingency actions. T he institution can then get a structured

roadmap, outlining potential liquidity risks, and the related management actions that it can

quantify for various stages of the liquidity crisis.

iv. Inclusive of Relevant Stakeholder Groups

A profound understanding of both strategic and tactical aspects of an institution is essential

when developing operational readiness in a CFP.

Involving several stakeholders provides a robust forum in which potential issues or

challenges can be openly discussed and addressed. Such groups include the asset-liability

committee (ALCO), risk and capital committee, investment committee, business units,

finance, corporate treasury, risk, operations, and technology. T hese stakeholders should be

involved when capturing the pertinent elements of the CFP as part of the design to ensure

successful coordination from an execution standpoint.

v. Supported by a Communication Plan

An institution needs to be coordinated internally to ensure timely communication in case of a

crisis. Additionally, external communication to clients, counterparties, and regulators with

timely and precise information is critical as it aids in the reinforcement of confidence in the

institution and mitigation of potential risk. Furthermore, this inhibits rumors and fears from

further precipitating, thus adversely impacting the institution.

The Key Components of a Contingency Funding Plan

Framework and Building Blocks

Institutions can develop their CFPs using an integrated framework that addresses people, process,

data, and reporting dimensions, deliberating the critical design considerations discussed in the

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previous session. T hey should customize their CFP framework to their business and risk profiles.

T he major components of a CFP framework include the following:

i. Governance and oversight

ii. Scenarios and liquidity gap analysis

iii. Contingent actions

iv. Monitoring and escalation

v. Data and reporting

Governance and Oversight

To develop a valid CFP, an institution should come up with well-defined roles and responsibilities, as

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well as a robust communication strategy that provides timely coordination and communication among

internal and external stakeholders. T he organizational roles and communications plan should be

justified by well-defined policies and procedures and reinforced through CFP periodic testing and

simulation exercises.

Stakeholders Involvement, Roles, and Responsibilities

Corporate treasury, management committee, liquidity crisis team, and board of directors have critical

roles in CFP design and implementation. T he following descriptions should be the starting point for

institutions in defining specific CFP roles and responsibilities. T hese roles should be adjusted to suit

the organizational structure, capabilities, and coverage/responsibilities of the institution:

Corporate T reasury

T he treasury monitors the ongoing business, funding, risk, and liquidity profile as part of its BAU

activities. T he treasury can consult the CFO and others to invoke the CFP and convene the liquidity

crisis team (LCT ) regarding a review of the markets, liquidity stress testing results, among others.

Liquidity Crisis Team (LCT )

T he LCT undertakes continuous monitoring of the institution’s liquidity profile. Moreover, it

provides recommendations on CFP actions, designs the CFP, and submits it to the senior management

for review and approval. T he LCT members include senior members of the institution’s business and

supporting functions, geographies, and legal entities.

Management Committee

T he senior management oversees the LCT and does a consultation with the board of directors to

monitor the institution’s liquidity risk profile and review specified recommendations for the

coordination of the CFP actions during a crisis.

Board of Directors

During a financial crisis, the board of directors serves as an advisor and counsel to the management

committee and the Liquidity Crisis Team (LCT ).

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Communication and Coordination

In CFP, a communication strategy and plan are essential to ensure enough notification, coordination,

issue reporting, and escalation. T he various groups across the institution should work in concert,

relying on each other to ensure information is available on time to support management decision-

making.

In any crisis, transparent and timely communication helps the institution to demonstrate a sense of

control and confidence that management understands the future challenges and has a plan of action.

Coordination points can vary across institutions, depending on their size, complexity, and organization

structure. T he following is an example of such coordination:

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Pol i ci es and Procedures

Institutions should endeavor to document their CFPs. Documentation should capture all aspects of

the CFP, including the governance structure, processes, data, and reporting activities. A CFP policy

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outline may look like this:

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Scenarios and Liquidity Gap Analysis

An institution’s CFP stress scenario must coordinate with those in its liquidity stress

testing framework, recovery, and resolution frameworks. T he liquidity stress testing

scenarios should cover both the systematic risk and idiosyncratic risks. T he stress testing

scenarios should deal with market liquidity and funding liquidity for stress periods.

Institutions employ the liquidity stress testing framework to ensure appropriate measuring

and monitoring of these stresses on its liquidity profile. On the other hand, the CFP should

provide a mechanism for escalating an emerging crisis to management’s attention and

ensuring actionable responses are attained.

Additionally, the CFP may contain other liquidity-related stress scenarios. T hese scenarios

might be beyond the institution's broader monitoring and limit structure. However, they

ensure effective contingency plans are in place when certain events that could potentially

impact liquidity occur.

Contingent Actions

Institutions can utilize liquidity gap analysis to develop contingent actions or capital

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recovery actions. T he institution should include a spectrum of business scoping activities,

pricing initiatives, and potential expense control actions that strengthen the institution’s

liquidity position. An institution can gauge whether such contingent actions are suitable for

application based on on the nature and amount of capital shortfall, timing and pattern of the

expected capital shortfall, estimated capital relief from the contingent action, and the

ability of the institution to implement internal or external activities related to such

contingent actions.

Some contingent actions include but are not limited to, the following:

Securitizing retail assets such as mortgages and loans

Assets pledging the Federal Reserve discount window

Increasing underwriting standards

Selling business, customer loans, and credit card receivables, among others.

T he systemic and idiosyncratic nature and amount of the stress events significantly

influence the availability and the potential impact of the above contingent events. Deposit

runoffs, an increase in the cost of funding, and cash deposit requirements are among the

market factors that can impact the institution’s ability to take contingent actions include.

T he management should try to predict these challenges hand in hand with the effects they

may pose on its liquidity responses. CFP should also document alleviating actions that

management would consider taking to address such challenges.

Monitoring and Escalation

T he CFP framework should include a portfolio of measures to monitor the current

liquidity profile and the expected impact of potential liquidity events. Factors that affect

the institution’s liquidity position can be represented by the market (external) and business

(internal) measures and liquidity health measures (internal). T hese measures form a set of

Early Warning Indicators (EWIs) that provide advance signaling of possible liquidity

problems on the onset. T his enables the management to assess and make the necessary

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steps as the crisis worsens.

Early Warning Indicators

Early warning indicators such as substantial changes in levels and volatility of the equity

markets, a significant dip of the institution’s stock price, and dramatic changes in the

business’ revenues from a specific geographic area, should warn the management.

Following these signs, the management should evaluate how fluctuating market conditions

and the institution’s business strategy may be adversely affected and thereby proactively

take timely actions of oncoming market disruptions.

Market and Business Factors

Institutions need to track information on macroeconomic, institution-specific, and industry

measures to monitor market trends. Mainly, they should look for EWIs encompassing

market and business factors such as a substantial and unanticipated decline in the stock

market indices, a spike in the market volatility, a decline in the quality of assets, among

others.

Liquidity Health Measures

We have seen that the macro-economic and industry measures offer a timely signal of a

potential pending liquidity crisis. However, institutions should also monitor several liquidity

health ratios to help quantify the impact of the liquidity risks and to support decision

making on CFP actions under consideration.

Some of the necessary liquidity health measures include the following:

Proj ected net fundi ng requi rements to current unused fundi ng capaci ty: which

gauges the funding and borrowing required to finance the institution’s increased lending

activities and banking activities. It measures the institution’s future lending obligations in

proportion to the total funds available at the institution.

Non-core fundi ng to l ong-term assets: measure the percentage of long-term funding

requirements that are supported by less stable sources of funding. A high non-core funding

to long term assets ratio implies a high dependence on volatile funding sources.

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Overni ght borrowi ngs to total assets: measure the dependence on overnight funding

to finance the institution’s assets as the use of this source of funding exposes the

institution to increased liquidity risk.

Short-term l i abi l i ti es to total assets: measure the funding levels that should be

rolled over within a predetermined short-term period, for example, under 30 days, 60 days,

to support the institution’s assets.

T he liquidity health measures for institutions with an advanced liquidity risk management

abilities include daily liquidity position reporting, Liquidity Coverage Ratio (LCR), and the

Net Stable Funding Ratio (NSFR).

T he liquidity health measures should be monitored continuously over the crisis. However,

note that their importance is related to their associated limits.

Escalation Levels

In designing the CFPs, institutions should develop a series of escalation levels adequately

leaning to the scenarios, contingency actions, and liquidity measures. T here exist no

guidelines on the number of escalation levels to be developed. However, the most

commonly used are three to five escalation levels.

Data and Reporting

T he frequency with which several measurements employed to monitor and manage

liquidity risk are generated, assessed, and reported is essential in ensuring that the

institution’s liquidity risk monitoring and measuring framework adequately supports the

objectives of the CFP. Many institutions employ daily reporting of the liquidity profile to

the treasury function and the funding desks. However, increasing the frequency of liquidity

management reporting can benefit several institutions that do not report daily.

It is vital for the reporting of liquidity management to carry contextual information and

qualitative guidance. T his aids senior management in its approach to perceive the

institution’s liquidity profile.

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Additionally, reports should show the methods used to dictate liquidity coverage for

upcoming liabilities and funding needs. Moreover, they should elaborate on the level of

coverage estimated by these measures. Further, institutions should ensure that existing

reports capture intraday liquidity positions and track exposure to contingent liabilities and

capacity usage in funding sources.

Finally, consideration should be given to the distribution of liquidity risk reports within the

institutions, their usage by management and the board in making strategic decisions, and the

appropriateness of the information, given their audience.

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Practice Question

Ashley Mathias is the financial risk manager at Sycamore Bank. Ashley plans to design a

contingency funding plan (CFP) for the institution. As a financial risk manager, which of

the following considerations, will she NOT be mindful of when conducting this exercise?

Ashley should NOT ensure:

A. Support by a communication plan

B. Integration with broader risk management frameworks

C. Inclusion of appropriate stakeholder groups

D. No liquidity gap before beginning the exercise

T he correct answer is D.

In designing a CFP, the onset of the exercise does not depend on whether there exists a

liquidity gap or not, liquidity gap analysis is a component of a CFP framework, hence a

part of the whole exercise, but not a factor to consider before the exercise.

A i s i ncorrect: In designing a CFP, communication to clients, analysts, counterparties,

and regulators with timely and accurate information is critical for enhancing confidence

in the institution.

B i s i ncorrect: CFP should be integrated into other components of enterprise risk

management (ERM) disciplines to increase its effectiveness and consistency.

C i s i ncorrect: Including the appropriate stakeholders when designing a CFP is critical.

Appropriate stakeholders provide a robust forum in which potential issues or challenges

can be openly discussed and addressed. Such groups include the asset-liability committee

(ALCO), risk and capital committee, investment committee, business units, finance,

corporate treasury, risk, operations, and technology.

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 Reading 134: Managing and Pricing Deposit Services

After compl eti ng thi s readi ng, you shoul d be abl e to:

Differentiate between the various transaction and non-transaction deposit types.

Compare different methods used to determine the pricing of deposits and calculate the

price of a deposit account using cost plus profit margin, marginal cost, and conditional

pricing formulas.

Explain challenges faced by banks that offer deposit accounts, including deposit insurance,

disclosures, overdraft protection, and basic (lifeline) banking.

Transaction and Non-Transaction Deposit Types

T here are three broad categories of deposits offered by banks and other deposit institutions. T hese

include:

I. T ransaction (Payments or Demand) Deposits

II. Non-transaction (Savings or T hrift) Deposits

III. Retirement Savings Deposits

We discuss them in the following sections:

I. Transaction (Payments or Demand) Deposits

A transaction deposit is an account used primarily to make payments for purchases of goods and

services. T he financial-service providers must instantly honor whatever withdrawals a customer

makes in person, or by a third party chosen by the customer to be the recipient of funds withdrawn.

T ransaction deposits are further divided into noninterest-bearing transaction deposits and interest-

bearing transaction deposits.

Noni nterest-beari ng demand deposi ts: offer customers payment services,

safekeeping of funds, and recordkeeping for any transactions committed by card, check, or

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 an electronic network. T hey are the most volatile and unpredictable source of funds.

Interest-beari ng demand deposi ts: offer all the services provided by noninterest-

bearing demand deposits and pay interest to the depositor. Additionally, they give the

depository institution the right to ensure a prior notice before any withdrawal of funds by

customers. T hey are subdivided into:

Negotiable orders of withdrawal (NOW) accounts;

Money market deposit (MMDA) account; and

Super NOW (SNOW) account.

II. Non-transaction (Savings or Thrift) Deposits)

Savings or thrift deposits have features that attract funds from customers who wish to reserve

money in expectation of future expenditures or for financial emergencies. In other words, a thrift

account is an account whose primary purpose is to encourage the bank customer to save rather than

make payments. Compared to transaction deposits, non-transaction deposits usually pay substantially

higher interest rates and are less costly to process and manage for the offering institutions.

Non-transaction deposits are split into:

Passbook savi ngs deposi ts: pay the depositor a competitive interest rate. A physical

notebook, called a passbook, accompanies the depositor to monitor (track) the flow of

funds into and out of the account.

Statement savi ngs deposi ts: include transactions involving deposits, withdrawals, and

interest earned, which are recorded as computer entries. T he depositor receives a regular

statement of account, showing all transactions up to the posting date. However, unlike

passbook savings deposits, the depositor does not receive a passbook evidencing

ownership of the account.

A ti me deposi t: also known as a certificate of deposits in the United States, is a bank

deposit that has a specified period to maturity and bears interest. T his deposit cannot be

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 withdrawn for a specific term unless a penalty is paid.

III. Retirement Savings Deposits

Retirement savings deposits can be categorized into three:

Indi vi dual reti rement account (IRA): Salaried and wage-earning individuals make tax

free and limited contributions each year to this account type, offered by depository

institutions, brokerage firms, insurance companies, and mutual funds, or by employers

with a qualified pension or profit-sharing plans.

Keogh Pl an: Self-employed individuals or businesses have access to a tax-deferred

pension plan called a Keogh Plan for retirement purposes. It can either be a defined benefit

or a defined contribution plan.

Roth IRA: T his is a retirement savings account that is tax-advantaged. In other words, it

permits an individual to withdraw their retirement savings tax-free.

T he main difference between Roth IRAs and traditional IRAs is that Roth IRAs are financed with

after-tax dollars. T his means that the contributions are not liable to tax-deductions, but once one

starts withdrawing funds, the money is tax-free. Conversely, traditional IRA deposits are made with

pre-tax dollars. T his implies that an individual is liable to a tax deduction on their contribution and

consequently pays income tax when they take out money from the account when they retire.

Interest rates on deposits majorly depend on:

T he maturity of the deposit;

T he size of the depository financial institution;

T he risk of the depository institution; and/or

T he marketing philosophy and goals of the depository institution.

Core deposi ts are a stable base of funds that are not highly sensitive to market interest rate

fluctuations and which tend to remain with the bank. T he following figure illustrates the core

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deposits.

Methods Used to Determine the Pricing of Deposits and

Calculation of the Price of a Deposit Account

T he main goal of depository institutions is to price their deposit services in a way that attracts new

funds and makes a profit. T he management faces a difficult decision-making scenario as it has to

balance between the institution’s needs to pay a high enough interest return to attract and hold

customer funds, at the same time, avoid paying an interest rate so costly it erodes any potential

profit margin.

However, financial institutions are price takers, not price makers in a perfectly competitive market.

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T he management must, therefore, decide if it wishes to attract more deposits and hold all those it

currently has by offering depositors at least the market-determined price, or whether it is willing to

lose funds.

Methods of calculating the price of a deposit account are discussed below:

Pricing Deposits at Cost Plus Profit Margin

Cost-plus deposit pricing encourages banks to determine the costs they incur in labor and

management time, materials, among others, in offering each deposit service. Cost-plus pricing

typically calls for a bank to charge deposit service fees enough to cover all the costs of providing the

service in addition to a small margin for profit.

Every deposit service may be priced high enough to recover all or most of the cost of offering that

service, using the following cost-plus pricing formula:

Unit price charged the customer for each deposit service

= (Operating expense per unit of deposit service
+ Estimated overhead expense allocated to the deposit service function
+ Planned profit margin from each service unit sold)

T he above equation ties deposit pricing to the cost of deposit-service production, which has

encouraged deposit providers to keenly match prices and expenses and eradicate many formerly free

services.

Nowadays, most depository institutions charge for excessive withdrawals, customer balance

inquiries, bounced checks, and AT M usages, as well as raising required minimum deposit balances,

among others. T hese trends have been favorable to depository institutions.

Example 1: Cost Plus Profit Pricing

ABC savings bank determines that its basic checking account costs the bank $3.00 per month in

servicing costs (assume the servicing costs are labor and computer time) and $2.00 per month in

overhead expenses. T his account requires a $600 minimum balance. Additionally, the bank also tries

to build a $0.60 per month profit margin on these accounts.

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Determine the monthly fee that the bank should charge each customer.

Solution

Breaking down the information given in the question.

Operating expense per unit of deposit service = $3.00

Estimated overhead expense allocated to the deposit service function = $2.00

Planned profit margin = $0.60

Following the cost-plus profit pricing formula, the monthly fee is:

Monthly fee = $3.00 + $2.00 + 0.60 = $5.60 per month

Example 2: Cost Plus Profit Pricing

ABC savings bank determines that its basic checking account costs the bank $3.00 per month in

servicing costs (assume the servicing costs are labor and computer time) and $2.00 per month in

overhead expenses. T his account requires a $600 minimum balance. Additionally, the bank also tries

to build a $0.60 per month profit margin on these accounts.

Analysis of ABC Savings Bank Customer accounts reveals that for each $150 above the $600

minimum balance maintained in its checking accounts, the bank saves about 5% in operating

expenses with each customer account.

For a customer who is consistent in maintaining an average monthly balance of $1,200, how much

should the bank charge to protect its profit margin?

Solution

If the bank saves about 5% in operating expenses for each $150 held in balances above the minimum

of $600, then a customer who maintains an average monthly balance of $1,200 saves the bank 20% in

operating expenses.

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 New operating expenses = $3.00– (20% × $3.00) = $2.40

T he appropriate amount that the bank should charge to protect its profit margin is therefore

Monthly fee = $2.40 + $2.00 + $0.60 = $5.00 per month

Using Marginal Cost to Set Interest Rates On Deposits

Many financial analysts would argue that the marginal cost, and not the historical average cost, should

be used to price deposits and funding sources. T his is because frequent fluctuations in interest rates

make historical average cost an unreliable standard for pricing.

T he marginal cost formula is as follows:

Marginal cost = Change in total cost

= New interest rates × Total funds raised at new rate
− Old interest rate× Total funds raised at old rate

Where,

Change in total cost

Marginal cost rate =
Additional funds raised

Example: Using Marginal Cost to Set Interest Rates on Deposits

A bank that has a base amount of savings deposits of $50 million and currently pays 8% rate on these

funds. T he bank seeks to raise additional funds but will have to increase the interest rate as the

amount of cash raised increases. Management anticipates an investment yield of 10% after investing

deposits.

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 Funds Average Total Marginal Change in Expected Difference Total
Raised Rate Interest Cost Total Revenue Expected Additional
Paid Cost less Profit
Marginal
50 m 8.0 % 4m 4m 8.0 % 10.0 % 2.0 % $1m
100 m 8.5 % 8.5 m 4.5 m 9.0 % 10.0 % 1.0 % $ 1.5 m
200 m 9.0 % 18 m 9.5 m 9.5 % 10.0 % 0.5 % $2m
300 m 9.5 % 28.5 m 10.5 10.5 % 10.0 % −0.5 % $ 1.5 m

T he calculations are as follows:

Total interest = Funds raised× Average Rate Paid

= 50,000, 000 × 8.0% = 4,000, 000

Marginal cost = Change in total cost

= New interest rates × Total funds raised at new rate
− Old interest rate× Total funds raised at old rate
= (8.5% × 100, 000,000) − (8.0% × 50, 000000) = 4, 500, 000

For the second case,

4, 500, 000
Change in Total Cost = = 9.0%
100, 000000 − 50, 000000

T he bank will, therefore, make a total additional profit of the amounts given in the last column. Total

profit tops out at $200,000,000. It would not pay the bank to go beyond this point. T he 9% deposit

rate is, therefore, the best choice, given all the assumptions and forecasts made.

At some point, expanding the deposit base becomes unprofitable. At that point, the bank must either

find a lower cost of funding (on the margin), or higher-yielding assets.

Conditional Pricing

Depository institutions, particularly banks, use conditional pricing as a tool to attract the kind of

depositors they want to have as customers. In this case, a depository institution sets up a schedule of

fees in which the customer pays a low fee or no fee given that the deposit balance is above some

minimum level. However, the customer is liable to higher charges if the average balance drops

below that minimum level. In other words, the customer pays the price conditional on how they use

a deposit account.

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Conditional pricing is based on one or more of the following factors:

T he average balance in the account during the period;

T he maturity of the deposit; and/or

T he number of transactions going through the account. For example, the number of

deposits made, or notices of insufficient funds issued.

T he customer chooses the deposit plan that accrues the lowest fees possible and maximum yield, or

both, given the number of checks he or she plans to write, the expected number of deposits and

withdrawals he plans to make, and/or the anticipated average balance he plans to keep in his/her

account.

Example: Conditional Pricing

Bright Savings bank has posted the following fees schedule for its business checking accounts:

Average Monthly Account Balances

Range Monthly Maintenance Fee Charge Per Check

Over $ 2, 000 $0 $0
$ 1, 500 − $ 2, 000 $3 $ 0.20
Less than $ 1, 500 $5 $ 0.30

What is the type of Bright’s business pricing?

Solution

Bright Savings Bank has posted a deposit fee schedule that has an allowance of free checking for

average account balances of over $2,000. Lower balances can only be assessed at an increasing

monthly maintenance fee plus an increased per check charge in line with falling average monthly

account balances.

T his is conditional pricing designed to encourage large and stable accounts. T his would perhaps give

the bank more money available for usage and a more stable funding base. T he condition of the higher

fee on under $1,500 accounts is strict and stiff, and that may chase away small depositors to other

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banks, which is the goal the financial institution is pursuing.

Relationship Pricing

Depository institution prices deposits according to the number of services purchased or utilized.

T he depositor may be given lower fees or have a part of the cost waived if they have used two or

more services – for example, having a checking account, a savings account, and his/her mortgage at

the same financial institution.

Challenges Faced by Banks that Offer Deposit Accounts

The Federal Deposit Insurance Corporation (FDIC) Insurance Coverage

Depository institutions can sell deposits at comparatively low rates of interest relative to interest

rates provided by other financial instruments since they have government-supplied deposit

insurance. T he FDIC was established to insure deposits and protect money supply in cases where

depository institutions with FDIC membership failed. T he FDIC only covers those deposits payable

in the United States.

Banks are insured through the Bank Insurance Fund (BIF), while savings and loans are insured

through the Savings and Association Insurance Fund (SAIF). Deposits of all types are typically

covered up at least $250,000 for each given account holder within the same bank. Note that deposits

held in separate institutions are insured separately.

Basic (Lifeline) Banking

Basic (lifeline) banking is the low-cost deposits and other services designed to meet the banking

needs of customers who cannot afford standard bank service offerings. T hese services carry low

service fees and usually do not provide all the components of banking services which carry full-

service charges.

T he compulsion on managers to offer essential banking services has triggered an extensive

controversy. From a profit-making perspective, banks should only provide valuable (profitable)

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services. On the other hand, the government partially subsidizes financial institutions in the form of

low-interest loans and deposit insurance. T his obliges them to some public-service responsibilities,

which may include providing certain essential services to all liable customers, regardless of their

income or social status.

Deposit Insurance

As mentioned in the previous subsection, it is the responsibility of financial institutions that take

deposits to provide lifeline financial services. T his has been incorporated in the new legal

requirements to serve the local community entirely. Furthermore, essential aids may be extended to

depository institutions from the government, granting them a competitive advantage over other

financial institutions. If depository institutions benefit from protection backed ultimately by the

public’s taxes, they have a public responsibility to provide some services that are accessible to all.

Overdraft Protection

Overdraft fees and revenue have skyrocketed over the past decade. However, there is no evidence

that banks have been earning profits or “rents” from the growing overdraft protection usage. On the

contrary, there is an emerging competitive market for overdraft protection among banks offering

overdraft services and with comparable products, such as payday lending. T here is no evidence of

reasonable returns to the banking industry, generally from the growth of overdraft protection.

Disclosures

T he T ruth in Savings Act of 1991 requires depository institutions to make greater disclosure of the

terms attached to the deposits they sell the public. Specifically, it requires consumers to be

informed of the deposit terms before they open a new account.

Under this act, depository institutions must disclose:

i. T he minimum balance required to open the account;

ii. T he minimum needed to be kept on deposit to avoid paying fees;

iii. How the balance in each account is figured;

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 iv. When interest begins to accrue;

v. Any penalties for early withdrawal;

vi. T he options at maturity; and

vii. T he annual percentage yield (APY).

Annual Percentage Yield

T he annual percentage yield is calculated using:

365
⎡ Interest earned Days in period ⎤
APY earned= 100 ⎢(1 + ) − 1⎥
⎣ Average account balance ⎦

where the account balance is the average daily balance held in the deposit for the period covered by

each account statement. Customers must be informed of the effect of early withdrawals on their

expected APY.

Example: Annual Percentage Yield

James Leo is a customer at ABC Savings Bank Limited. Leo holds a savings deposit in the bank for a

year. T he balance in the account stood at $3,000 for 200 days and $150 for the remaining days of the

year.

Assuming that ABC Bank paid Leo $10.05 in interest earnings for the year, what APY did Leo receive?

Solution

T he correct formula is:

365
⎡ Interest earned Days in period ⎤
APY earned = 100 ⎢(1 + ) − 1⎥
⎣ Average account balance ⎦
($3, 000 × 200 days) + ($150 × 165 days)
Average account balance = = $1, 712
365 days
365
⎡ $10.05 365 ⎤
APY = 100 (1 + ) − 1 = 0.59%
⎣ $1, 712 ⎦

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Practice Question

Abacca Bank determines that its basic checking account costs the bank $3.00 per month

in servicing costs (assume the servicing costs are labor and computer time) and $2.00

per month in overhead expenses. T his account requires a $500 minimum balance.

Additionally, the bank also tries to build a $0.50 per month profit margin on these

accounts.

Further analysis of Abacca Bank customer accounts reveals that for each $100 above the

$500 minimum balance maintained in its checking accounts, the bank saves about 6% in

operating expenses with each customer account.

For a customer who is consistent in maintaining an average monthly balance of $700,

how much should the bank charge to protect its profit margin?

A. $3.14

B. $4.64

C. $2.64

D. $5.14

T he correct answer is D.

If the bank saves about 6% in operating expenses for each $100 held in balances above

the minimum of $500, then a customer who maintains an average monthly balance of

$700 saves the bank 12% in operating expenses.

New operating expenses = $3.00– (12% × $3.00) = $2.64

T he appropriate amount that the bank should charge to protect its profit margin is,

therefore:

$2.64 + $2.00 + $0.50 = $5.14 per month

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 Reading 135: Managing Nondeposit Liabilities

After compl eti ng thi s readi ng, you shoul d be abl e to:

Differentiate the various sources of non-deposit liabilities at a bank.

Describe and calculate the available funds gap.

Discuss the factors affecting the choice of non-deposit funding sources.

Calculate the overall cost of funds using both the historical average cost approach and the

pooled-funds approach.

Different Sources of Non-Deposit Liabilities at a Bank

T he most considerable importance of a bank is to offer loans to all qualified customers. If it does not

have sufficient funds, the bank should seek the cheapest cost of funding to meet its customers’

needs. However, this may lead to poor quality loans. Liability management involves buying funds,

especially from other financial institutions, to cover good-quality credit requests and meet legal

reserve requirements for deposits and other borrowings that may be required by the law.

T he most common non-deposit sources that financial institutions use include:

i. Federal Funds Market (“Fed Funds”)

ii. Repurchase Agreements

iii. Federal Reserve Banks

iv. Advances from Federal Home Loan Bank

v. Negotiable Certificates of Deposit

vi. Commercial Paper Market

vii. Eurocurrency Deposit market

viii. Long-Term Nondeposit Funds Sources

i. Federal Funds Market

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 Fed funds market is the most popular domestic source of borrowed reserves that allows

depository institutions that are short of reserves to meet their legal reserve requirement as

well as immediately usable funds from the other institutions who have idle funds temporarily.

Types of Federal Funds Market

Overni ght l oans are unwritten, often uncollateralized agreements usually negotiated over

a telephone and are payable the next day.

Term l oans are long-term contracts, usually accompanied by a written contract. Term

loans may take days, weeks, or even months.

Conti nui ng contracts have daily renewals unless either the lender or borrower decides

to end the contract. T he agreements are commonly between smaller respondent institutions

and their more significant correspondents, where the latter automatically invests the smaller

institution’s deposits held with it in Fed funds loans until told to do otherwise.

ii. Repurchase Agreements

Repurchase agreements are viewed as collateralized fed fund transactions. In such an

agreement, one party agrees to sell high-quality assets such as T-bills to another party

temporarily. At the same time, the selling party issues an agreement to buy back those

securities on a specific future date at a predetermined price. T hese agreements are basically

for overnight funds, though it can be extended for days, weeks, and even months.

T he interest cost for repurchase agreements is equivalent to:

Interest cost of RP = Amount borrowed× Current RP rate

Number of days in RP borowing
×
360

Example: Calculation of the Interest Cost of a Repurchase

Agreement

Suppose Pathway Bank borrows $4,300 million through a repurchase agreement with a

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 government bond collateral for 16 days. T he current repurchase agreement rate in the

market is 8%. How much would be the bank’s total interest cost?

16
Interest cost of RP = 4, 300 × 0.08 × = 15.29
360

Hence the cost of the RP will be approximately equal to $15.29 million.

iii. Borrowing from Federal Reserve Banks

Banks borrow from the federal reserve when they are unable to meet their reserve

requirements due to low cash at hand at the close of the day. When banks borrow from the

government’s central bank, they are making use of a discount window. T here exist different

types of loans depending on the needs with different rates of interest. However, there are

limits/restrictions on the frequency of borrowing from the federal reserve.

Types of Federal Reserve Loans

Pri mary credi t refers to loans available for the short-term and only to institutions in

sound financial conditions. T he interest rate is higher than the federal funds rate.

Secondary credi t is available to institutions that do not qualify for primary credit but at a

higher interest rate. Secondary credit is, however, tracked by the central bank to avoid

excess risk.

Seasonal credi t is loans that cover more extended periods relative to primary credit.

T hey are mostly utilized by small and medium firms that experience seasonal fluctuations in

deposits and loans.

In summary, secondary credit attracts the highest interest rates, followed by primary credit,

and finally, seasonal credit with the lowest interest rates.

iv. Advances from Federal Home Loan Banks

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 Federal Home Loan Bank lends substantial amounts of money, allowing institutions to use

home mortgages as collateral for advances. T hese loans are utilized as a way of improving

the liquidity of home mortgages at the same time motivating more lenders to provide credit.

T he maturity for federal home loan banks ranges from overnight to more than 20 years.

v. Negotiable CDs

A negotiable CD is a source of short-term funds for commercial banks developed to tap

temporary surplus funds held by large corporate and wealthy individual customers. It is an

interest-bearing receipt evidencing the deposit of funds in the bank for a specified period for

a specified interest rate. It is a hybrid account since it is legally a deposit.

Types of Negotiable CDs

Domesti c CDs are issued by U.S institutions, which are inside the U.S territory.

Dol l ar-denomi nated CDs are issued by banks outside the U.S and are also known as

EuroCDs.

A Yank ee CD is a foreign certificate of deposit usually denominated in the U.S dollars.

Thri ft CDs are certificate of deposits sold by non-bank institutions

T he interest rates of fixed-rate CDs are quoted based on their interest-bearing, where the

rate is computed based on a 360 days year. T he advantage of negotiable CDs I that they offer

a way to attract large amounts of funds quickly and for a known period. However, these

funds are incredibly sensitive to interest and often are withdrawn as soon as the maturity

date arrives unless management aggressively bids in terms of yield to keep the CD.

Example: Negotiable CDs

Assume a depository institution promises a 10% annual interest rate to a customer who buys

a $950,000 120-day CD. How much will the customer have at the 120 days?

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 Days to maturity
Amount=Principal + (Principal × )
360days
× Annual rate of interest
120 days
950, 000 + ($950, 000 × × 0.10) = $981, 667
360 days

T herefore, at the end of the 120 days, the depositor will have $981,667.

vi. Eurocurrency Deposit Market

T he Eurocurrency deposit market is the most significant unregulated financial market place

in the world. It involves a group of banks that accept deposits and also make loans in foreign

currencies outside their country of issue. T hey were initially developed in Western Europe

to provide liquid funds to swap among institutions or act as loans to customers. T he

Eurodollar market is one of these markets. Eurodollars are dollar-denominated deposits

placed in banks outside the United States.

Access to the Eurocurrency market is obtained by contacting correspondent banks by

telephone, wire, or cable.

vii. Commercial Paper Market

T he commercial paper market involves short-term notes with a maturity period ranging

from three or four days to nine months, issued by well-known companies to raise working

capital. T hey are sold at a discounted price from their face value.

Types of Commercial Paper

Industri al paper is used by non-financial institutions to finance purchases of inventories

and to meet immediate financial needs. T he inventories include goods or raw materials.

Fi nance paper is mostly issued by finance companies and the associates of a financial

holding company. Issuing this paper provides the income useful for purchasing loans off the

books of other financial firms within the same organization. T his results in the firm creating

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 additional funds for giving loans.

Note that banks do not issue commercial paper directly. However, its associates can issue

them.

viii. Long-Term Nondeposit Fund Sources

Long-term non-deposit funding sources involve loans that are extended for a period beyond

one year. T hese loans include mortgages to fund the construction of new buildings,

debentures, and capital notes. T hey range from a period of 5-12 years and supplements the

owners’ capital or equity.

Note that, despite the mismatch created by long-term funding sources as most assets and

liabilities held by depository institutions are short-term to medium-term, larger financial

firms find long-term funding attractive due to the leverage effects of such debts.

Description and Calculation of the Available Funds Gap

The Available Funds Gap

Available funds gap is the distinction between current, and the projected credit and deposit flows that

generate a need for increasing additional reserve when the gap is negative or profitably investing any

excess reserve that may occur in case the gap is positive. In summary, this gap depends on:

i. T he current and projected demand and deposits that the bank aims to make; and

ii. T he current and expected deposit inflows and other available funds.

T he size of the available funds gap determines the need for non-deposit funds.

Available funds gap (AFG)

= Current and projected loans and investments the lending institution desires to make
− Current and expected deposit inflows and other available funds

Example: The Available Funds Gap

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Prime Bank expects new deposit inflows of $400million and deposit withdrawals of $600 million in

the coming month. T he bank has projected that new loan demand will reach $500 million, and

customers with approved credit lines will need $200 million in cash. T he bank will sell $520 million

in securities but plans to add $100 million in new securities to its portfolio. What is Prime Bank’s

projected available funds gap?

Solution

AFG = ($500 + $200 + ($100 − $520)– ($400 − 600) = $480 million

Once an institution identifies the available funding gap, it can then seek the available non-deposit

funding sources to cover the gap. Many institutions will have a small available funding gap, which is

easily funded by tapping the available non-deposit funding sources.

Factors Affecting the Choice of Non-Deposit Funding Sources

As we have mentioned in the previous section, the size of the available funding gap determines the

need for non-deposit funds. T herefore, management should evaluate the best nondeposit source to

use to cover the available funds gap. T hey should consider the following five factors:

i. T he relative cost of raising funds associated with each source;

ii. T he risk of each funding source;

iii. T he maturity of the funds;

iv. T he size of the institution; and

v. Regulations restricting the use of various fund sources.

i. The Relative Cost

Institution managers should compare the prevailing interest rate in the Fed Funds market, as

it is the cheapest funding in terms of interest rates, with that of the negotiable CD market.

Noninterest costs, deposit insurance costs, and the amount of money that will be available

for new loans should be included.

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Fed funds are advantageous as they are readily available, and their maturities are often

flexible. However, their interest rates fluctuate, making it difficult to plan. T he interest

rates for the commercial paper and the CDs are somehow stable but range around and

slightly above the rates for fed funds.

The Cost of Borrowing Non-Deposit Funds

T he actual cost of borrowing non-deposit funds consists of the interest cost and noninterest

cost, such as time spent by the management staff in seeking new funding sources when

necessary. A reliable formula for evaluating the cost of borrowing non-deposit funds is as

follows:

Effective cost rate on deposit and nondeposit sources of funds

(Current interest cost on amounts borrowed
+ Noninterest costs incurred to access these funds)
=
Net investable funds raised from this source

Where:

Current interest cost on amounts borrowed = Prevailing interest rate in the money market
× Amount of funds borrowed

Noninterest costs to access funds=(Estimated cost rate representing staff time,facilities,

and transaction costs × Amount of funds borrowed)

Net investable funds raised=Total amount borrowed less legal reserve requirements deposit,
insurance assessments and funds placed in nonearning assets

Example: The Cost of Borrowing Non-Deposit Funds

Assume that a commercial paper is currently trading at an interest rate of 8.5%. It is

estimated that the marginal noninterest cost, in the form of personnel expenses and

transaction fees, from raising additional monies in the fed fund market is 0.3%. Assume that a

depository institution needs $56 million to fund the loans it plans to make today, of which

only $54 million is fully invested due to other immediate cash needs.

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 Evaluate the effective annualized cost rate for the commercial paper.

Solution

Current interest cost on fed funds = 0.085 × $56 million = $4.76 million

Noninterest cost in acquiring the commercial paper = 0.003 × $56 million

= $0.168 million

Net investable funds raised = $56 million − 2 million = $54 million

Hence the effective annual cost rate of the commercial paper earned is given as:

$4.76 + $0.168
= 0.091
54

T herefore, the net annualized return on the loans and investments it purposes to undertake

with the borrowed commercial paper is 9.1%.

ii. Risk Factor

T here are two types of risk factors that management should take into consideration, interest

rate risk and credit availability risk.

Interest rate ri sk is the volatility of credit costs. Interest rates fluctuate, especially in a

perfect market where the rates are determined by the interaction between demand and

supply forces. T he level of interest fluctuation is correlated to their maturity periods. In

other words, the shorter the period, the more the volatility. Considering the period of

maturity, then we realize that most fed funds are more volatile as their period of credit

extension ranges from one night to a few days.

Credi t avai l abi l i ty ri sk is the risk associated with the unavailability of credit. T here are

times when lenders have limited loans to offer due to strict credit conditions. In such cases,

lenders prefer to offer loans to their favorable and loyal clients or even increase the

interest rates for the loans. For example, the commercial paper markets, Eurodollar, and

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 negotiable CDs have shown to be sensitive to credit availability risk. T herefore, financial

institution managers should plan and make arrangements on how to source substitute

sources of credit.

iii. The Length of Time Funds are Needed

T he required credit may not be immediately available at the time of need. T herefore, the

institution managers should evaluate the urgency with which the credit is required and chose

the appropriate credit source. For example, a manager may consider short-term funding,

such as fed funds for urgent credit requirements.

iv. The Size of the Borrowing Institution

Most money market loans have a standard trading unit of $1 million. T his denomination

exceeds the borrowing requirements for the smallest financial institutions. However, the

central bank discount window and the fed funds market make smaller denominations

appropriate for small institutions.

v. Regulations Restricting the use of Various Fund Sources

T he federal and state regulations may limit factors such as amount, frequency, and use of

borrowed funds. For example, the maturity of CDs in the United States should be at least

seven days, while the depository institutions exhibiting substantial risk of failure may have

its borrowing from the discount window been limited by the federal reserve bank.

Calculation of the Overall Cost of Funds

Historical Average Cost Approach and the Pooled-Funds Approach

T he historical average cost approach, just as the name suggests, looks at the funds an institution has

raised to date, and the costs related to raising such funds.

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Example 1: Historical Average Cost Approach

ABC Bank has the following breakdown of funding sources with the respective interest and non-

interest rates. Given the bank's total earning assests of $1,100 million, we demonstrate the historical

cost approach as follows:

Amount Interest Interest Non- Noninterest Total

($millions) Rate Cost interest costs Funding
Rates Costs
Checkable 300 1.25% 3.75 3% 9 12.75
deposit
accounts
T ime and 600 3.00% 18 1.25% 7.5 25.50
savings
deposits
Money 200 3.25% 6.5 1.00% 2 8.50
market
borrowings
Stockholders’ 200 15% 30 0 0 30.00
equity
Total 1, 300 28.25 46.75
Funding

Total interest paid

Weighted average interest expense =
Total deposits and borrowings
$28.25
= = 2.57%
1, 100

Break-even cost rate on borrowed funds invested in earning assets

Total funding costs 46.75
= = = 4.25%
Total earning assets 1, 100

Assuming the stockholder’s equity capital is estimated at 15% before taxes (the bank is currently in

the 35-percent corporate tax bracket), we can calculate the historical weighted-average cost of

capital (before-tax) as follows:

= (Breakeven cost rate × Proportion of borrowed funds)

+(before-tax cost of stockholders' equity
× proportion of stockholders' equity)
1,100 200
= 4.25% × ( ) + (15% × ) = 5.90%
1,300 1, 300

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The Pooled-Funds Approach

T his method of costing borrowed funds is future-oriented; that is, it focuses on future factors such

as the level of minimum returns that should be earned on loans and investments in the future to

cover the cost of all raised new funds. For illustration, assume that an institution’s estimate for the

future funding sources and their cost are as shown in the following table:

Example: The Pooled-Funds Approach

Money Bank is considering funding a package of new loans for $500 million. Money Bank has

projected that it must raise $550 million to have $500 million available to make the new loans (91%

will actually be available to acquire earning assets).

Money Bank expects to raise $450 million of the total by selling time deposits at an average

interest rate of 4%. Noninterest costs from selling time deposits add an estimated 1% in

operating expenses.

Money Bank expects another $100 million to come from noninterest-bearing transaction

deposits, whose noninterest costs are expected to be 2% of the total amount of these

deposits.

What is the Bank’s projected pooled-funds marginal cost? What hurdle rate must it achieve on its

earning assets?

Projected Pooled-funds Marginal Cost

Dollar Interest Non Total Total

Amount rate interest interest non-interest
($ millions) cost rate expenses expenses
T ime 450 4.00% 1.00% 18 4.5
deposits
T ransaction 100 0% 2.00% 0 2
deposits
Total 550 18 6.5

All expected operating expenses

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 All expected operating expenses
Projected pooled-funds marginal cost =
All new funds expected
(18 + 6.5)
= = 4.45%
550

The Hurdle Rate of Return

A hurdle rate is defined as the minimum rate of return on an investment required by a manager. T he

hurdle rate of return is equivalent to:

All expected operating costs

Hurdle rate =
Dollars available to place in earning assets

T hus, in our example above, the hurdle rate of return is equivalent to:

(18 + 6.5)
Hurdle rate = = 4.90%
500

T hus, the firm, in this example, should earn 4.9% and above on average before taxation on all its new

funds invested to meet the expected new funding cost.

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Practice Question

T he financial data in the following table belongs to Yankee Bank. Use the data to evaluate

the weighted average overall cost of capital for the institution.

Break-even cost 12.50%

T he after-tax cost of stock of stockholder's investment 11%
Tax rate 15%
Stockholder’s investment $200, 000
Earning assets $300, 000

A. 21.1%

B. 18.7%

C. 19.8%

D. 31.9%

T he correct answer is A.

Weighted average overall cost of capital

= Break-even cost
After-tax cost of stockholders’ investment
Stockholders’ investment
+ ×
(1– Tax rate) Earning assets

Which is equivalent to:

$100, 000 11% $200,000

× 12.5% + × = 12.79%
$300, 000 (1– 0.15) $300,000

T hus, 21.1% is the lowest rate of return overall fund-raising costs Yankee Bank can

afford to earn on its assets if its equity shareholders invest $200,000 in the institution.

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 Reading 136: Repurchase Agreements and Financing

Upon compl eti ng thi s readi ng, you shoul d be abl e to:

Describe the mechanics of repurchase agreements (repos) and calculate the settlement

for a repo transaction.

Discuss common motivations for entering into repos, including their use in cash

management and liquidity management.

Discuss how counterparty risk and liquidity risk can arise through the use of repo

transactions.

Assess the role of repo transactions in the collapses of Lehman Brothers and Bear Stearns

during the (2007–2009) credit crisis.

Compare the use of general and special collateral in repo transactions.

Identify the characteristics of special spreads and explain the typical behavior of US

T reasury special spreads over an auction cycle.

Calculate the financing advantage of a bond trading special when used in a repo transaction.

T his chapter is about repurchase agreements or repos. Repurchase agreements refer to short-term

collateralized loan obligations. T hey are utilized by the big financial organizations to acquire short-

term financial funding via mortgaging/pledging their assets for short-term loans or earning interests

through lending money collateralized by those assets. Over the years, commercial organizations have

heavily relied on repos to fund sectors with fixed income inventory. Financing an institution by using

repos has the advantage of secured, short-term loan that is relatively cheap as compared to

borrowing from a bank.

Repurchase Agreement Mechanics and Calculation of a Repo

Transaction Settlement

Repurchase agreements/repos are agreements between a lender and a borrower in which the lender

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purchases securities to the borrower with the condition that the securities will be bought back at a

stipulated date and stipulated higher price. T he securities are a form of collateral for the money

borrowed.

T he variation between the amount loaned and repurchased price is the amount of interest paid to the

lender by the borrower. T his can be calculated using the following formula:

Repo Term in Days

Dollar Interest = Principal × Repo Rate ×
360 days

(Repo formul as appl y a bank er's year of 360 days)

From the above formula, we deduce that the repo rate (annual interest rate of the repo transaction)

is equivalent to:

Dollar Interest 360

Repo Rate = ×
Principal (Repo Terms in Days)

Example: Computing the Settlement for a Repo Transaction

Assuming that a counterparty 1A is selling $397 million face amount of the DBR 4’s (Deutschland

Bundesrepublik, or German Government Bond with a coupon of 4%) of August 4th, 2034, to

counterparty 2A scheduled for settlement on September 30th, 2018, at an invoice price of

$513million. At the same time, counterparty A1 agrees to repurchase $397 million face amount five

months later, for settlements on 28th, February 2019, at a buying rate equal to the invoice price plus

the interest at a repurchase agreement rate of 0.45%

T hus:

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$513, 000, 000 (1 + 0.45% × ) = $513, 968, 287.50
360

Motivations for Entering into Repos and their Use in Cash and
Liquidity Management

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T he three significant reasons for carrying out repos are:

i. Lending funds with a secured basis on short term conditions;

ii. Funding long positions in a security; or

iii. Borrowing securities to sell them in short agreement.

Repos and Cash Management

Classification of Repo Investors

Investing in repos is regarded as an absolute solution for investors holding cash for safekeeping or

liquidity reasons. An excellent example of this situation is the money market mutual fund industry,

whose main aim is to make investments in support of investors disposed to accept minimal returns

for the sake of safety and liquidity.

In essence, relative to liquid non-interest-bearing and super-safe bank deposits, repurchase

agreement (repo) investments consist of short-term pay rates in the absence of making huge liquidity

sacrifices as well as having to incur notable default risks.

Additionally, municipalities form another significant classification of repo investors. T he schedule of

public expenditures has less association with the timing for tax receipts; municipalities prefer to

manage cash excesses from tax receipts to ensure that money is readily available at hand to meet

expenditures. Investments of tax revenue cannot be made under risky securities; however, the cash

collected should not be left lying idle. Short term loans supported by collaterals, like repos, fulfill

both safety and revenue considerations.

Features of Repos

Investors tend to lend overnight loans since there is a premium placed on liquidity. It refers to

maturity that is longer than a day. Most investors willing to give money via the repo platform for an

extended period, prefer taking part in the open repo; i.e., a repo that requires daily renewal until

either of the parties cancels it. However, lenders who are ready to take up on some counterparty

risks and liquidity with interest rate risks lend via repos terms. T he term repos are available for

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investors and have various maturities up to several months. Nevertheless, demand for such repos

usually decreases rapidly with the condition.

T he main feature of repos is the fact that they generally accept securities of the highest quality as

collateral. It is because safety is a fundamental consideration for repos investors. T hus, debt matters

from government-sponsored businesses and government securities, among others, are the most

approved choices.

As noted, it is taking the highest quality assets as securities that make up the main feature in a repo.

T he lenders have not escaped from the fact that a borrower might fail to pay back the cash

borrowed at the same time; securities do depreciate with time. It implies that if a borrower has

defaulted paying back the loan, the lender eventually incurs losses since selling the collateral might

not recover the loan amount.

In that sense, haircuts are usually provided in repos agreements, in which the borrower offers

security that has more worth than the loan.

Furthermore, in repo agreements, there are margin calls in which the cash borrowers provide extra

collateral in diminishing markets but have room for withdrawal of the insurance in improving

markets.

In most cases, of value to the repo investors is the quality of the collateral they obtain, they have

fewer concerns for the type of bond brought their way. T hus, such repo investors are regarded as

general collateral, and they trade at general collateral repo rates.

How Counterparty Risk and Liquidity Risk Arises through a

Repo Transaction

Repos and Long Financing

Financial institutions are the primary cash borrowers in repo markets. Repo markets are utilized by

commercial organizations to fund their inventories in making markets. Besides, they can be used in

financing the institution’s customer and proprietary positions.

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An explanation for proprietary repo positions can be done by considering a relevant trading desk as a

counterparty with internal aims to purchases and sell bonds. Repo for financing customer positions

can be viewed in the sense that it is a customer who is the counterparty and intends to fund the

buying of DBR 4s.

A repo with the client, a transaction of cash (lending), and acquisition of the DBR 4s as collateral are

done through the financial institution’s counterparty (trading desk). A different trading desk avails the

cash and acquires the initially supplied guarantee, and thus gets connected with the other

counterparty in a back-to-back repo. Essentially, in each leg of the transaction, there is a haircut

charged, which heavily relies on the relevant counterparties’ creditworthiness, however, where the

haircuts are absent, the money amounts will be the same.

Reverse Repos and Short Positions

A bond short by professional investors can either be a bet that the interest rates are likely to

increase or partly as a bet on relative value that the price of another security increases

corresponding to the cost of the security being sold short.

For instance, in a case where a hedge fund wants to sell some particular DBR 4s, the bond will be

short, and thus, to make it deliverable, it gets borrowed from another place. In short, in a hedge

fund’s view, a reverse repurchase will take place, which entails the reversal of securities.

Later on, the hedge fund initiates a reversal when it is ready to account for its short; that is, it is in a

position to neutralize its economic exposure to the bond through purchasing the bond back. Such

that, at this time, the hedge fund buys the bond and initiates unwinding of its reversal.

An example of this scenario is a case where there is a hedge fund willing to purchase the bond at

market price and then have it delivered to the other counterparty who has to return the hedge fund’s

money with interest. As such, in case there are lower bond returns than repo rate of interest, then a

profit on hedge fund is registered against an absolute short position. T he converse is also true,

where the returns on the bond are higher than the repo rate of interest, a loss is registered against

an absolute short position.

In that sense, it is crucial to keep in mind that, while repo investor is readily willing to accept

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general collaterals, there are specific bonds that are necessary for reverses, despite the repo

investors willing to accept general collateral— thus accounting for special trades which refer to

repo transactions that need specific bonds. T hese special trades are taken at special collateral rates.

Repo, Liquidity Management, and Financial Crisis of 2007–

2009

Currently, broker-dealers are less reliant on repo financing than they did before the 2007-2009 crisis.

T here are various ways in which financial institutions can borrow funds. Some of the methods are

deemed as more stable than others, meaning they can easily be managed under financial stress while

others are not easily maintained.

Stable and None Stable Sources of Funds

Equity capital is known for being one with a stable source of funds since equity holder does not

follow any form of schedule in regards to their payments and also, they cannot lawfully force the

redemption of their shares.

On the other hand, long-term debts are less stable since the bondholders must be paid principal and

interest according to bond indentures.

Also, there are short-term unsecured funding in financial stability, e.g., commercial papers. T hese

types of funds must be paid within a range of weeks or months as they mature. An organization under

critical conditions might find it hard to get financial loans elsewhere.

Funds sourced from stable sources have high expected returns according to the fund provider terms.

T hus, liquidity management comes in to save institutions in balancing the costs of funding versus the

risks of being found with a lack of finances, which are critical for survival.

In the vast financing choices, repo markets are relatively liquid and with low rates in repo

borrowing. Also, repos have short maturities making it unstable in the funding sources. However,

they are more stable as compared to a short-term unsecured loan. Moreover, repo collateral should

be able to prevent repo lenders from bolting too quickly in the onset of unfavorable news or rumors.

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Risks Associated with Repo Funding

T he risks involved with repo funding in repo investing results in tension between lenders and

borrowers. Also, issues related to regulations create some tension. In that, borrowers want an

extended term of their repo borrowing, through their regulator’s advice. T hey aim to create more

time in case refinancing conditions deteriorate and allow for avenues of alternative financing through

raising capital or selling a part of the corporate entities.

On the other hand, lenders prefer a shortened term with their regulators' advice to reduce the risks

of their borrowers’ defaulting. T he repo rates are available for different conditions for all types of

lenders and borrowers. However, the financial systems, in general, cannot have maturities of

secured financing and contract on timelines of secured lending extended.

Before the 2007-2009 financial crisis, the borrowers financed lower-quality collaterals ranging from

low-quality corporate bonds to lower-quality mortgage-backed securities. T hey were available at the

low rates as well as haircuts in the repo market.

T herefore, the collaterals were embraced by lenders who, in turn, accepted higher rates compared

to the ones available during high-quality collateral lending.

At the time of the crisis, the results of the expansion of collaterals approved for repo did not turn

out quite well. Especially, borrowers who failed to meet the margin calls were a real example of the

expansion effect. T he leading cause was as a result of decreasing the values of securities as well as

numerous other borrowers.

Other impacts suffered by worst affected borrowers were collateral liquidation, business failures,

losses, and exhaustion of capital.

Case Study: Repo Financing and the Collapse of Bear Stearns

Generally, Bear Sterns’ method of financing was through borrowing funds on an unsecured and

secured basis and utilizing equity capital. In 2006, the amount of short term unsecured funding

(primarily borrowed commercial paper) was decreased.

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On the other hand, its secured funding average condition was increased considerably during the first

half of 2007. Repos of six months and more (longer-terms) were acquired for financing institution’s

assets while creating limitations on the use of its short-term secured funding for T reasury financing.

As a result, there was instability in the fixed income repo markets, which ran roughly from 2007 to

early 2008 since the loan durations had been shortened by fixed income repo. T hus, borrowers and

lenders were asked to have the higher-quality collateral post to have the said loans supported.

Bear Sterns suffered an unwarranted loss of confidence by its lenders and borrowers. Market

rumors concerning the company’s liquidity position might have partly been the cause of loss of

confidence

T he results were:

Frequent and rapid withdrawals of money by the primary brokerage clients;

T he decrease of lenders in the repo market to renew repo loans, even though the loans

had higher-quality collateral support; and

Dismissal by counterparties to pay not unless the Bear Stearns paid first.

Case Study: JPMorgan Chase’s Repo Exposure to Lehman

Brothers

In a repo, one of the significant risks of lending money is the impending possibility of a borrower to

default and insufficient collateral values to cover the amount of the loan. Overnight loans are loans

lent by investors to financial institutions through the tri-party repo system in which collateral is

taken as security.

Before the final week of Lehman, more than $100 billion was lent to Lehman by JPM’s tri-party.

JPM, on its tri-party advances, had never taken haircuts until the start of 2008. JPMorgan took

advantage of LBHI’s life and death since it was on the verge of getting bankrupt. It is because JPM

had its central clearing bank coerce LBHI into a set of agreements inclined on one side, thus

extorting billions of dollars in assets that had important use.

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JPM repeatedly demanded LBHI to increase on the amount posted on collateral payments, and thus,

their desperate need for cash was drained by JPM. Compared to a single tri-party investor, JPM

extorted on its broker-dealer’s whole tri-party repo book on a daily book. It was later known that

Lehman's security pledges to JPM were illiquid and were debts structured and given overstated

values.

Unfortunately, LBHI exposure to JPM kept increasing to the point of including sectors that were

unconnected to third-party repo clearing. It later emerged that some of the biggest collaterals

pledged by LBHI were not only illiquid, but their valuation was reasonably impractical but was highly

supported by LBHI’s credit. While all these were going on, JPM kept making major credit extensions

to the already crumbling bank.

Characteristics of Special Spreads and Typical Behavior of U.S

Treasury in Special Spreads over an Auction Cycle

General and Special Repo Rates

Repo trades are classified as;

i. T hose using general collateral (GC)

ii. T hose using special Collateral

In general collateral, the lender has no specification of the type of security the cash lender is willing

to accept. However, there might be a specific specification on broad categories that are known as

acceptable securities. For special trading, the cash lender has to initiate the repo to have particular

security.

T here is daily general collateral in each tempo term and each bucket of insurance. Repo investors

are more suited for general trades since they can get the highest collateral rate that they are willing

to agree to. In the case of special trade, traders aiming to particular short securities should have this

type of repo transaction. More so, they have to decide on whether they are ready to lend money at

lower rates as compared to GC to borrow securities.

On a particular date, a specific issue’s special rates are dictated by its demand for borrowing to that

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date in comparison to the supply availability. T hus, there is a difference between demand and supply

of borrowing and lending issues to the demand and supply for purchasing and selling issues.

As such, high demand is placed on a bond that trades richly in comparison to other bonds in

correlation to outstanding supply. In short, to predict one’s bond special spread is quite a hard task.

Special Spreads in the US and the Auction Cycle

Every three months, the United States treasury usually auctions a new ten-year T reasury bond note

at the mid-quarter refunding in February, May, August, and November. T he U.S treasury sells bonds

maturing at various times based on the three-month fixed period. A ten years OT R (On-the run)

security, for instance, carries more trade significance as compared to that of thirty years. Current

issues tend to be more liquid; as a result, they consist of low bid-ask spreads; thus, businesses of

large sizes can relatively be undertaken much quicker.

T reasuries with newly been issued bonds are the right candidates for both long and short positions

because they have extra liquidity. Most of the treasury shorts hold relatively brief periods. In a

situation where all factors are held constant, holders of the relatively short position prefer to sell

liquid treasuries, to recover them within a short period, and at preferably lower costs.

In case there is a sacrifice to be made on liquidity through lending the bond in a repo market, traders

and investors in long OT R should be granted compensation as a result of liquidity. Also, investors and

traders having the will to short OT R securities should show interest to pay for the liquidity of the

said bonds when acquiring them in the repo market.

T he auction cycle is also essential in ascertaining bonds that trade special as well as how particular

individuals purchase throughout the auction cycle. It has been observed that special trades are quite

unstable as they are based on day-to-day in which each day, which reflects on the supply and demand

for special collateral. It is prevalent for trades to be small after auctions and reach peak levels

before auctions, although the OT R special spread cycle is irregular.

T here is a significant similarity between the cases of a five-year OT R and ten-year OT R. It suggests

that similar patterns are registered for shorter maturity OT Rs; however, the spread’s tendency is

not so broad. T he reason behind such is explained by the fact that short-maturity T reasuries are

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issued more frequently. T hus, it bars any particular issues from being the significant liquid or short

with most favors.

Special Spreads in the US and the Level of Rates

Recently, penalties were introduced as a punishment for defaulting on delivering a bond bought. T he

implication was that, before the sanctions, the special rate was maintained above 0%.

If a trader shorts a ten-year OT R but defaults to deliver upon an agreement, such a trader has to lose

that day’s money plus the interest on the same money.

In case a trader borrows a bond overnight at 0% rate in the repo market, to make a delivery, the

profitability of the borrow to the trader is the same as a loss. T he reason being, there is no interest

in selling a bond in such a scenario. Before, the bond could not be borrowed by any traders since

special rates were 0% or less. T hus, to have the bond eligible for borrowing, the special rates should

at all times be more than 0% but not exceeding the general collateral rates.

T he introduction of the penalty for failure to deliver formed a penalty rate as the new upper limit for

special spreads only, excluding the general collateral rates.

Valuation of the Financing Advantage of a Bond Trading

Special in Repo

OT R bonds usually trade at a premium due to their liquidity advantage. T hus, special spreads need to

be translated into yield premiums or price. T he bond’s financing value refers to the amount of

lending a bond in a repo, borrowing loans at its special rate, and having the cash invested at the higher

general collateral.

T he assumption made in this case is how the trading of the special bond will be, and the period it will

take. T he market view should also be inline, as expressed in the term structure of the special

spreads.

Example: Calculating the Financial Advantage of a Special Trading

Bond in a Repo Transaction

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In calculating the financing advantage of a special trading bond in a repo transaction, we will consider

the example below;

Given that lending cash value of $156.89 has a spread of 0.789% for 221 days, calculate the financial

advantage of the special bond;

221 days × 0.789%

$156.89 × = $0.75991 ≅$0.76
360 days

T his implies that 76 cents per $156.89 market value of the bond.

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Practice Question

Suppose that DBR 4s with a face value of $100 million are to be sold by a counterparty to

another counterparty for settlement at the price of $109 million. T he counterparty

selling the DBR 4s decides to buy back the $100 million face amount some 101 days later

for settlement at a buying price equal to that of the invoice price with a repo rate of

0.26%. At what price can the counterparty repurchase the bond?

A. $109.08 million

B. $100.07 million

C. $126.26 million

D. $109.78 million

T he correct answer is A.

T he repurchase price is:

0.0026 × 101
$109, 000,000 (1 + ) = $109, 079, 509
360

≈ $109.08 million

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 Reading 137: Liquidity Transfer Pricing: A Guide to Better Practice

After compl eti ng thi s readi ng, you shoul d be abl e to:

Discuss the process of liquidity transfer pricing (LT P) and identify best practices for the

governance and implementation of an LT P process.

Discuss challenges that may arise for banks during the implementation of LT P.

Compare the various approaches to liquidity transfer pricing (zero cost, average cost,

matched maturity marginal cost).

Describe the contingent liquidity risk pricing process and calculate the cost of contingent

liquidity risk.

Liquidity Transfer Pricing (LTP) Process and the Best

Practices for the Governance and Implementation of an LTP
Process

Liquidity Transfer Pricing

LT P is a process that ascribes the costs, benefits, and risks of liquidity to relevant business sections

within a bank. Liquidity was taken for granted before the global financial crisis of 2007-2008. Banks

assumed the availability of funds at extremely low or no cost. T he implication of this is that banks

lacked strong liquidity practices, and leaned heavily on financing long-term assets with short-term

liabilities refinancing to ensure that they made profits.

After the global financial crisis, liquidity management has become a ‘hot topic’ for both financial

institutions and regulators. Currently, liquidity can only be obtained at a cost, and there are fewer

lenders of last resort.

To successfully transfer liquidity costs and benefits from business units to a pool managed centrally,

LT P charges users of loans/assets for the cost of liquidity, and credits providers of funds

(liabilities/deposits) for the benefit of liquidity. Additionally, it replenishes the cost of carrying a

liquidity cushion by charging contingent commitments, such as lines of credit, based on their

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expected use of liquidity.

T he following chart demonstrates the liquidity transfer pricing process:

Best Practices for the Governance and Implementation of an LTP

Process

Good LT P practices call for banks to produce and stick to an LT P policy that defines the purpose of

LT P and provides principles to ensure that LT P achieves its intended purpose. Banks with good LT P

processes accrue less illiquid and interrelated assets, utilize more stable sources of funding to meet

the business demands as well as carry a more sufficiently sized liquidity cushion to withstand

unexpected market-wide disruptions.

On the other hand, poor LT P practices in banks lead to underpricing or, in worse case scenarios,

failure to price liquidity. T hus, they accrue contingent exposure and illiquid assets, as well as

undervalued sources of funding. Most financial institutions and many banks absorbed the same

outcome before the global financial crisis.

In December 2010, the Basel Committee initiated liquidity standards forming part of the Basel III

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regime. Notably, it introduced the liquidity coverage ratio and (LCR) and the net stable funding ratio

(NSFR). T hese standards were aimed to increase banks’ short-term and long-term resilience. T he

LCR gauges the adequacy of high-quality assets within a bank to survive stressed liquidity conditions

over 30 days. On the other hand, NSFR enables banks to adopt more stable sources of funding over

the long-term. Additionally, the Basel Committee introduced monitoring tools to track the

diversification of funding sources, encumbrances on assets, and to alter disclosure to supervisors.

Some of the best practices that Banks can adopt to implement LT P successfully include:

i. Effectively managing the liquidity cushion

ii. Modifying governance

iii. Aligning LT P and risk appetite

iv. Altering transparency and disclosure

v. Instituting stress testing

vi. Constructing an IT system to help manage liquidity standards

vii. Changing reporting

Effectively Managing the Liquidity Cushion

It is costly to maintain a cushion for unexpected liquidity flows. Most times, income earned on the

cushion is lower than the costs of funding it. Several banks are increasingly considering the repo and

securities lending business intending to generate additional income. However, managing the specific

risks of these instruments, such as concentration risk or the risk of a substantial devaluation of the

collateral in case of a default, involves new counterparty credit risk management capabilities.

Modifying Governance

T raditionally, the asset-liability committee (ALCO) was responsible for allocating balance sheets and

liquidity limits. However, following the recent regulatory scrutiny, the chief risk officers are now

more often engaged in the decision-making process.

Aligning LTP and Risk Appetite

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T ypically, banks gauge their liquidity buffer needs using simple scenarios. However, besides these

indicators being rough and static, they may be inadequate for the dynamic pricing of liquidity in line

with the business strategy and a specific bank’s liquidity profile. T he indicator requires extra

support from appropriate policies and procedures in effectively managing liquidity risk according to

the institution’s liquidity risk appetite.

Altering Transparency and Disclosure

Very few banks used to share information about the composition of their funding sources, liquidity

reserves, and stress testing results in their annual reports. However, the Enhanced Disclosure Task

Force (EDT F) now requires banks to fulfill these disclosure requirements since 2012. To

accomplish that, many banks had to make substantial investments.

Instituting Stress Testing

Several major financial institutions have established stress testing and contingency plans. Moreover,

the frequency of stress testing has also changed. T hese financial institutions require access to the

right data as it is critical for carrying out meaningful stress tests. Banks should work on improving

the link between stress testing and contingency planning to incorporate new stress test results in

contingency plans.

Constructing an IT System to Help Manage Liquidity Standards

Liquidity risk entails a large amount of data being put together within the entity and across the group.

T he IT infrastructure should support a consistent representation of the data. Moreover, there

should be an alignment between external reporting and internal management needs. T he IT system

should be responsive to reflect updated liquidity risk numbers. Banks should avoid setting up an IT

system that is parallel to the one already utilized for other reporting needs. T his helps in preventing

reconciliation efforts as well as improving its cost-efficiency.

Changing Reporting

Banks are facing increased management needs for monitoring decision-making indicators as well as

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regulatory requirements for disclosure. T herefore, banks now want consistency in the group

liquidity reporting as well as the capability to cope with the entity-level or regional-level specific

regulations and needs. T his means that having a consistent data hub at the group or regional level is

crucial. Banks can consider automating their reporting solutions to solve the increasing complexity

in reporting and in covering various liquidity metrics and considering different asset classes and

currencies.

Challenges that May Arise for Banks during the

Implementation of LTP

Good liquidity transfer pricing (LT P) practices require banks to have sound liquidity risk policies and

procedures in areas where regulations can play a vital role. In the past, financial crises may have

been activated by market breakdowns and a lack of regulatory oversight.

Governing LTP

In a broader view, all processes, policies, and practices need governing. Such governing is attained

via combining internal control elements such as threat management and regulation, and external

control elements such as competition and regulation. External environment factors affect

overseeing equally across all businesses. T hus, the main difference trickles down to the governance

applied to internal control factors.

Internal governance entails having group-wide aims met, and this is what differentiates most

businesses. T hus, having robust internal control bears the achievements of an institution’s goals,

while weak internal controls result in adverse selection and moral hazards. T herefore, most banks

may have poor LT P practices due to weak internal controls

Management of the LTP Process

LTP Policies

Lack of LT P policy is a poor practice, especially now with the knowledge of liquidity risk.

T raditionally, banks depended on internal transfer pricing in their management of interest rate threat

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in the banking book and also in the evaluation and monitoring of product performance and business

units, but with minimal changes for liquidity benefit, costs, and risks.

T he Financial Stability Institute recently conducted a study that analyzed 38 large banks from nine

countries. T he study showed several challenges in the context of the allocation of liquidity costs and

benefits. Some of the key conclusions of this study include:

i. Many banks did not have LT P policies and employed inconsistent LT P regimes;

ii. Various banks did not charge liquidity costs to assets and liquidity credits to liabilities; and

iii. Using one average rate to measure costs does not cover long-term agreements – it fails to

penalize long-term funding and conversely reward long-term liabilities – and does not take

market changes into account.

It was also noted that the most striking example of poor practices was the failure of banks to

account for the costs, benefits, and risks of liquidity in all or some aspects of their business

activities. T hese banks looked at liquidity as being free and thus seeing zero liquidity risk. T herefore,

this attributed zero charges to some assets for the cost of using funding liquidity and conversely

attributed no credit to some liabilities for the benefit of providing funding liquidity.

Internal Funding Structure – Centralized vs. Decentralized

Banks can either have a centralized funding center where wholesale funding restricted to a

subsidiary treasury or a group or a decentralized funding center where specific business units raise

funding from their sources to cover their own liquidity needs.

However, the survey established that banks that applied decentralized funding centers, especially the

ones with sizeable key brokerage business schemes, were more vulnerable to poor LT P practices.

For instance, some business units used external sources of funds and traded those funds to other

business units

(or the treasury) at a higher rate, resulting in a risk-free profit for the business unit involved.

Internal arbitrage was not only caused by decentralized funding systems but also weak oversight and

inefficient risk controls. T he basis for arbitrage comes about when these factors prevent business

units and the treasury to know the prices paid by other businesses for funding from external

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sources. More so, most banks that employed decentralized funding systems applied inconsistent LT P

policies and counted on manual off-line methods to have their funding costs updated.

Towards Better LTP Practice

Most of the banks are aiming to improve their LT P practices. T his is through establishing LT P

policies that provide a clear outline of LT P's purpose as well as some rules and principles to make

sure that business units grasp the need for charges associated with the utilization of liquidity.

A move towards better LT P practice consists of the following:

i. Banks operating with decentralized funding centers are changing towards wholesale funding

controlled centrally via a treasury function.

ii. Banks should come up with trading book procedures and policies by developing risk limits and

controls for trading activities for proper measuring, monitoring, and assessment of liquidity

threats attached to businesses.

iii. Banks should improve existing controls and measures. T hese improvements enhance risk-

adjusted profit measures, thus encouraging business units to factor in the liquidity cost as

part of their decision to book certain assets.

iv. Banks with small trading book exposures in their business activities want to do away with

over-trading behaviors by applying higher funding rates on net funding needs upon breaching

certain funding limits.

v. All banks are being keener on enhancing oversight.

vi. All levels of management, treasury purposes, and independent risk and financial control

personnel are purposing on becoming more engaged in the LT P practice.

Approaches of Liquidity Transfer Pricing (Zero Cost, Average

Cost, and Matched Maturity Marginal Cost)

Need for LTP in Banks

Banks make money through daily funding from short-term deposits (liabilities) and long-term loans

(assets) via a process referred to as maturity transformation. T hus, banks must use LT P to account

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for the benefits, costs, and risks or liquidity in new product approval processes, product pricing, and

performance evaluation. T his way, they should be more encouraged to engage in maturity

transformation.

Practicing poor LT P policies leads to accrued vast amounts of long-term illiquid liabilities, thus

enhancing susceptibility to shortfall funding.

1. Zero Cost of Funds

T he zero cost of funds approach ignores accounting for the benefits, costs, and risks of liquidity in

entirely all or some of a bank’s business activities. In this case, banks regard funding liquidity as free

while funding liquidity threat as virtually zero. In other words, there is no charge applied to some

assets for the price of utilizing funding liquidity — additionally, there is no credit application on some

liabilities for the benefit of providing funding liquidity.

When there is a zero charge on liquidity costs, zero credit on liquidity benefits aggravates maturity

transformation to the highest degree. As such, this method leads to long-term, highly illiquid assets

hoarding and less long-term steady liabilities to cater for financing needs as they became of due.

Why Banks Chose this Approach

T here were favorable funding conditions before the global financial crisis of 2007-2008; thus, some

banks regarded liquidity as a free good while funding liquidity risk at zero. If banks assumed that

funding would always be readily available and at a steadily inexpensive rate, it could have encouraged

the essence of charging assets for liquidity costs as well as credit liabilities for liquidity benefit.

2. Average Cost of Funds Approach

Some banks acknowledge the need to have users and credit providers charged for providing liquidity

funding and thus came up with a pooled method to LT P. In this method, the average rate is derived

based on the interest expense, i.e., the funds’ cost in all the existing funding sources.

Relative to the zero-cost funds' approach, this approach is better. However, since only one average

funding rate is applied, all assets get charged on the rate of usage of liquidity cost (funds) with no

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consideration of their varying maturity.

Example: Average Cost of Funds Approach

Suppose that the average rate across all funding sources is 20 bps, all loans would receive a charge of

$4,000 on a principal amount of $2 million, irrespective of their maturity. Assuming this rate was also

used to reward fund providers, then all deposits would receive a credit of $4,000 on a principal

amount of $2 million, irrespective of their maturity.

Term in years 1 2 3 4 5
Loan/deposit $2 million $2 million $2 million $2 million $2 million
principal
Average cost of 20 bps 20 bps 20 bps 20 bps 20 bps
funds (bps)
Charge for use $4, 000 $4, 000 $4, 000 $4, 000 $4, 000
of funds
Credit for benefit $4, 000 $4, 000 $4, 000 $4, 000 $4, 000
of funds

Shortcomings of the Average cost of Funds Approach

T he average cost of funds approach has two problems. T hese include:

i. It fails to factor in the high liquidity threat present in long-term assets. T his is because,

when one fixed charge “average rate” is applied for the utilization of funds, it technically

assumes that al l assets, regardl ess of thei r maturi ty, have the same l i qui di ty

threat. It is the same case for the average rate applied for credit fund providers.

ii. T he utilization of average cost is a projection of historical prices and costs. T hus, it fails to

make a clear projection of the real market costs of funds.

T he following is a graphical illustration of a single average for the benefit and cost of funds:

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A better approach to the above applies a separate ‘average’ rates for the costs and benefits.

Suppose that the average cost of funds is 20 bps, as in the example presented above, all loans would

be charged $4,000 on a principal of $2 million, irrespective of their maturity. Further, if the average

benefit of funds is 10 bps, all deposits would be credited $2,000 on a principal of $2 million,

irrespective of their maturity. We can, therefore, deduce that lowering the average cost of funds

from 20 bps to 10 bps encourages loan generation. However, since we have a separate rate for the

average benefit of funds, this variation will not directly discourage business units from raising

deposits.

T he following is a graphical representation of the same:

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Indications of the Average Cost of Funds Approach

T he average cost of funds approaches champions for maturity transformation. In other words, it

promotes both healthy and unhealthy maturity transformation. Business units are overly encouraged

to write long-term assets since, over a more extended period, as they are not charged heavily for

their use of funds over a longer-term. On the other hand, they become more discouraged to engage in

long-term liabilities since there is no premium ascribed to liabilities providing funding for a more

extended period.

Additionally, information asymmetries and remuneration factors effortlessly motivate long-term asset

generation; however, in the average costs of funds method, the motivation is aggravated.

T his approach di storts profi t assessment as it leads to the mispricing of and the accrual of assets

on severely distorted risk-adjusted conditions.

Why Banks Choose Average Cost of Funds Approach

i. It is simple to find the mean of the funding costs across all assets relative to charging

specific assets, transactions, or products as per their contractual maturities.

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 ii. It is simple, thus makes it easier for banks to understand and comply with the LT P process.

iii. T he approach makes it easy to apply the LMIS basics for efficient management of LT P.

iv. T he average cost of funds approach is vulnerable to transitional changes in banks’ real

market cost of funding, therefore minimizing net interest income deviation across all

businesses.

3. Matched-Maturity Marginal Cost of Funds Approach

T he matched-Maturity marginal cost of funds approach is currently the best practice for liabilities

and assets on the balance sheet, which is based on the concept that the treasury, serves as a conduit

for all of the institution's funds using current market marginal funds costs. In this approach, individual

business units trade their liabilities at reasonable transfer prices to the treasury. Furthermore, each

business unit buys the funds required to support its assets at appropriate transfer prices from the

treasury.

As such, each business unit is handled as a wholly/entirely matched book where assets get a transfer

price charge that depicts their maturity. On the other hand, liquidity features such as maturity, cash

flows, origination date, and repricing get transfer prices on credits that show the market worth of

funds with similar characteristics.

One of the significant advantages of this approach is that each element of the net interest margin can

be measured independently;

i. Lending or asset spread is the variation between the real yield on assets with their matched

costs for bought funds from the treasury. T his spread calculated the economic return on

assets independently without adding actual funding sources.

ii. Funding spread or liability is the variation between the actual deposit costs and the credit

sale of funds to the treasury. T his spread measures the opportunity value of deposit funds

independent of their use.

T he following is a graphical representation of the matched-maturity marginal cost of funds approach

to LT P and its components:

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Determining the Rates for Users and Providers of Funds

T he rates charged for the use of funds and credited for the benefits of the fund are based on the term

liquidity premiums. T his should be in line with the maturity of the transaction. However, for

indeterminate-maturity or amortizing products, the rates for providers and users of funds is

determined by the blended term of liquidity premiums consisting of their estimated or known cash-

flow profiles.

Examples: Matched-Maturity Marginal Cost of Funds Approach

Example 1: Non-Amortizing Bullet Loans

Non-amortizing bullet loans are those loans that do not provide repayments throughout their term.

T hus, because the interest and principle get repaid at maturity, it is necessary to have a funding

commitment throughout the duration of the loan.

For an illustration of the matched maturity marginal cost approach, assume the following term

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liquidity premiums and the average cost of funds were recorded by a bank at a point before the crisis

(pre-GFC), and more recently.

Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds

Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 1 2 4 8 10
Average cost of funds 3 3 3 3 3
Difference −2 −1 1 5 7
Current (post-crisis)
Term liquidity premium 6 8 12 18 30
Average cost of funds 10 10 10 10 10
Difference −4 −2 2 8 20

A one-year non-amortizing bullet loan should have received a charge of 1 bp if originated pre-crisis,

and six bps if arisen more recently. Assume that the principal of the loan was $2 million. T his should

have translated to charges of $200 and $1,200, respectively, to the business unit(s) writing the loans.

Example 2: Amortizing Loans

Contrary to the non-amortizing bullet loans, amortizing loans provide cash flows (repayments) in the

entire life of the loan. Because a proportion of the interest and principal is paid before its maturity,

no funding commitment is necessary throughout the term of the loan. T his is because the loans

become self-funding at some level in between the start and maturity of the loan.

Consider a five-year linearly amortizing bullet loan with a principal amount of $2 million. You can

think of this as five separate annual loans, each of $400,000, using a matched-maturity marginal cost

of funds approach. Let's use the same table as in the previous example.

Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds

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 Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 1 2 4 8 10
Average cost of funds 3 3 3 3 3
Difference −2 −1 1 5 7
Current (post-crisis)
Term liquidity premium 6 8 12 18 30
Average cost of funds 10 10 10 10 10
Difference −4 −2 2 8 20

Now calculate the charge that the loan should have received, assuming it was originated pre-crisis.

1 (1) + 2(2) + 3(4) + 4(8) + 5(10)

Charge received pre-crisis = = 6.6 bps
1+2 +3+4 +5

T his is a blended (tenor-weighted) term liquidity premium, which is derived from the tranching

approach.

Using the same method, if the loans were generated in recent times, the charge it should have

received is equivalent to:

1 (6) + 2(8) + 3(12) + 4(18) + 5(30)

Charge received post-crisis = = 18.7 bps
1+2 +3+4 +5

Although the matched-maturity marginal cost of funds approach is more complex relative to the

average cost of funds approach, it promotes a better LT P practice. Moreover, it recognizes that the

costs and benefits of liquidity are related to the maturities of assets and liabilities, and therefore

allow higher rates to be assigned to products that use or provide liquidity for more extended periods.

Contingent Liquidity Risk Pricing Process and Calculate the

Cost of Contingent Liquidity Risk

LTP in Practice: Managing Contingent Liquidity Risk

Calculating the charge for utilizing liquidity and the credit for providing liquidity for most on-balance

sheet items is relatively simple. However, this differs for contingent commitments such as lines of

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credit and other financial contracts. T he best method is to impose a situation model, establish a

reasonably low likelihood of worst-scenario results, and charge transaction, business units, or

products at the most granular point for the expense of covering this outcome.

Mostly, banks consider a liquidity cushion. T his is a “buffer” of highly liquid assets to assist them in

surviving times of unforeseen funding outflows. Unanticipated funding outflows include but are not

limited to wholesale funding run-off, drawdowns on lines of credit, and secured lending runoff.

As mentioned in the earlier sections, in December 2010, the Basel Committee initiated liquidity

standards forming part of the Basel III regime. Notably, it introduced the liquidity coverage ratio and

(LCR) and the net stable funding ratio (NSFR). T hese standards were aimed to increase banks’ short-

term and long-term resilience. T he LCR gauges the adequacy of high-quality assets within a bank to

survive stressed liquidity conditions over 30 days. On the other hand, NSFR enables banks to adopt

more stable sources of funding over the long-term. T he two standards aim to minimize the burden on

central banks of having to act as the last resort lender and the likely effects of moral hazards as an

outcome of these actions.

Liquidity Cushions: A Principle of Liquidity Risk Management

T he 12th BCBS principle requires a bank to maintain a cushion of unencumbered, high-quality liquid

assets to be held as insurance against a range of liquidity stress scenarios.

LTP and Liquidity Cushion

Usually, banks attribute the cost of carrying liquidity cushions through LT P. However, there are no

actual links established between liquidity cushion and LT P in existing academic writing. Mainly these

two are independently treated as two different principles used in liquidity risk management.

Liquidity risk costs are defined as transfer prices covering liquidity risks. T hese costs can be split

into the cost of the liquidity cushion and the cost of the liquidity reserve. T he following figure shows

the cost components of liquidity transfer pricing:

T he cost of the liquidity cushion refers to the cost of providing a liquidity cushion for unanticipated

cash flows obtained from product models, which are based on individual parameters. Repo deals and

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asset sell-offs are examples of these liquidity cushions which cover unexpected cash flows of

products. T he causation principle allocates liquidity cushion costs to specific balance sheet items.

Inadequate Attribution of Cost of Carrying a Liquidity Cushion

T ypically, carrying a ‘buffer’ of extremely high liquid assets is expensive for banks since the costs of

assets funds consisting of the cushion generally outweigh the outcome they generate. T hus, most

banks usually aim to reduce their liquidity cushion’s capacity so that it does not have a negative

implication of dragging their profits.

Most banks consider the cost of carrying additional liquidity costs as a business cost instead of as an

opportunity cost. As such, the treasury (central management) should not incur the cost of carrying.

Instead, it should be brought back into the business through the LT P process.

T he following figure is an illustration of the liquidity cushion:

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 FT P=Base Rate + Term Liquidity Premium + Liquidity Premium

Where:

FT P is the fund transfer price;

Base Rate is the rate resulting from the swap curve relative to the asset’s contractual/ behavioral

maturity or repricing term, whichever is less;

Term Liquidity Premium is the spread between the swap curve and the bank’s marginal cost of funds

curve as per the contractual/ behavioral asset’s maturity; and

Liquidity Premium is the cost of carrying liquidity cushion averaged over the total assets of the bank.

T he above equation implies that cushioning assets on short-term funding reduces the negative cost of

carrying, making it much easier for banks to recoup through the addition of liquidity premium to the

cost of financing charged to assets.

Better Management of Contingent Liquidity Risk

Banks are enhancing the way they manage contingent liquidity risk. Here are some of the strategies

they have adopted:

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 i. Most banks are changing towards widened scenarios as part of stress-testing processes to

account for various types of market disruptions that are likely to occur as per BCBS

recommendations.

ii. T he management is incorporating stress-testing outcomes in generating the size needed for

liquidity cushions.

iii. T he liquidity cushion asset composition is also broadening since most banks are now

appreciating holding government securities and cash more than ever.

iv. Banks are moving towards applying higher funding charges on their assets being held as part

of a liquidity cushion bearing in mind that it could take longer for it to generate liquidity when

required.

v. Charging higher funding costs to liquid assets is deemed as crucial for banks since

undertaking an expensive liquidity cushion leads to more drags on profit

vi. Banks should not ignore the contingent liquidity threat attached to different business

undertakings, thus, being unable to attribute charges based on their prediction or expected

utilization of funding liquidity. Business activities that create more unforeseen and significant

funding outflows should apply higher contingent liquidity charges.

Pricing Contingent Liquidity Risk

All banks should be charging contingent commitments based on their likelihood of drawdown. T he

rate charged for contingent liquidity risk should be derived as follow:

(Limit − Drawn amount)

Rate charged = × Likelihood of drawdown × Cost of funding liquidity cushion
Limit

Example: Pricing Contingent Liquidity Risk

All banks should charge contingent commitments based on their likelihood of drawdown at the

extreme basic level of what is considered to be a better practice. For example, suppose a line of

credit with a limit of $50 million has $5 million already drawn. Further, assume there is a 70% chance

the customer will draw on the remaining credit and that the cost of term funding assets in the

liquidity cushion is 20 bps T he rate charged for contingent liquidity risk should be calculated as

follows:

$50 − $5
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 $50 − $5
Rate charged = × 0.7 × 0.0020 = 0.00126
50

T his is equivalent to 12.6 bps.

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Practice Question

Calculate the monthly payment required to amortize a loan whose principal is $225,000

at an annual interest rate of 3.25% for a term of 30 years.

A. 739.23

B. 799.21

C. 979.21

D. 2700.21

T he correct answer is C.

(P × i)
R=
1 − (1 + i)

Note:

A loan of P dollars at interest rate i per period may be amortized in an equal periodic

payments of R dollars made at the end of each period.

Where:

i
r=
m

i is the interest rate per period

r is the interest rate on loan (periodic payment)

m is the number of compounding periods per year.

n=m×t

t is the term of the loan

P= 225,000

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r =3.25% (0.0325)

m = 12

But,

0.0325
i=
12

n = 12 × 30 = 360

Hence,

0.0325
225, 000 ×
12
R= = $979.21
0.0325 −360
1 − (1 + )
12

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 Reading 138: The US Dollar Shortage in Global Banking and the
International Policy Response

After compl eti ng thi s readi ng, you shoul d be abl e to:

Identify the causes of the U.S. Dollar shortage during the Great Financial Crisis.

Evaluate the importance of assessing maturity/currency mismatch across the balance

sheets of consolidated entities.

Discuss how central bank swap agreements overcame challenges commonly associated

with international lenders of last resort.

Causes of the U.S. Dollar Shortage during the Great Financial

Crisis

Sources of funding in banks can become unstable, and the global financial crisis proved this. During

the crisis, the majority of the banks had a hard time acquiring short-term U.S. dollar funding. T hus,

this led to central banks across the world employing extreme policy approaches, such as

international swap arrangements with the U.S. Federal Reserve. T he reason was to be able to supply

commercial banks with U.S. dollars per their jurisdictions.

T he Bank of International Settlements (BIS) identified reasons for the U.S Dollar shortage during the

Great Financial Crisis (GFC) as follows:

Increased Appetite for Foreign Currency Assets

T he investors had an overwhelmingly high thirst for the so-called "safe haven" or foreign currency

assets, notably the U.S.-denominated claims on non-bank entities. T he funding difficulty during the

GFC had a direct relation to banks' global balance sheet expansions over the past decade before the

crisis. T hus, the growth of banks' balance sheets respectively heightened their thirst for foreign

currency assets.

Cross Currency Funding

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T his refers to the extent to which banks invest in one currency and fund in another via F.X. swaps.

Europe and Japan banking systems mainly engaged in cross-currency funding. Since 2000, the two

banking systems took enormous amounts of the net on-balance-sheet positions in foreign currencies,

especially in U.S. dollars. T he associated currencies exposures were left hedged off-balance-sheet

since the accumulation of net foreign currency position led to a situation where the banks were on a

foreign currency funding risk. In other words, these banks were exposed to the risk that their

funding positions could not be rolled over.

U.S. Dollar Funding Gap

Unlike domestic banks, non-US banks had limited access to a stable base of dollar deposits. T his

means that they relied on short-term and potentially more volatile sources of funding, such as

commercial paper and loans from other banks. A lower bound approximate of banks' funding gap,

which is the net amount of U.S. dollars channeled to non-banks, shows the vast funding needs of the

major European banks. It became more complicated to secure this funding after the onset of the

crisis. T his is because, after the GFC, credit risk concerns led to disruptions in the interbank and

F.X. swap markets as well as in money market funds. European banks reacted to these disruptions

through the support of central banks.

Reversal of Carry Trades

T he dollar profited from the unwinding of carry trades. A carry trade involves an investor holding a

high-yielding currency asset (target asset), which is financed with a low-yielding currency liability

(funding liability). When financial markets become very volatile, the target currencies with the most

lucrative yields significantly depreciate, and the funding currencies appreciate. T his was the case

during the GFC. T he dollar interest rates decline by mid-2008 had already recommended the dollar to

carry traders as a funding currency alongside the yen.

When equity volatility rose, the higher currency's yield in the previous six months implied a higher

depreciation against the dollar. Target currencies were struck (hit hard) as investors sold them

against the dollar or yen.

Over Hedging of Non-U.S. Banks and Non-U.S. Institutional Investors

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Many banks invested heavily in the U.S. dollar assets until mid-2007. T hey funded these positions by

borrowing dollars directly from various counterparties, as well as using foreign exchange swaps.

Dollar asset declines left institutional investors outside the United States over-hedged. European

banks were forced to buy dollars in the spot market as they wrote down the value of holdings of

dollar securities. T he aim was to retire the corresponding hedges. On the same note, European

pension funds bought the dollar as they experienced losses on dollar securities hedged into the euro.

Importance of Assessing Maturity/Currency Mismatch Across

the Balance Sheets of Consolidated Entities

Banks' International Positions: Concepts and Data

Stress accumulates on a global bank's balance sheet in the form of assets and liabilities maturity or

currency mismatches, and understanding these mismatches can only be achieved by looking into the

bank's worldwide positions consolidated across all office locations. For a bank aiming to expand

globally, it needs to fund a specific portfolio of securities and loans in which some of it is based on

foreign currencies.

Banks can finance these foreign currency positions through:

i. Borrowing of domestic currency then converting through straight F.X. spot transaction,

hence being able to buy the foreign asset in the converted currency.

ii. Converting domestic currency liabilities into foreign currency through the use of F.X. swaps

and purchasing foreign assets.

iii. Borrowing foreign currency through the interbank market, mainly from central banks or

participants of the non-bank market.

Banks get vulnerable to funding risks as a result of the different options of funding or in situations

where they are unable to roll over funding liabilities. T he degree of maturity transformation

associated with a bank balance sheet is what determines the implications of the risk. T he need to

invest relies on the preferred holding period, market liquidity, and the underlying asset's maturity. In

case the rolling over of the contractual liabilities is not possible, the foreign currency assets meant

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for holding are rather sold and more likely in conditions of distressed market situations. A funding gap

refers to the amount that banks must rollover before the maturity of their investments

Funding Risk

Technically, funding risk is associated with stresses on a broad basis on the global balance sheet: the

mismatches between currency, maturity, and counterparty of liabilities and assets. In quantifying

these threats, there is a need to measure banking activities based on consolidation, specifically at the

individual bank level (the decision-making economic unit).

Data on a clear breakdown of positions per currency, liabilities, assets, counterparty and maturity

type, as well as off-balance sheet positions, are meant to assist in identifying potential mismatches.

However, the available public information fails to factor in this idea. Although published bank

accounts on a consolidated level are available, they lack essential information on the breakdown of

maturity, counterparty, and currency required.

Construction of Individual Bank's Global Balance Sheet

T he structure of the individual bank's global balance sheet entails summing up the local and cross-

border balance sheet positions from its domestic offices and the host states around the globe into a

consolidated whole for each banking system.

The Structure of Banks' Operations

Banks that are actively operating across the world have numerous offices in various countries. T heir

management of maturity and currencies are based on a consolidated global entity instead of per

office. T his implies that significant mismatches measured on an office's balanced sheet located in a

different office may be offset/hedged off-balance sheet through an on-balance sheet position booked

by other offices elsewhere. T his results in a matched book for the bank as a whole.

Balance Sheet Expansion since 2000

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T he banks' international balance sheet expansions since 2000 are highly associated with the U.S.

dollar shortage. T he stocks on banks' foreign claims significantly grew from $10 trillion at the start

of 2000 to $34 trillion by the end of 2007. By 2001, international claims were at 10% while at the end

of 2007, it approached 30%. T hese significant changes occurred mainly during the financial

innovation period. It included expansion growth in the hedge fund industry, the introduction of

financial structures, and the spreading of universal banking, which combined proprietary trading,

investment, and commercial banking activities.

In 1999, there was the introduction of the Euro, leading to increased activity in the European banking

system, and the outcome was significant intra-euro area lending. T he European bank positions

dominated in U.S. dollar and other non-euro currencies is responsible for most of the overall

expansion in their foreign assets between the end of 2000 and the mid of 2007.

Maturity Transformation across Banks' Balance Sheets

In banking, maturity transformation plays a critical role. Necessarily, banks are required to make the

transfer of funds from agents in excess (demanding short-term deposits) to agents in deficit (with

long-term financing needs). T he maturity mismatch needed for the facilitation of long-term

investment projects, as well as serving the liquidity needs of the investor, should allow banks to earn

a positive spread.

Banks might get motivated to excessively increase their maturity mismatch, thus rendering

themselves vulnerable to funding risks embedded in rolling-over short-term liabilities. Excessive

maturity transformation creates undesirable financial stability issues as it puts the entire banking

system at risk.

How Central Bank Swap Agreements Overcome Challenges

Commonly Associated with International Lenders of Last
Resort

The U.S. Dollar Shortage

A dollar shortage refers to a scenario where a country lacks a sufficient supply of U.S. dollars for

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effectively managing international trades. T his situation comes into place when a country is required

to pay more U.S. dollars for its imports as compared to the U.S. dollars received from exports.

Most countries have to hold their assets in dollars to sustain the steady growth of the economy and

transact with other countries who use the U.S. dollar since it is the globe's key traded currency.

When a dollar shortage occurs, it affects global trade since the U.S. dollar acts as a peg for other

currencies' value. During the GFC, maturity transformation was unsustainable since the leading

banks' sources of short-term funding were unstable. Short-term interbank funding got compromised

by increased counterparty liquidity risk. T he associated disarrangements in F.X. swap markets made

it even worse, as it was expensive to acquire U.S. dollars through currency swaps. On the other

hand, the European bank's U.S. dollar funding needs were more than other entities' funding

requirements in different currencies.

The International Policy Response

International policy response came into place due to the severe U.S. dollar shortage among banks

outside the United States. T he European Central Bank embraced measures to relieve funding

pressures in their domestic currencies since they were unable to avail of adequate U.S. dollar

liquidity. T hey thus opted for temporary reciprocal currency arrangements (swap lines with the

Federal Reserve) to have U.S. dollars directed to banks with their corresponding jurisdictions.

T hrough providing the U.S. dollars on a worldwide scale, the Federal Reserve technically participated

in international lending of last resort.

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The Success of the International Policy Response

T he auctioning of the U.S. dollar led to a minimized level of volatile swap spread.

It assisted in averting more large-scale distress-selling of assets with dollar denomination.

It mitigated upward pressure and interbank rate volatility on the U.S. dollar.

T he international swap arrangements mitigated two main challenges, mainly related to international

lending of last resort. T hese included:

T he Federal Reserve and its foreign counterparts were accorded the power of creating

whatever amounts of money they choose to as compared to global financial institutions

administering resources in limited nature.

T he swap network did not consist of information issues that could lead to moral dangers.

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Practice Question

T he American National Bank wants to expand globally. It must fund a specific portfolio of

securities and loans, in which some of it is based on foreign currencies. A research

analyst suggests the following ways in which it can finance these foreign currency

positions:

I. Borrowing of domestic currency then converting through straight F.X. spot

transaction, hence being able to buy the foreign asset in the converted currency.

II. Converting domestic currency liabilities into foreign currency through the use

of F.X. swaps and purchasing foreign assets.

III. Borrowing foreign currency through the interbank market, mainly from central

banks or participants of the non-bank market.

Which of the following suggestions are correct?

A. I and II

B. I and III

C. II and III

D. I, II, III

T he correct answer is D.

For a bank aiming to expand globally, it needs to fund a specific portfolio of securities and

loans in which some of it is based on foreign currencies. Banks can finance these foreign

currency positions through:

I. Borrowing of domestic currency then converting through straight F.X. spot

transaction, hence being able to buy the foreign asset in the converted currency.

II. Converting domestic currency liabilities into foreign currency through the use

of F.X. swaps and purchasing foreign assets.

III. Borrowing foreign currency through the interbank market, mainly from central

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 banks or participants of the non-bank market.

T herefore, all of the research analyst’s suggestions are correct.

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 Reading 139: Covered Interest Rate Parity Lost: Understanding the
Cross-Currency Basis

After compl eti ng thi s chapter, you shoul d be abl e to:

Differentiate between the mechanics of FX swaps and cross-currency swaps.

Identify critical factors that affect the cross-currency swap basis.

Assess the causes of covered interest rate parity violations after the financial crisis of

2008.

FX Swaps

In an FX swap agreement, one party borrows one currency from another party and, at the same

time, lends another currency to the same counterparty. Each party utilizes the repayment obligation

as collateral. Moreover, the repayment amount is fixed at the FX forward rate as of the beginning of

the contract.

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In the above example, we can see that X.S at the start of the contract is the FX spot rate and X.F is

the FX forward rate agreed at the initiation of the contract but exchanged at the maturity date.

FX swaps are FX risk-free collateralized borrowing/lending. FX swaps do not incorporate an open

currency position. More so, they assume that the associated counterparty, credit, liquidity risks, and

market risks are negligible.

Uses of F.X. Swaps

i. Institutional investors use FX Swaps to hedge their positions.

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 ii. Banks use FX swaps to raise foreign currencies for themselves, other banks, or their

customers.

iii. T wo offsetting positions can be combined with different original maturities for speculative

trading.

Cross-currency Swaps

A cross-currency swap is an over-the-counter (OT C) derivative presented in a contract’s form

between two parties who purpose to exchange interest payments and principal in different

denominated currencies. T ypically, in a cross-currency swap, principal and interest in a particular

currency are exchanged for interest payments and principals in a different currency. During the

agreements’ term, the interest payments exchange is done at fixed intervals. Usually, cross-currency

is highly customized and can consist of fixed, variable interest rates, or both.

Uses of Cross-Currency Swaps

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 i. Cross-currency swaps are used for exchanging cash flows in one currency for another.

ii. Market participants use cross-currency swaps in transferring financing positions in one

currency for a funding position in another currency.

Differences between FX Swaps and Cross-currency Swaps

FX swaps and cross-currency swaps are both derivative instruments utilized in the hedging of foreign

currency exposures, but there are some differences

In a FX swap, the principal exchanged at the maturity date is the forward rate.

In a cross-currency swap, the principal exchanged at the maturity date is the initial spot

rate. However, there are payments attached to interest rates during the term of the

contract, which are absent in FX swaps.

Cross-Currency Basis

Let’s consider a European institution borrowing a one-year loan from its local domestic bank to fund

its operations abroad in the U.S. For currency risk hedging, the institution chooses to enter a one-

year currency swap (EUR/USD) with a market counterparty. As such, the institution swaps a

specified amount of Euros from U.S dollars at the current spot rate, with the agreement of getting

the funds swapped back at the same price rate in one year.

Since the European institution does not technically own the U.S. dollar, it instead pays back U.S.

Libor as interest while receiving the Eurobond offered rate (Euribor) from the counterparty.

T ypically, this is as per the covered interest rate parity (CIP). Practically, when the demand for the

dollar is high, the lending counterparty of the dollar will request to be paid a price premium. T his is

known as a “cross-currency basis.” T he European institution will payout U.S Libor and, in return,

receive Euribor plus the cross-currency basis.

Example: Cross-Currency Basis

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Assume that the current U.S. Libor is 3.2%, and Euribor is -0.8%. T his implies that the cost for the

EUR/USD currency swap to say a European firm is 4%. T hat is, it not only pays out 3.2% on the

dollar interest but also pays out 0.8% on the Euro interest since it is negative. T his leads to a dollar

shortage, and the counterparty quotes a “basis of -0.8%” T he new swap for the European institution

becomes:

= (3.2% of the dollar interest + 0.8% of Euro interest + 0.8% currency basis = 4.8%)

Critical Factors that Affect the Cross-Currency Swap Basis

T he factors that determine the cross-currency swap basis include:

i. Variation in credit levels in U.S dollar and foreign currency Libor;

ii. Demand and supply for cross-currency basis swaps; and

iii. Impacts of the foreign exchange market.

i. Variation of Credit Levels In U.S Dollar and Foreign Currency

Libor

T he cross-currency basis is the basis spread added primarily to the U.S. dollar LIBOR when

the USD is funded through foreign exchange (FX) swaps using the Japanese yen or the euro

as a funding currency. Principally, the basis in cross-currency swaps should be zero, unless

there are variations in credit risk ingrained in the underlying reference rates of one

currency relative to another.

In practice, there is a variation in the credit levels between firms that are always able to

finance in USD Libor flat and those which are always able to finance in foreign currency

Libor flat. T hus, the payment in USD Libor-flat rate cannot be exchanged for the receipt in

the foreign currency Libor-flat rate.

Because of financial conditions in the US and foreign country markets, it is natural for

market players to consider that the credit reflected by USD Libor flat is different from that

by foreign currency Libor flat. In this sense, the basis in cross-currency swaps is

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 determined by the difference in credit levels reflected by USD and foreign currency Libor.

ii. Demand and Supply for Cross-Currency Basis Swaps

T his is the dominant factor in determining the short-term level of basis according to the

market players. In the most recent past, the cross-currency basis has been widening

globally. T he increased demand for U.S. dollars has driven this as a result of the monetary

policy divergence between the U.S. and similar economically stable countries. Non-U.S.

investors have increased their investments in USD-denominated assets, and the portion of

these investments that are hedged for FX risk or funded via FX swaps exerts a widening

pressure on the basis.

Additionally, there has been a drop in the supply of the U.S dollars from foreign reserve

sovereign/managers wealth funds versus the fall in emerging currency depreciation and

commodity prices, causing the cross-currency basis to widen.

iii. Impacts of the Foreign Exchange Market

Changes in the global bank’s activities lower the market liquidity in the FX swap market in

various ways. Newly introduced regulations, such as leverage ratio requirements, have

reduced the appetite for market-making and consequently lowering the market liquidity.

Moreover, the introduction of a leverage ratio requirement would reduce arbitrage trading

activities between the FX swap market and the money market due to the increased cost of

expanding balance sheets. T he transaction volume in the FX swap market reached a peak at

the beginning of 2014 and has been leveling off.

In addition to the direct impacts of regulatory reforms, the increased uncertainty of USD

funding rates at quarter-ends decrease global banks' market-making activities for FX swaps

with longer tenors. T his is because the FX swap market makers regularly cover their

positions using short-term FX swaps that have relatively high liquidity. T hus, under

uncertainty regarding quarter-end rates, it is difficult for market makers to quote bid/ask

prices for term instruments over quarter-ends with narrow spreads, which seems to lower

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 the market liquidity.

T he reduced appetite for arbitrage trading and market-making activities and the decline in

market liquidity are thought to amplify the cross-currency basis widening. T he basis quickly

widens under small demand/supply shocks.

Causes of the Covered Interest Rate Parity Violations after the

Financial Crisis of 2008

Covered Interest Rate Parity (CIP)

Covered interest rate parity is defined as a hypothetical condition where the correlation between

interest rates, spot and forward currency rates of two states are equal once the foreign currency

risk is hedged. T hat means that there is no chance for arbitrage when using a forward contract under

CIP.

Basically, in CIP, the spot exchange rate and cash market interest rates can be larger than the ones

for FX derivatives. T his shifts the currency swap and FX swaps that controls forward exchange

rates away from CIP, thus providing an outcome of a non-zero basis. Such changes should typically

immediately result in arbitrage transactions, bringing the basis back to zero. T his is because, in the

real world, CIP arbitrage is commonly treated as riskless.

F 1 +r
=
S 1 + r∗

Where:

S is the spot exchange rate in US dollar per foreign currency

F is the corresponding forward exchange rate

r is the US dollar interest rate

r∗ is the foreign currency interest rate.

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Example 1: Covered Interest Rate Parity (CIP)

Assume that a mid-market USD/CAD spot exchange rate is 1.4500 CAD with a one-year forward rate

of 1.4380 CAD. Additionally, there is a 3% USD and a 4% CAD risk-free interest rate. Find out if the

covered interest rate parity between the two currencies holds.

Solution

We need to establish whether:

F 1 +r
=
S 1 + r∗

T he ratio of forward rate to spot rate:

F 1.4380
= = 0.99 USD/CAD
S 1.4500

T he ratio of the rate of returns:

1+r (1 + 3%)
= = = 0.99 USD/CAD
1 + r∗ (1 + 4%)

T he two values calculated are approximately equal; thus, the covered interest rate parity holds.

Example 2: Covered Interest Rate Parity (CIP)

Given a spot rate of interest of 2.26 USD/EUR, with a U.S dollar interest rate of 3% and Euro

currency interest rate of 5%, calculate the forward exchange rate for one year, if the covered

interest rate parity holds.

Solution

T he formula is the interest rate parity holds is as follow:

F 1 +r
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 F 1 +r
=
S 1 + r∗

Rearranging the equation:

1+r
F=S
1 + r∗

1 + 0.03
F = 2.26 × = 2.2170 $/€
1 + 0.05

For the covered interest rate parity to hold the exchange rate must be 2.2170 $/€.

Causes of Covered Interest Rate Parity (CIP) Violations after

the 2008 Financial Crisis

T he basis, b, is the amount by which the interest rate on one of the legs has to be modified to match

the pricing of FX swaps observed in the market:

(1 + r + b)
F − S =S −S
(1 + r∗)

We may also rearrange the equation as follow:

(F − S)
b≡ − (r − r∗)
S

Although banks have strengthened their balance sheets and regained easy access to funding since the

great financial crisis, CIP is still violated. As mentioned earlier, CIP holds that the interest rate

differential between two currencies in the money markets should be the same as the differential

between the forward and spot exchange rates. Otherwise, arbitrageurs could make a seemingly

riskless profit.

Similarly, we said that the cross-currency basis indicates the amount by which the interest paid to

borrow one currency by swapping it for another differs from the cost of directly borrowing this

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currency in the cash market. A non-zero cross-currency basis indicates a violation of CIP.

T he cross-currency basis has been persistent since the GFC, indicating CIP violations. In the

following section, we discuss these violations broadly in terms of hedging demand and tighter limits to

arbitrage.

Demand for Currency Hedges: Why the Basis Opens Up

T he demand for FX swaps is driven by hedging of open FX positions. Demand from non-financial

firms, banks, and institutional investors make up the primary sources of hedging demand. T hese

sources are insensitive to the size of the basis, and, hence, exert sustained pressure on it even when

it is nonzero. In the next session, we discuss the structural causes of demand for foreign currency

hedges:

Business Models of Banks

Banks have commonly been known for being the chief players in running currency mismatches on

their balance sheets. Given banks’ core deposit base, banking systems may be structurally short or

long in specific currencies. A foreign currency funding shortfall can then be managed by borrowing

cash in money markets and the bond market. FX swaps can be used to resolve the remaining gaps

between banks’ assets and liabilities in a given currency. T he unresolved gaps between banks’

liabilities and assets in each currency are referred to as closed currency derivatives, and an example

is FX swaps. T his depicts violations of covered interest rate parity.

Strategic Hedging Decisions of Institutional Investors

For strategic hedging of foreign currency, institutional investors use swaps. An improvement has

been registered in recent times in funding flows and cross-currency investments as a result of credit

and term spread compression related to unconventional monetary policies in most of the countries.

T he hedge ratio for investors is usually insensitive to hedging costs and tends to move slowly over

time. T herefore, anything that motivates the investors to reduce or increase their investments on

foreign currency seemingly exerts pressure on the basis, resulting in CIP violation.

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Non-Financial Firms’ Debts Issuance across Currencies

A CIP violation comes about as non-financial firms seek to borrow through opportunistic ways in

markets where there is a narrower credit spread. It is of relevance when there is systematic

variation in credit spread. For example, most U.S. companies seeking dollars have been issuing euros

currency to take the opportunity of the very attractive spreads in that currency and have the

proceeds swapped into dollars. T his makes it possible for them to avoid currency mismatches in

euros while using the dollars for their business activities. Essentially, they borrow dollars and lend

Euros through the swap market.

Tighter Limits to Arbitrage: Reasons Why the Basis Does not Close

Arbitrage limits have been tightened by structural changes, especially on how market participants

price the market, counterparty, credit, and liquidity after the Great Financial Crisis. In this scenario,

the balance sheet is not free. Instead, it is rented.

Due to tighter management of threats and associated balance sheet constraints, the arbitrage incurs a

cost per unit of balance sheet. T he cost incurred is passed on to FX swaps pricing, in which a

premium is introduced due to swap market imbalances. One of the outcomes is that the spot-forward

relationship in the currency draws out of line with covered interest parity (CIP).

T ypically, arbitrage can pose a lot of risks and high costs. An arbitrageur must expand its balance

sheet, sustain credit risks in both investing and borrowing, and probably undergo mark-to-market and

liquidity threats in the positions’ valuation. Post-crisis, participants have been able to manage these

actual costs and risks that are in existence at all times. T here has been increased pressure from

creditors, shareholders, and authorities on the pricing of risks based on their relevant market after

the Great Financial Crisis.

Also, dynamics in regulation have emphasized market pressures for the need for tighter management

of balance sheet risks. More so, likely future exposure adjustment charges in U.S. leverage ratios

and Basel III need the participants in the market to hold capital in as per their derivatives and other

exposures. Mostly, the tighter limits on arbitrage make it complex to have the basis narrowed at any

point when it opens due to pressures that reflect the present order imbalances.

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Causes for CIP Deviations

i. The resul tant effects of constrai nts i n bank s’ bal ance sheets : According to the

quarter-end snapshots for European banks, constraints in the balance sheet are severe at

quarter ends due to regulatory filings. Since the onset of the Great Financial Crisis, there

were notably some CIP violations increments at quarter ends. Mostly, contracts found on

the bank’s balance sheets depicted this deviation. T his implies that new regulatory policies

have a critical impact on the prices of assets.

ii. The costs of bank s; bal ance sheets : T wo-thirds of the short-term CIP deviations are due

to banks’ balance sheet costs.

iii. The devi ati ons i n CIP corresponds to spreads i n other mark ets : For example, with

tenor spreads considered as near-threat-free fixed income spreads, deviations in CIP have a

positive correlation with nominal interest rates across countries and over time. Countries

with higher levels of interest rates consist of lower implied dollar interest rates from the FX

swamp market.

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Practice Question

Suppose the quarter-market USD/EUR spot exchange rate is 1.2345 EUR with a one-

year forward rate of 1.3280 EUR. T he market consists of a risk-free rate of 4% USD and

6% EUR, respectively. Establish whether there exists a covered interest rate parity

between USD and EUR by choosing which of the following statements is correct.

A. T he covered interest rate parity hol ds and the forward to spot rate is 1.0757.

B. T he covered interest rate parity does not hol d and the forward to spot rate is

1.0757.

C. T he covered interest rate parity hol ds and the forward to spot rate is 1.0000.

D. T he covered interest rate parity does not hol d and the forward to spot rate is

0.9811.

T he correct answer is B.

T he covered interest rate parity is checked using the formula:

F 1 +r
=
S 1 + r∗

F 1.3280
Ratio of forward to spot rate = = = 1.0757
S 1.2345

(1 + 4%)
Ratio of interest rates = = 0.9811
(1 + 6%)

T he covered interest rate parity does not hold between the USD and EUR since the ratio

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of forward to spot rate and ratio of returns are not equal, i.e., 1.0757 ≠ 0.9811.

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 Reading 140: Risk Management for Changing Interest Rates: Asset-
Liability Management and Duration Techniques

After compl eti ng thi s readi ng, you shoul d be abl e to:

Discuss how asset-liability management strategies can help a bank hedge against interest

rate risk.

Describe interest-sensitive gap management and apply this strategy to maximize a bank’s

net interest margin.

Describe duration gap management and apply this strategy to protect a bank’s net worth.

Discuss the limitations of interest-sensitive gap management and duration gap management.

How Asset-Liability Management Strategies Help a Bank to

Hedge Against Interest Rate Risk

Asset-liability management (ALM) is utilized to control a bank’s sensitivity to changes in market

interest rates and to limit losses in its net income or equity. Financial service managers should pay

attention to an institution’s portfolio as a whole and how it contributes to the firm’s ultimate goal of

sufficient profitability and allowable risk.

Asset-Liability Management Strategies

T here are three asset-liability management strategies. T hese include:

i. Asset management strategy;

ii. Liability management strategy; and

iii. Funds management strategy.

i. Asset Management Strategy

Asset management strategy involves control over assets, but not control over liabilities. In other

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words, the bank’s management regulates the allocation of the bank’s assets but believes that the

bank’s sources of funds, i.e., deposits, are outside its control.

ii. Liability management

Liability management entails the control over the bank’s liabilities, i.e., borrowed funds, by changing

interest rates offered on the liabilities. Banks use this strategy to maintain a balance between the

assets and liabilities’ maturities to maintain liquidity while at the same time facilitating lending, hence

maintaining a healthy balance sheet.

iii. Funds management

Funds management strategy combines both asset and liability management strategies to achieve a

balanced liquidity management strategy. T he fund manager ensures that the maturity schedule for the

deposits matches the demand for loans. T he need to establish new sources of funds in the 1970s and

risk management problems faced with troubled loans and volatile interest rates in the 1970s and

1980s led to the concept of planning and regulation over both sides of a bank's balance sheet, thus

the essence of funds management.

T he following diagram illustrates asset-liability management in banking and financial services:

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Interest Rate Risk

Interest rate risk is one of the primary and potentially most damaging forms of threats that all

financial firms face. Fluctuations of interest rates have an impact on the balance sheet and the

income statement as well as expenses on financial institutions.

Forces Determining Interest Rates

Loanable Funds Theory

T he level of market interest rates is a factor of supply and demand for credit. In other words, when

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the need for credit rises, the interest rates increase. On the other hand, a decline in the demand for

money causes interest rates to decline. T he converse is also true.

T he following figure illustrates the determination of interest rates in the financial marketplace

where the demand and supply of credit interact to set the credit price:

Inflation

Inflation also has an impact on the levels of interest rates. When the inflation rate is high, interest

rates rise. T his is because lenders demand higher interest rates to compensate for the decline in the

purchasing power of the cash they will pay in the future.

Governments

T he government plays a central role in determining how interest rates are impacted. Mainly, the Fed

in the U.S. usually makes periodic announcements on how changes in monetary regulations are likely

to influence interest rates. T hus, for survival, financial managers must be price takers and not price

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makers, as they have to accept interest rate levels as providers and plan as per the presented

interest rate levels.

Financial firms typically face two main kinds of interest rate risk as the market interest rates move.

T hese include:

i. Pri ce ri sk : T he market value of bonds or assets falls when interest rates rise.

ii. Rei nvestment ri sk : Falling interest rates make interest payments (coupons) of bonds to

be reinvested at lower rates.

The Measurement of Interest Rates

Interest Rates are the Price of Credit

T he interest rate refers to the proportion of the fees one is required to pay to acquire credit.

T ypically, this ratio is expressed in percentage format:

1
points and base points ( of a percentage point)
100

Yield to Maturity (YTM)

T he yield to maturity is one of the most basic methods used in measuring rate. It is the approximate

discount rate that equates the current market price of a loan with the expected stream of future

income payments generated by the loan. It is also referred to as redemption yield or book yield.

Calculation of the Yield to Maturity

Current market price of a loan or security

Expected cash flow in Period 1
=
(1 + YT M)1
Expected cash flow in Period 2
+ +⋯
(1 + YT M)2
Expected cash flow in Period n
+
(1 + YT M)n
Sale or redemption pricf security or loan in period n
+
(1 + YT M)n

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Example: Calculation of Yield to Maturity

Assume that a bond is purchased at $1,200. One is required to make level interest payments of $200

per annum over the next five years. If it is redeemed for $1,000 at maturity, what is the yield to

maturity?

Solution

We need to find YT M such that the current price is equal to $1,200.

$200 $200 $200 $200

$1200 = + + +
1 2 3
(1 + YT M) (1 + YT M) (1 + YT M) (1 + YT M)4
$200 $1, 000
+ +
(1 + YT M)5 (1 + YT M)5

To solve the above equation, we use a financial calculator with the variables: N = 5, P V = −1200,

P MT = 200 and F V = 1000 then hit CP T followed by I/Y . You should be able to get 14.1529. Hence

the YT M is 14.15%.

Bank Discount Rate

T he bank discount rate refers to the interest rate quoted for short-term loans and money-market

instruments such as treasury bills.

Bank Discount Rate

100 − Purchase price on loan or security
=( )
100
360
×( )
Number of days to maturity

T he bank discount rate ignores the effect of compounding of interest and is based on a 360-day year,

unlike YT M, which assumes a 365-day year and assumes that the interest income is compounded at

the calculated YT M. Additionally, it utilizes the face value of a financial instrument to compute its

yield/rate of return, which makes this method more straightforward but theoretically incorrect.

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Under the bank discount rate, the purchase price of a financial instrument is used, instead of its face

value, since it forms a better base in the calculation of the instrument’s exact rate of return.

Example: Bank Discount Rate

Assume that a treasury bill has a face value of $1,000 set for payment at maturity. Its purchase price

is $97. If the security is to mature in 60 days, calculate the interest rate measured using the bank

discount rate.

Solution

(100 − 97) 360

Bank Discount Rate = × = 0.18 = 18%
100 60

Converting a Bank Discount Rate to the equivalent YTM

(100 − Purchase Price) 365

YT M equivalent yield = ×
Purchase Price Days of maturity

Example: Converting a Discount Rate to YTM

Assume that a treasury bill has a face value of $1,000 set for payment at maturity. Its purchase price

is $97. If the security is to mature in 60 days, calculate the yield to maturity equivalent yield.

Solution

(100 − 97) 365

YT M equivalent yield = × = 0.1881, or 18.81%
97 60

The Components of Interest Rates

Market interest rates are a function of:

i. T he risk-free real rate of interest; and

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 ii. Various risk premiums including default risk, inflation risk, liquidity risk, call risk, and

maturity risk.

T he market interest rate on a risky security or loan is given as the sum of risk-free real interest rate

(inflation-adjusted return on government securities) and risk premiums to compensate lenders who

accept risk to cover credit risk and liquidity risk, among other risks.

T he risk-free real interest rate changes over time as a result of shifts in supply and demand for

loanable funds, while risk premiums change over time as a result of “characteristics of the

borrower,” the maturity of securities, and marketability.

Yield Curves

A yield curve is a graphical portrayal of the relationship between yields and maturities of securities.

Generally, yield curves are established with treasury bonds to keep the credit (default) risk constant.

T he yield curve comes in different shapes as follows:

i. An upward sloping curve shows that the long-term rates are higher relative to the short-term

rates.

ii. A downward sloping curve implies that the short-term rates are higher relative to the long-

term rates.

iii. T he horizontal curve shows equal risk for long-term and short-term rates.

Essentially, financial institutions do much better with an upward-sloping yield curve. Mostly, lending

organizations experience a positive maturity gap between the average maturity of their assets and

liabilities in the following circumstances:

If the yield curve is sloping upwards, thus, revenues generated from longer-term assets

will be more than the expenses incurred from shorter-term liabilities.

T ypically, the outcome is a positive net interest margin. In other words, the interest

revenues are more than the interest expenses.

However, horizontal (relatively flat) or negatively sloping yield curve results in a minimal

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 or even negative net interest margin.

Interest-Sensitive Gap Management and its Application in

Maximization of a Bank’s Net Interest Margin

Aims of Interest Rate Hedging

One of the purposes of interest rate hedging is to protect the net interest margin. A bank’s

management should hold a fixed net interest margin (NIM) to cushion the bank’s profits against

severe interest rate fluctuations.

Net interest income

Net interest margin (NIM) =
Total earning assets

T he net interest margin is the difference between the interest income/revenue from loans and

investments and the interest expense on deposits and other borrowed funds.

Example: Net Interest Margin

Nineva is an international bank in the United States. It reports $10 billion in interest revenue from

its loans and security investments and $6.7 billion for its interest expense incurred to attract

borrowed funds. If the bank’s total earning assets are worth $65 billion, calculate the bank’s net

interest margin.

Solution

$10 billion − $6.7 billion

NIM = × 100 = 5.08%
$65 billion

Interest-Sensitive (IS) Gap Management

T he IS gap management strategy calls for the manager to perform an analysis of maturities and

repricing opportunities linked to the bank’s interest-bearing asset, money market borrowings, and

deposits. T he IS gap management involves control over the difference between the volume of a

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bank’s interest-sensitive liabilities and interest-sensitive assets.

Notably, the gap management aims to ensure that for each period, the dollar amount of interest-

sensitive (re-priceable) assets is equivalent to the dollar amount of interest-sensitive (re-priceable)

liabilities. T his way, a financial institution can hedge itself against interest rate fluctuations,

regardless of the direction of the interest rate movement.

Re-priceable Assets and Liabilities

Re-pri ceabl e assets include short term loans that are almost maturing or are nearing

repricing/renewal. Examples are household loans or variable rate business. For instance, if there is a

rise in interest rates, the bank/lender is most probably going to reinvest or renew the newly

released funds at a higher interest rate. T hey also include short-term securities that are issued by

the government, which are about to mature.

On the other hand, re-pri ceabl e l i abi l i ti es are money market deposits that are almost maturing

in which customers and firms have to negotiate for new deposit interest rates. An example is the

floating rate deposits.

Interest Sensitive Gap

A gap exists between the interest-sensitive assets and liabilities in a situation where the re-priceable

assets and re-priceable liabilities are not equal.

Interest sensitive gap = Interest sensitive assets − Interest sensitive liabilities

Negative Interest Sensitive Gap

A ratio that is less than one, or a negative gap, comes about when the volume of a bank’s interest-

sensitive liabilities is more than that of the interest-sensitive assets.

Interest sensitive gap = Interest sensitive assets − Interest sensitive liabilities < 0

Since in a negative gap the interest-sensitive assets are less than the interest-sensitive liabilities,

there exists a risk in that if the interest rates rise, there will be losses as the bank’s net interest

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margin will reduce.

A defensive strategy can be applied to eliminate an adverse bank’s interest-sensitive gap.

Management at the bank can do one of the following:

Shortening the maturities of assets or lengthening the maturities of liabilities; or

Decreasing interest-sensitive liabilities or increasing interest-sensitive assets.

Positive Interest Sensitive Gap

A ratio higher than one or a positive gap comes about when a financial institution’s interest rate

sensitive assets are more than its sensitive interest liabilities.

Interest sensitive gap = Interest sensitive assets − Interest sensitive liabilities > 0

Since a positive gap implies interest-sensitive assets outweigh interest-sensitive liabilities, the

associated risk is losses in case of a decline in interest rates as the bank’s net interest margin will

fall.

A bank can employ a defensive strategy to eliminate a positive gap by:

Extending the maturities of assets or shortening the timelines of liabilities; or

Reducing interest-sensitive assets or increasing interest sensitive liabilities.

Measuring the Interest-Sensitive Gap (IS GAP)

Dollar IS GAP

T he dollar IS GAP is the difference between the interest-sensitive assets (ISA) and interest-sensitive

liabilities (ISL).

Dollar IS GAP=ISA-ISL

An institution is said to be asset-sensitive if it has a positive dollar IS GAP while it is liability-sensitive

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if it has a negative dollar IS GAP.

Example: Dollar IS GAP

Prime bank’s interest-sensitive assets have a value of $300, and its interest-sensitive liabilities are

worth $250. Calculate the dollar IS GAP.

Solution

Dollar IS GAP = $300 − $250 = $50

Relative IS GAP Ratio

IS GAP
Relative IS GAP ratio =
Total Assets

A financial firm is asset-sensitive when the relative IS GAP is greater than Zero while it is liability

sensitive when its relative IS GAP is less than zero.

Interest Sensitivity Ratio

ISA
Interest Sensitive Ratio(ISR) =
ISL

Where I SA is the interest-sensitive assets; and

I SL is interest-sensitive liabilities.

Example: Interest Sensitivity Ratio

Prime bank’s interest-sensitive assets have a value of $300 million, and its interest-sensitive

liabilities are worth $250 million. Calculate the interest-sensitive ratio of the bank.

Solution

ISA $300
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 ISA $300
Interest Sensitive Ratio(ISR) = = = 1.2
ISL $250

If ISR is < 1, then this is a liability-sensitive firm, while a firm whose ISR is > 1 is referred to as an

asset-sensitive firm. A financial firm is said to be relatively insulated from interest rate risk if its

interest-sensitive assets are equal to the interest-sensitive liabilities.

Computer-Based Techniques

T he majority of the firms are using computer-based techniques where they have their liabilities and

assets categorized as per their repriceable dates either weekly or in the next 30 days (monthly) and

so on. An institution’s management attempts to have the bank’s sensitive interest assets matched

with its interest-sensitive liabilities in each maturity bucket to have better chances of improving the

institution’s financial earning objectives.

For instance, assume the latest computer run of a firm might indicate as follows.

Maturity Buckets Interest Interest Size of Cumulative

Sensitive Sensitive Gap Gap
Assets Liabilities
1 day (next 24 hours) $56 $34 +22 +22
Day 2- 7 140 180 −40 −18
Day 8-30 78 67 +11 −7
Day 31-90 300 240 +60 +53
Day 91-120 435 356 +79 +132

T he computer runs to assist the firm to have a clear understanding of its actual interest-sensitive

position.

For instance, in the above example, it has a positive gap in the next 24 hours. T hus, the firm's

earnings will improve if there is a rise in the interest rate between today and tomorrow. However,

on the 2nd to the 30th day, the cumulative gap registered is negative, meaning if there is a rise in the

market interests' rates, interest expenses will increase by more than interest revenues. T he

remainder of the maturity bucket seems to fare well in case any interest rate rises since the

cumulative gap turns out as a positive.

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Interest-Sensitive (IS) in maximizing a Bank’s Net Interest
Margin (NIM)

We calculate an institution’s net interest income to gauge how it will change following a rise in

interest rates. T he net interest income is derived as follows:

Net Interest Income = Total Interest Income − Total Interest Cost

=[Average Interest Yield on rate sensitive assets
× Volume of rare sensitive assets
+ Average Interest Yield on Fixed(non-rate Sensnitive assets)
× Volume of Fixed Assets]−[Average interest cost on rate
− sensitive liabilities × Volume of interest sensitive liabilities
+ Average interest cost on fixed (non-rate
− sensitive) liabilities
× Volume of fixed (non-rate-sensitive) liabilities]

Example: Net Interest Income

Suppose that a hypothetical bank has an average yield on rate-sensitive and fixed assets of 9% and

10%, respectively. Additionally, the bank has rate-sensitive and non-rate-sensitive liabilities cost of

7% and 6%, respectively.

During the coming week, the bank holds $2,000 million in rate-sensitive assets and $2,100 million in

rate-sensitive liabilities. Assume that the asset total is 5,000. Further, suppose that these annualized

interest rates remain steady.

Calculate the firm’s net interest income on an annualized basis.

Solution

Net interest income on an annualized basis = 0.09 × $2,000 + 0.10 × [5, 000 − 2, 000]
− 0.07 × $2, 100 − 0.06 × [5, 000 − 2, 100] = $159 million

Assuming that the market interest rate on rate-sensitive assets rises to 11% and the interest rate on

rate-sensitive liabilities rises to 9% during the first week, this liability-sensitive institution will have

an annualized net interest income of:

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 Net interest income on an annualized basis = 0.11 × $2,000 + 0.10 × [5, 000 − 2, 000]
− 0.09 × $2, 100 − 0.06 × [5, 000 − 2, 100] = $157 million

T hus, this bank will lose $2 million in net interest income on an annualized basis if market interest

rates rise in the coming week.

Weighted Interest-Sensitive Gap

Suppose that National Bank currently has the following interest-sensitive assets and liabilities on its

balance sheet:

Interest- Interest-Rate Interest- Interest-Rate

Sensitive Sensitivity Sensitive Sensitivity
Assets Weight Liabilities Weight
(Assets) (Liabilities)
Federal $75 1.51 Interest- $275 0.87
Fund bearing
Loans) deposits
Security $52 1.23 Money- $87 0.94
holdings market
borrowings
Loans $320 1.56
and
Leases

Use the information to calculate the weighted interest-sensitive gap.

Solution

Weighted Interest Sensitive Gap

=(InterestSensitiveAssets
× Interest Rate Sensitivity Weight for Assets)
−(Interest Sensitive Liabilities
× Interest Rate Sensitivity Weight for Liabilities)

T hus,

Weighted Interest Sensitive Gap =[(75 × 1.51) + (52 × 1.23) + (320 × 1.56)]
[(275 × 0.87) + (87 × 0.94)]
=$355.38

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The Cumulative Gap

T he cumulative gap is an overall measure of interest rate exposure. It is the total difference

between repriceable assets and liabilities over a specified period. We can calculate the approximate

impact of market interest rate fluctuations on the net interest income.

Change in net interest income

= Total change in interest rate (Percentage points)
× Size of cumulative gap in dollars

Duration Gap Management and its Application to Protect a

Bank’s Net Worth

Duration gap management is a managerial tool used in insulating a firm’s net worth from serious

implications of interest rates. Using duration as an asset-liability management tool is better relative

to using interest-sensitive gap analysis. T his is because the interest-sensitive gap only looks at the

effects of changes in the interest rates on the bank’s net income and fails to take into account the

impact of interest rate changes on the market value of the bank’s equity capital position. However,

duration provides a single number, which makes it possible for the banks to be aware of the overall

exposure to interest rate risk.

Definition of Duration

Duration refers to the value and time-weighted measure of maturity that considers the timing of cash

inflows from earning assets and cash outflows related to liabilities. It primarily measures the mean

maturity of expected future cash payments. In other words, it calculates the average time required

to recover finances directed towards a particular investment.

T he formula for calculating the duration is as follows:

Period t
∑nt=1 Expected CF in period t ×
(1 + YT M)t
D=
Current Market Value or Price

Where the current market value or price is given by:

Expected cash flow in period t
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 Expected cash flow in period t
(1 + YT M)t

Example: Duration

Assume that a bank gives a loan to a customer to be repaid in 5 years. T he customer promises the

bank an annual interest payment of 8% per annum. T he par value of the loan is $2,000, which is also

its price because the loan’s current yield to maturity is 8%.

Calculate the loan’s duration.

Solution

5 5
∑5t=1 $160 × + (2, 000 × )
5
(1.08) (1.08)5
Dloan =
$2, 000

T his can be computed easily as in the following table:

Year 1 2 3 4 5 Total
Payment 148.15 274.35 381.04 470.42 544.47 + 6, 805.83 8,624.26

$8, 624.26
Dloan = = 4.31 years
$2, 000

Duration as a Risk-Management Tool

T he net worth (NW) a business is equivalent to the value of its assets less the value of its liabilities.

Net Worth (Equity) = Asset − Liabilities

T he value of an institution’s assets and liabilities change as the market interest rates changes,

resulting in a change in its net worth.

Change in Net Worth = Change in Assets − Change in Liabilities

According to portfolio theory, an increase in the market interest rates results in the market value

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(price) of both fixed-rate liabilities and assets to decrease. Additionally, when a financial firm’s

maturity of liabilities and assets is longer, they are more likely to decrease in market value (price)

when there is a rise in market interest rates.

Management can balance the average maturity of the anticipated assets cash inflows with the

average maturity of the expected cash outflows related to liabilities by use of the equation of assets

and liability durations. T herefore, duration analysis is applied in stabilizing, or immunizing the market

price (value) of a financial organization’s net worth.

Price Sensitivity

One of the crucial characteristics of duration in the perspective of risk management is that it

measures a financial instrument’s market value sensitivity to changes in interest rate.

Change in Price Change in Interest rate

= −D ×
Price (1 + i)

Change in Price
Where represents the percentage change in the market price
Price

Change in Interest rate

refers to the relative change in interest rates related to the asset or liability.
(1+i)

D is the duration, and the negative sign attached to D implies that market prices and interest rates of

financial instruments move in opposite directions.

Example: Price Sensitivity

Assume that a firm holds a bond with a duration of 5 years and a price of $2,000. T he market interest

rates associated with this bond currently stand at 8%. Recent forecasts show that the interest rates

may rise to 9%.

Calculate the percentage change that is expected to occur in the market value of the bond.

Solution

Change in P Change in Interes trate

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 Change in P Change in Interes trate
= −D ×
P (1 + i)
Change in P (0.09 − 0.08)
= −5 years × = −4.63%
P 1.08

Convexity and Duration

Convexity is a key term related to duration, and it captures the relationship between an asset’s

change in price and its change in the interest rate or yield. T hus, it highlights the presence of a

nonlinear relationship between changes in an asset’s price and changes in market interest rates.

It incorporates a number designed to assist portfolio managers in controlling and measuring the

market risks in portfolio assets. Usually, a portfolio or an asset consisting of low duration and low

convexity indicates a relatively small market threat. An increase in asset duration implies an increase

in convexity.

T his means that the rate of change in any interest-bearing asset’s price for a particular interest rate

varies depending on the prevailing interest rates level.

Using Duration to Hedge against Interest Rate Risk

Financial institutions interested in fully hedging themselves from interest rate changes should choose

assets and liabilities such that the duration gap is made as close to zero as possible. T hat is:

Duration gap = Dollar-weighted duration of Assets − Dollar-weighted Duration of Liabilities ≈ 0

Since the dollar volume of assets usually is more than the dollar volume of liabilities, a financial firm

purposing to minimize the implications of interest rate fluctuations must adjust for leverage:

Leverage Adjusted Duration Gap = Dollar-weighted duration of Assets−

Total Liabilities
Dollar-weighted Duration of Liabilities ×
Total Assets

T his implies that liabilities values must change more relative to the cost of assets to do away with a

financial institution’s entire interest-rate threat exposure. T hus, the more significant the leverage-

adjusted duration gap, the more sensitive the net worth (equity) of the firm to the changes in interest

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rates.

Change in the value of a firm' s net worth

Change in interest rate
= [−Average duration of assets × × Total Assets]
(1 + Original discount rate)
Change in interest rate
− [−Average duration of liabilities × × Total Liabilities]
(1 + Original discount rate )

Example 1: Change in the Value of a Firm’s Net Worth

Suppose that a financial institution’s average duration of its assets is five years. Additionally, the mean

liability duration of the firm is six years, and the total liability of the firm is $250m, while its total

assets are worth $380m. T he initial interest rate was 8% but suddenly increased to 11%.

Calculate the change in the value of the firm’s net worth.

Solution

Change in the value of net worth

0.03 0.03
= [−5 × × 380] − [−6 × × 250] = −$11.11m
(1 + 0.08) (1 + 0.08)

Example 2: Dollar-weighted Asset Portfolio Duration

Assume that a bank holds assets with duration and market values as given the following table:

Assets Held Estimated Market Asset Duration (Years)

Values of Assets
Consumer loans 129 8.65
T reasury bonds 89 1.34
Consumer loans 65 4.75
Real estate loans 34 2.87

Calculate the dollar-weighted asset portfolio duration for this firm.

Solution

(8.65 × $129) + (1.34 × $89) + (4.75 × $65) + (2.87 × $34)

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 (8.65 × $129) + (1.34 × $89) + (4.75 × $65) + (2.87 × $34)
DW asset portfolio duration = = 5.1780 years
($129 + $89 + $65 + $34)

Example 3: Calculating the Duration of a Bank’s Assets and Liabilities

T he following tables represent a part of ABC Bank’s balance sheet:

Asset Composition T he market value Interest Rate Average. Duration

of Assets($M) of Assets Assets (Years)
U.S. T reasury securities 400 12.00% 5.45
Commercial loans 120 8.00% 2.34
Municipal bonds 230 12.00% 1.23
Total 750

Liability T he market value Interest Rate Average. Duration

Composition. of Liabilities($M) of Liabilities Liabilities (Years)
Negotiable CDs 200 4.56% 3.45
Other time deposits 120 12.00% 2.56
Subordinated notes 100 8.00% 1.54
Total Liabilities 420
Stockholders’ equity 330
Total Equity and 750
Liabilities

Using the above tables,

i. Calculate the average duration of assets and liabilities.

T he average duration of assets:

400 120 230

× 5.45 + × 2.34 + × 1.23 = 3.658266667 = 3.658 years
750 750 750

T he average duration for liabilities:

200 120 100

× 3.45 + × 2.56 + × 1.54 = 2.741 years
420 420 420

ii. Calculate the current leverage-adjusted duration gap.

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 Current Leverage-adjusted duration gap
Total Liabilities
= Average Asset suration − Average liability duration ×
Total Assets
420
= 3.658 − 2.741 × = +2.123 years
750

iii. Calculate the change in the value of net worth if the interest rates
for both liabilities and assets register a rise from 7% to 10%.

Δr Δr
Change in value of net worth = −DA × × A − [−DL × × L]
(1 + r) (1 + r)

Change in value of net worth

(+0.03) (+0.03)
= −3.658 × × 750 − [−2.741 × × 420]
(1 + 0.07) (1 + 0.07)
= −44.643m

T his institution’s net worth would fall by approximately $44,643 million if interest rates increased by

3 percentage points.

Limitations of Interest-Sensitive Gap Management and

Duration Gap Management

Limitations of Interest-Sensitive GAP Management

T he interest paid on liabilities tends to move much faster as compared to the interest rates

earned on assets, thus leaving financial institutions with interest-rate threat exposure.

It is quite hard to identify the repricing point of some liabilities and assets.

T he interest-sensitive gap fails to put into consideration the implications of interest rate

fluctuations on the positions of equity.

T here is a basis risk that refers to the interest rates associated with assets of different

kinds changing by different volumes and varied speed as compared to the interest rates of

liabilities.

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 Interest paid on liabilities fluctuates much faster relative to the interest earned on assets.

Limitations of Duration Gap Management

It is hard to find liabilities and assets of the same duration.

Some liabilities and assets may fail to have well a defined pattern of cash flows, thus,

making it difficult to calculate the duration.

Customer prepayments of loans might distort the anticipated cash inflows in a particular

duration.

Also, the expected cash inflows in duration can be disrupted by the customers defaulting

payments (credit risk).

T he duration gap approach assumes that there is the existence of a linear relationship

between the market value of liabilities and assets and interest rates, which is not entirely

true.

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Practice Question

National Bank has a cumulative gap for the coming year of +$128 million. T he interest

rates are expected to decrease by one and a half percentage points.

What is the expected change in the Bank’s net interest income?

A. -1.23 million

B. -1.92 million

C. 1.89 million

D. 128 million

T he correct answer is B.

Change in net interest income

= Total change in interest rate (Percentage points)
× Size of cumulative gap in dollars.

T hus,

Expected change in net interest income = $128 million × (−0.015) = −1.92 million

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 Reading 141: Illiquid Assets

After compl eti ng thi s readi ng, you shoul d be abl e to:

Explain the essential features of illiquid markets.

Explain the effects of market imperfections on illiquidity.

Assess the effects of biases on the reported illiquid asset returns.

Explain the Geltner-Ross-Zisler unsmoothing process and state its properties.

Compare liquidity premiums across as well as within asset categories.

Explain portfolio choice decisions on the incorporation of illiquid assets.

Illiquid assets are the assets for which the optimal sale or purchase strategy entails a time-consuming

search. One measure of illiquidity is the average time to sell under optimal pricing.

Characteristics of Illiquid Markets

All assets are Illiquid. Some assets are, however, more illiquid than others. Infrequent trading, small

amounts being traded, and low turnover are some of the manifestations of illiquidity.

For the public equities class of assets, the average time between transactions is seconds with an

annualized turnover of over 100%. For corporate bonds, on the other hand, the average time

between transactions is within a day with turnover in the range of 25-35%.

However, for institutional real estate, the average time between transactions ranges anywhere

between 8-11 years with an annualized turnover of approximately 7%. T his implies that institutional

real estate is more illiquid relative to the other two.

T he following are the main characteristics of illiquid markets:

i. Most asset cl asses are i l l i qui d: One feature of most asset classes is long periods

between trades and low turnover except for public equities and fixed income. T hese include

some sub-asset classes of stocks and bonds taking a week or more between transactions and

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 an annual turnover of less than 10%.

ii. Il l i qui d asset mark ets are si gni fi cant: T he public, liquid markets of stocks, and bonds

are smaller than the wealth held in illiquid assets. In 2012, for example, the market

capitalization of NYSE and NASDAQ was approximately $17 trillion relative to $16 trillion

held in US residential real estate and $9 trillion held in the institutional real estate market.

iii. Investors hol d l ots of i l l i qui d assets: Illiquid markets dominate most investors’

portfolios. For individuals, illiquid assets represent 90% of their total wealth. T he share of

illiquid assets in institutional portfolios has increased over the years. T he average

endowment held a portfolio weight of around 5% in the early 1990s, whereas in 2011, it was

more than 25%.

iv. Li qui di ty dri es up: Liquidity tends to dry up during periods of severe market distress.

During these times, most liquid markets become illiquid. For instance, during the 2008-2009

financial crisis, the market for commercial papers (usually very liquid) experienced a

“buyers strike” by investors unwilling to trade at any price.

Effects of Market Imperfections

T he following are market imperfections that lead to illiquidity:

i. Parti ci pati on costs: Investors incur costs of market participation, e.g., time and energy,

to be able to gain the necessary skills to carry out transactions, monitor market movements,

and have ready access to a financial exchange.

ii. Transacti on cost: To carry out a transaction, one would have to spend money on paying

taxes, commission, the costs of due diligence, and title transfers, among others.

iii. Search fri cti ons: One needs to find the appropriate buyer and seller for many assets.

T here is, nevertheless, no centralized market and this may result in long waiting times

before one finds a counterparty. For instance, most investors do not have sufficient funds to

buy skyscrapers. T here are long periods of waiting and, therefore, prices are negotiated.

T his might mean that the bid-ask spread will be extended due to lack of competition.

iv. Asymmetri c i nformati on: In a perfect market, all investors have the same information

about the payoff of the risky asset. T his, however, is not the case in real-life practice.

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 Different investors have different information either because they have various sources of

information or have different abilities to process information from the same source.

Investors are reluctant to engage in trade if one of the investors is more knowledgeable than

their counterparts. In this case, the concern of liquidity suppliers about trading against

better-informed agents influences the supply of liquidity.

v. Imperfect competi ti on: In a perfect market setting, all investors are equally competitive

and do not affect prices. T his is not always the case in practice since some investors are

very influential and may have an effect on prices.

vi. Demand pressure and i nventory ri sk : When an investor wants to sell an amount of

stock, there may not necessarily be any buyers. In perfect markets, a market maker will

then buy the asset from the investor and will require compensation for the risks that they

face due to warehousing the stock.

Effects of Biases on the Reported Illiquid Assets Returns

Andrew Ang (2014) summarizes many of the critical issues with illiquid asset return data. T he

following biases contribute to illiquid asset returns being flawed:

i. Survivorship bias.

ii. Selection bias.

iii. Infrequent trading.

i. Survivorship Bias

Survivorship bias is the tendency to view the excellent performance of some stocks or funds in the

market as a representative sample overlooking those that have not performed. Survivorship bias

results in the overestimation of the historical performance of a fund or market index. Oftentimes,

this leads to investors making misguided investment decisions based on published investment fund

return data.

ii. Selection Bias

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Sampling selection bias occurs when returns on assets are reported only when they are high and

overlooked when they are low. T his selection bias is witnessed in private equity, where companies

are only taken out when stock values are high.

iii. Infrequent Trading

Andrew Ang (2014) argued that when one uses the reported returns to compute estimates of risk

with infrequent trading, one is likely to underestimate the risks (volatilities, correlations, and betas).

For instance, if the returns are sampled quarterly rather than daily, then the information obtained is

not an accurate representation of the real returns. T herefore, this misrepresentation leads to the

wrong estimation of the risks. By simulation, Andrew Ang (2014) obtained the following graphs:

Geltner-Ross-Zisler Unsmoothing Process and its Properties

T he risks and performance of illiquid assets are unknown due to the difficulty in measuring these

quantities with standard techniques. Usually, the reported returns partially reflect past changes in

economic values when reported. However, economic values differ due to infrequent trading. T his

smoothing effect creates bogus return autocorrelation and invalidates traditional measures of risk

and performance, Couts, Gonçalves, and Rossi (2019).

Andrew Ang (2014) compares unsmoothing to moving from infrequent (e.g., quarterly) sampling to

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daily sampling. As observed in Figure 1, the quarterly sampling on the left looks a bit smooth,

whereas the graph on the right looks unsmooth. In practice, returns are noisier and, therefore, don't

always look smooth.

Let’s now look at the Geltner-Ross-Zisler unsmoothing process. Denote the actual return at the end

of the period t as r∗t which is unobservable and the reported return as r∗t which is observable, too.

Suppose the observable returns follow:

r∗t = C + ϕr∗t−1 + εt (1)

Where:

ϕ is the autocorrelation coefficient and is less than 1 in absolute value.

C is a drift term.

εt an error term.

T he above equation is an autoregressive process in which the current value is based on the

immediately preceding value, the autoregressive process of order 1, AR (1). T he equation is used to

invert out the actual returns when the observed returns are functions of current and lagged actual

returns. If the smoothing process involves only the averaging returns for this period and the prior

period, then the observed returns can be filtered to estimate the actual returns, from observed

returns, r∗t using:

1 ϕ
rt = r∗t − r∗t−1 (2)
1−ϕ 1 −ϕ

Equation (2) unsmooths the observed returns. If the assumption on the transfer function is correct,

then the observed returns obtained by (2) will have zero autocorrelation. We should note that the

variance of the actual returns is higher than that of the observed returns:

1 + ϕ2
var (rt ) = var (r∗t ) ≥ var (r∗t ) (3)
1 − ϕ2

Unsmoothed returns at time t, r∗t is a weighted average of the actual return at time t, rt and the

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lagged unsmoothed return in the previous period, r∗t−1.

Couts, Gonçalves, and Rossi (2019), on the other hand, argued that these previous techniques

represented a crucial first step in measuring the risks of illiquid assets, but did not fully unsmooth

the systematic component of returns. As such, previous techniques understated the importance of

risk factors in explaining illiquid asset returns. T hey provided an adjustment to return unsmoothing

techniques to deal with that issue.

Characteristics of Unsmoothing Process

Unsmoothi ng onl y affects ri sk esti mates and not expected returns: Estimates of

the mean require only the first and last price observation. T he first and the last

observations are unchanged by infrequent sampling. Unsmoothing, therefore, only changes

the volatility estimates.

Unsmoothi ng does not affect uncorrel ated observed returns: In many cases,

reported illiquid asset returns are autocorrelated because illiquid asset values are

appraised. T he appraisal process induces smoothing because appraisers use both the most

recent and comparable sales together with past appraised values. Illiquid asset markets,

e.g., real estate, private equity, and timber plantations, among others, are markets where

information is not available to all participants, and capital cannot be immediately deployed

into new investments. Persistent returns characterize informationally inefficient markets

with slow-moving capital.

Unsmoothi ng i s an art: T he Geltner-Ross-Zisler unsmoothing uses the simplest

possible autocorrelated process, an AR (1), to describe reported returns. Most illiquid

assets have more than first-order lag effects. Real estate, for example, has a well-known

fourth-order lag arising from many properties being reappraised only annually. A suitable

unsmoothing procedure takes a time-series model; this requires excellent statistical skills.

It also requires underlying economic knowledge of the structure of the illiquid market to

interpret what is a reasonable lag structure.

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Illiquidity Risk Premiums

T he illiquidity risk premium is the additional return demanded by investors for assuming the risk of

illiquidity. Illiquidity risk premiums compensate investors for the inability to access capital

immediately as well as for the withdrawal of liquidity during the illiquidity crisis. Illiquidity risk

premium is a natural feature of private assets, for which investors are generally compensated over

the cycle. However, in public asset markets, illiquidity risk investors may not always be

compensated. T he delay in liquidizing an asset at a reasonable price brings about the risk of illiquidity.

Harvesting Illiquidity Risk Premiums

T he four ways an asset owner can capture illiquidity premiums, according to Andrew Ang (2014) are:

i. Setting a passive allocation to illiquid asset classes.

ii. Choosing securities within an asset that is more liquid by engaging in liquidity security

selection.

iii. Acting as a market maker at the individual security level.

iv. Engaging in dynamic strategies at the aggregate portfolio level.

According to economic theory, bearing illiquidity risk should attract a premium, though small.

Illiquidity Risk Premiums Across Asset Classes

Quantifying Illiquidity Premium

Schroders (2015) identified four key issues with quantifying the illiquidity premium. T hey include:

i. Di ffi cul t i n i sol ati ng the i l l i qui di ty premi um from other ri sk premi a: An asset

will contain various risks that deserve to be rewarded. Corporate bonds, for example, are

exposed to duration, inflation, and credit risk. T here is a challenge in determining which part

of the overall return is associated with each risk.

ii. Il l i qui d asset return data i s fl awed: According to Andrew Ang (2014), "reported

illiquid asset returns are not returns." Ang claims that people overstate the expected returns

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 and understate the risk of illiquid assets, which he attributes to three fundamental biases:

selection bias, survivorship bias, and infrequent sampling; this poses problems for accurately

quantifying the illiquidity premium.

iii. The ri sk of i l l i qui d assets i s di ffi cul t to measure: T he risk of illiquid assets is often

underestimated.

iv. Il l i qui di ty i s not constant: Assets often become harder to sell in times of crisis. Assets

that are typically reasonably liquid may see liquidity dry up in the time of crisis, as discussed

previously with the example of the commercial papers in 2008-2009.

Most market participants assume that there is a reward for bearing illiquidity across asset classes.

However, the following are reasons why this is not true:

i. Il l i qui di ty bi ases: We have looked at various illiquidity biases, including survivorship bias,

infrequent sampling, and selection bias. T hese biases result in the expected returns of

illiquid asset classes being overstated using raw data.

ii. Ignores ri sk : Illiquid asset classes contain more than just illiquidity risk. Adjusting for

these risks makes illiquid asset classes far less compelling.

iii. Lack of “mark et i ndex” for illiquid asset classes.

iv. Manager sel ecti on: T he dispersion between managers is much higher for investments in

hedge funds than for investments in listed equities. Since there is no predefined consensus

on the existence of an illiquidity premium, the decision to invest in illiquid asset classes and

how successful this is will depend majorly on the ability to select top-performing managers,

according to Swensen (2009).

Illiquidity Risk Premiums Within Asset Classes

Within all the major asset classes, more illiquid securities have higher returns, on average than their

more liquid counterparts. We consider a few of these classes in the section that follows.

US Treasuries

A well-known liquidity phenomenon in the U.S. T reasury market is the “on-the-run/off-the-run bond

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spread.” Newly auctioned T reasuries (on the run) are more liquid and have higher prices, and hence
lower yields, than seasoned T reasuries (off the run). T here is a variance in the spread of these two

types of bond time, reflecting time-varying liquidity conditions in T reasury markets.

A T reasury bond initially carrying a 20-year maturity is the same as a T reasury note. During the

financial crisis, T reasury bonds traded lower than T reasury notes by more than 5% on otherwise

identical securities. T his goes to show that in one of the world’s most essential and liquid markets,

these are substantial illiquidity effects.

Corporate Bonds

Within the corporate bond world, there is evidence to suggest that less liquid bonds often have

higher returns. Dick-Nielsen, Feldhutter, and Lando (2012) show that the liquidity level premium

before the financial crisis was 4 bp for investment-grade and 58 bp for high yield. After the crisis,

these premiums went up to 40 to 90 bp for investment-grade securities and 200 basis points for high-

yield bonds.

T he most significant part of the total liquidity premium in this market comes from the liquidity level

premium rather than the liquidity risk premium. T his liquidity premium in corporate bond markets

varies considerably over time, and there may be significant differences in bull and bear markets.

Public Equity

Stocks with low liquidity levels tend to earn higher returns than liquid stocks in equity markets.

Illiquidity results in higher returns for private equity, according to Franzoni, Nowak, and Phalippou

(2012). However, these premiums have diminished in the recent past, according to Ben-Rephael,

Kadan, and Wohl (2015).

Illiquidity risk can help explain the cross-section of equity returns during the crisis in 2008. Some

liquid stocks had more significant drawdowns during this period than the more illiquid stocks with

lower exposure to illiquidity risks.

Illiquid Assets

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Franzoni, Nowak, and Phalippou (2012) showed that illiquidity results in higher returns for private

equity. T his is the same for hedge funds, as demonstrated by Khandani and Lo (2011), and also for real

estate as shown by Liu and Qian (2012).

Concerning hedge funds, the risk-adjusted illiquidity risk premiums for some illiquid categories were

sometimes as high as 10% per year. T his, for example, was the case in the period 1986-2006.

Illiquidity premiums for equity market-neutral funds have declined significantly for several reasons,

including lower volatility and higher demand for hedge funds over the period 2002-2006.

Portfolio Choice Decisions on the Incorporation of Illiquid

Assets

Illiquidity risk affects portfolio choice decisions. According to Ang, Papanikolaou, and Westerfield

(2013), there are two ways in which this happens:

i. Li qui d and i l l i qui d weal th are i mperfect substi tutes: For one to meet their

obligations, either in consumption or payout, there is a need to have liquid assets; otherwise,

one will not be able to meet these crucial obligations. T he availability of liquid assets

ensures that an investor does not get to a position where their investment funds are

insolvent (or can’t meet their immediate expenses); this results in underinvestment in

illiquid assets.

ii. Fl uctuati ons i n the share of i l l i qui d assets: T he investor’s ability to fund

intermediate obligations depends on his/her liquid assets, and this leads to changes in the

share of illiquid assets. T he investor will try to balance between liquid and illiquid assets. In

one way or another, they will be in a situation where there are fewer and some other times

more illiquid assets relative to the Merton benchmark; this induces a time-varying risk

aversion.

We should note the following:

T ransaction cost models assume that by meeting a particular cost, trade is always possible;

this, however, is not true for private equity, real estate, infrastructure, etc. Over a short

horizon, there may be no opportunity to find a buyer. Even after finding a buyer, you need

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to wait for due diligence and complete a legal transfer. Many liquid assets also experienced

liquidity freezes during the financial crisis, where no trading was possible because of a lack

of counterparties.

If a risky asset can be traded on average every six months, the optimal holding of the

illiquid asset contingent on the arrival of the liquidity event is 44%. When the average

interval between trades is five years, the optimal allocation is 11%. For ten years, this

reduces to 5%. As such, illiquidity risk has a tremendous effect on portfolio choice.

T here are no illiquidity “arbitrages.” Investors should not load up on illiquid assets because

these assets have illiquidity risk and cannot be continuously traded to construct an

“arbitrage.”

Investors must demand high illiquidity risk premiums. Andrew Ang (2014) came up with a

way of calculating the illiquidity premium. He argues that when liquidity events arrive

every six months, on average, then an investor should demand an extra 70 basis points and

approximately 1% when liquidity comes once a year, on average. When the waiting period

is ten years, on average, to exit an investment, one should demand a 6% illiquidity

premium.

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Practice Question

Illiquid assets can generate excess return because:

A. T hey allow the transfer of idiosyncratic risk from liquid markets.

B. T hey have lower transaction costs.

C. T hey generate arbitrage opportunities.

D. T hey require large investments.

T he correct answer is A.

Liquid asset markets are information efficient. Information regarding the assets is freely

available and every participant has equal access. T his makes the generation of alpha

(excess return) in such markets a challenging task.

However, the market for illiquid assets markets is fraught with information asymmetry.

T his information asymmetry can be exploited to generate excess returns. T herefore,

the idiosyncratic risk of liquid assets can be transferred to illiquid assets and help

generate excess returns.

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