Basel III Liquidity Risk Management

Jun Zhu 11/19/2012

Agenda
Basel III Liquidity Risk Requirements
New regulation for liquidity risk Modeling on liquidity risk
Cash flow modeling Deposit modeling Stress test Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Monitoring standards

What can be done in E*Trade?

eTrade balance sheet structure Integrate liquidity into business strategy

Goal of Basel III Liquidity Risk Regulation

Learning from the recent crisis.. The recent credit crisis compounded itself quickly into a major liquidity crisis (or funding problem), leading to insolvency of major financial institutions A key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk in many banks Many banks did not have a dedicated liquidity buffer or liquidity portfolio that was managed Regulators response.. The Basel III liquidity risk regulation underscores the importance of managing the liquidity contingency buffer in much the same way as capital Focusing on maintaining a high quality liquidity portfolio that can hedge out liquidity outflows under stress scenarios And, integrate the liquidity pricing and hence incentive to raise liquidity as well as price costly liquidity according to the opportunity cost of raising the needed buffer

Liquidity Risk Management

Basel III Regulation for Liquidity Risk

Regulatory Reporting Standards Monitoring Standards Contractual Maturity Mismatch Funding Concentration Unencumbered Assets Market Monitoring
Minimum Reporting Basel (2010) International Framework for Liquidity Risk Measurement, Standards and Monitoring

Liquidity Coverage Ratio (LCR)

Introduced on Jan 1, 2015

Net Stable Funding Ratio (NSFR)

Introduced on Jan 1, 2018

Guiding Principles Basel (2008) Principles for Sound liquidity Risk Management and Supervision

A New Regulation for Liquidity risk Guiding Principles Basel (2009) Principles for Sound Stress Testing Practices and Supervision

Liquidity Coverage Ratio

The LCR aims to ensure that banks maintain an adequate level of high-quality liquid assets to survive a severe liquidity stress scenario lasting for 30 days

Liquidity Coverage Ratio (Contd)

Total net cash outflows are defined as the total expected cash outflows minus total expected cash inflows in the specified stress scenario

Liquidity Coverage Ratio (Contd)

Fundamental characteristics of high quality liquid assets: Low credit and market risk Ease and certainty of valuation Low correction with risky assets Listed in a developed and recognized exchange Market-related characteristics Active and sizable market Presence of committed market makers Low market concentration Flight to quality

Liquidity Coverage Ratio (Contd)

The definition of high quality liquid assets and the treatment of interbank funding are the keys

Liquidity Coverage Ratio (Contd)

Potential ways to manage LCR: LCR =
Levers to manage the ratio:
Increase Liquidity buffer (-> higher costs)
Hold more Cash Sell illiquid assets and buy level 1 or 2 assets

Liquidity buffer (Cash outflow Cash inflowcap 75%) 30d

Decrease Cash outflow (-> lower returns)
Increase duration of liabilites (e.g. short term deposits) Increase stability of deposits (e.g. stable retail deposits and wholesale operational accounts) Decrease potencial liquidity drains (credit/ liquidity facilities)

Increase Cash inflow (-> lower returns)

Decrease duration of assets (e.g. short term loans)

Net Stable Funding Ratio

The NSFR should ensure that long term assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles

Net Stable Funding Ratio (Contd)

Funding provided by financial institutions and loans to such firms are assigned with a low ASF and a high RSF respectively

Net Stable Funding Ratio (Contd)

Available amount of stable funding: Capital Preferred stock with maturity of equal to or greater than one year Liabilities with effective maturities of one year or greater The portion of stable non-maturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution extended stress Required amount of stable funding: The value of assets held and funded by the institution, multiplied by a specific required stable funding factor assigned to each particular asset type The amount of off-balance sheet activity (or potential liquidity exposure) multiplied by its associated required stable funding factor

Net Stable Funding Ratio (Contd)

Potential ways to manage NSFR:
NSFR = Available Stable Funding (ASF) Required Stable Funding (RSF)
Decrease RSF (-> lower returns)
Sell (non-level 1/2) assets Substitute assets with longer duration (>1yr) by assets with shorter duration (<1y) Substitute assets with high RSF (illiquid bonds, term loans, retail loans) by assets with lower RSF (0%-risk weight govies, short term loans to financial institutions) New asset business does not improve the ratio

In principle, the bank has two levers to manage the ratio: Increase ASF (-> higher costs)
Securitize existing business which is already term funded (and keep existing funding) Substitute liabilities with short duration (<1y) by liabilities with longer duration (>1yr) Substitute liabilities with low ASF (wholesale) by liabilities with higher ASF (retail) Originate new liabilities (and invest cash into assets with lower RSF)

Net Stable Funding Ratio

NSFR Isolines Potential Adjustments on Business Model
compress net position of derivatives cut credit lines focus on advisory business revival of originate and distribute model

ASF

1 2

NSFR =
RSF

ASF RSF

NSFR

To improve a given NSFR (indicated by above) an institution has two options: 1.

in the chart

Adjust Asset Side

reduce maturities shift to assets with lower RSF impact on earnings

Adjust Liability Side

increase maturities shift to liabilities with higher ASF impact on costs

The institution can increase the ASF by adjusting the liability side of its balance sheet (e.g. liabilities with higher roll-over factors or longer duration) The institution can decrease the RSF by adjusting the asset side of ist balance sheet (e.g. assets with lower roll-over factors or shorter duration)

2.

Liquidity Monitoring Standards

Modeling for Liquidity Risk

Liquidity Risk Management Components

Cash Flow Projection

Static Liquidity Measures

Typical Static Liquidity Gap Report

Dynamic Liquidity Measures

Balance Sheet Organization

Dynamics of Cash Flow Distribution

Stochastic distribution of cash flows without future business assumptions

Shifted stochastic distribution after inclusion of business strategy and future business assumptions

Dynamic analysis: Integrating business strategies Future business assumptions will largely impact the cash flow distribution Time dynamics (including external economic variables) will change the distribution too
Reference: Algo Liquidity Risk Management

Quantifying Behavioral Dynamics

Liquidity Risk Components

Modeling Cash Flows

Modeling Cash Flows (Contd)

Deposit Balance Modeling

First, we segregated deposit accounts into tiers based on the amount held in each account
We believed tiers were necessary due to dissimilar depositor behaviors between holders of larger accounts versus holders of smaller accounts Tiers used for deposit amounts 1. < $5,000 2. $5,000 - $10,000 3. $10,000 - $25,000 4. $25,000 - $50,000 5. $50,000 - $100,000 6. $100,000 - $250,000 7. > $250,000 Deposit Model Equation: One month change in log of balance lnB(t) = ln(B(t)/B(t-1)) = f(X) +

We tiered accounts by end of opening month balances

From our analysis of historical deposit data, we determined deposit balances were driven by six primary factors or terms

1 2

Aging Term Build Incentive Term Seasonal Term Rate Seeking Term Burnout Term External Market Term

Deposit Balance Forecast =

(existing accounts)

3 4 5 6

Stress Test
Stress Scenarios: Stress scenarios are essential for evaluating the durability and dependability of the liquidity management processes. Stress scenarios are generated according to the three risk factors: structural, contingent, and market risk.

Stress Test (Contd)

The stress scenario incorporates many of the shocks experienced during the crisis: (a) the run-off of a proportion of retail deposits; (b) a partial loss of unsecured wholesale funding capacity; (c) a partial loss of secured, short-term financing with certain collateral and counterparties; (d) additional contractual outflows that would arise from a downgrade in the banks public credit rating by up to and including three notches, including collateral posting requirements; (e) increases in market volatilities that impact the quality of collateral or potential future exposure of derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs; (f) unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to its clients; and (g) the potential need for the bank to buy back debt or honour non-contractual obligations in the interest of mitigating reputational risk.

Reference: Basel 2010 - International framework for liquidity risk measurement, standards and monitoring

Parameters for Scenario Analysis

E*Trade Liquidity Risk Management

E*Trade 2011 10K Balance Sheet

December 31, 2011 2010

ASSETS Cash and equivalents Cash and investments required to be segregated under federal or other regulations Trading securities Available-for-sale securities (includes securities pledged to creditors with the right to sell or repledge of $3,916,927 and $5,621,156 at December 31, 2011 and 2010, respectively) Held-to-maturity securities (fair value of $6,282,989 and $2,422,335 at December 31, 2011 and 2010, respectively; includes securities pledged to creditors with the right to sell or repledge of $2,092,570 and $884,214 at December 31, 2011 and 2010, respectively) Margin receivables Loans receivable, net (net of allowance for loan losses of $822,816 and $1,031,169 at December 31, 2011 and 2010, respectively) Investment in FHLB stock Property and equipment, net Goodwill Other intangibles, net Other assets Total assets LIABILITIES AND SHAREHOLDERS EQUITY Liabilities: Deposits Securities sold under agreements to repurchase Customer payables FHLB advances and other borrowings Corporate debt Other liabilities Total liabilities $ 2,099,839 1,275,587 54,372 $ 2,374,346 609,510 62,173

15,651,493

14,805,677

6,079,512 4,826,256 12,332,807 140,183 299,693 1,934,232 285,805 2,960,673 $ 47,940,452 $

2,462,710 5,120,575 15,121,919 164,381 302,658 1,939,976 325,403 3,083,673 46,373,001

26,459,985 5,015,499 5,590,858 2,736,935 1,493,552 1,715,673 43,012,502

25,240,297 5,888,249 5,020,086 2,731,714 2,145,881 1,294,329 42,320,556

E*Trade Liquidity Risk Management

Potential Liquidity Challenges: (a) Mismatch of long-term assets and short-term liabilities (b) Funding diversity (c) Unexpected liquidity events (d) Lack of capacity to precisely predict future net cash flow Solutions: (a) Closely monitor the contractual maturity mismatch, and propose the optimized way to manage the mismatch (b) Diversify the asset and liability (c) Stress test integrate stress scenarios into business decision (d) Introduce advance modeling techniques to model cash flow and liquidity

Hedging Interest Rate Risk and Impact on Liquidity

Purpose Action Issue bullet (noncallable) debt Duration risk Issue callable debt Swaps: pay fixed rate and receive floating (3m Libor) Issue callable debt How It Works Impact on Balance Sheet Impact on Liquidity Gain high quality liquidity asset (e.g. Cash) Swap is highly liquid on exchange and liquid on OTC Gain high quality liquidity asset (e.g. Cash) Swaptions / options is highly liquid on exchange and liquid on OTC

Short duration Add cash on assets to offset long side, add debt on duration of asset liability side portfolio Offset the duration change by floating rate Call the bond and re-issue at lower rate when rates fall Positive convexity to offset the negative convexity of prepayment Net value recorded on either asset or liability side Add cash on assets side, add debt on liability side Net value recorded on either asset or liability side

Convexity Risk

Options: swaptions, call or put option on treasury futures

Integrate Liquidity into Business Strategy

Integrate planned transactions into the liquidity picture Large liquidity gaps are highly likely to disappear Mismatches will be reduced The probability distribution of mismatches will reflect a more realistic view of future exposures Integrate stress scenario into the decision Fully incorporate Dynamics into liquidity risk analysis and business decisions Stress simulations can produce a comprehensive view of a firms current exposure to liquidity risk, as well as the potential evolution of liquidity risk within the business planning horizon Firms should have the ability to integrate business development strategies as well as inherent business constraints into their liquidity planning activities Incorporate time dynamics to modeling for cash flow and liquidity forecasting

Reference
Basel Committee 2008 Principles for sound liquidity risk management and supervision 2009 Strengthening the resilience of the banking sector 2009 Principles for sound stress testing practices and supervision 2010 International framework for liquidity risk measurement, standards and monitoring 2011 Basel III: A global regulatory framework for more resilient banks and banking systems OCC 2012 Liquidity: Comptrollers handbook 1998 Interest rate risk: Comptrollers handbook FDIC 2008 Liquidity risk management

Appendix

E*Trade Q3 2012 Balance Sheet

E*Trade Deposit
Amount September 30, December 31, 2011 2012 Weighted-Average Rate September 30, December 31, 2012 2011

Sweep deposits (1) Complete savings deposits Other money market and savings deposits Checking deposits Time deposits (2) Total deposits (3)
(1) (2) (3)

21,874,534 $ 5,184,141 1,003,200 950,840 115,111 29,127,826 $

18,618,954 5,720,758 1,033,254 863,310 223,709 26,459,985

0.05% 0.05% 0.05% 0.10% 1.86% 0.06%

0.08% 0.15% 0.15% 0.10% 2.96% 0.12%

A sweep product transfers brokerage customer balances to banking subsidiaries, which hold these funds as customer deposits in FDIC insured demand deposit and money market deposit accounts. Time deposits represent certificates of deposit and brokered certificates of deposit. As of September 30, 2012 and December 31, 2011, the Company had $101.3 million and $89.2 million in non-interest bearing deposits, respectively.

Deposit accounts for 64% of the liability Need to build deposit balance model to predict balance change
Main portion of the liability

Capital Ones Q3 2012 Balance Sheet

Contingency Funding Plan (CFP)

Basel (2008) A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust. FDIC (2008) Contingency funding plans should incorporate events that could rapidly affect an institutions liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty. OCC (2012) A contingency funding plan (CFP) includes policies, procedures, projection reports, and action plans designed to ensure a banks sources of liquidity are sufficient to fund normal operating requirements under contingent liquidity events.
Note: Stress tests must be the basis for elaborating contingency plans

Balance Sheet Management Functions

Liquidity Risk Management vs. FTP

Basel III will influence internal processes, but is neither a blue-print for an internal steering system nor for an internal (liquidity) funds transfer price system

Fund Transfer Pricing

The FTP reflects the fair economic value (or spread) of a contract Equivalently, it is the (fictitious) price of hedging all financial risks in the market

Best Practices FTP Principles

1. Reflect marginal wholesale funding costs to ensure arms-length product pricing 2. Insulate LOBs from interest rate risk, while managing rate risk within Treasury
Mirror the duration and cash flow characteristics of the underlying product Incorporate costs and credits for prepayments and pricing caps/floors Capture any mismatch between FTPs and actual interest expense in the Treasury P&L

3. Use a consistent methodology across the enterprise that enables fair performance measurement across LOBs and sound risk management 4. Treat deposits as a line of business by transfer pricing balances using the same FTP principles as we do for loans