Financial Risk Manager

2020

EXAM PART II
Liquidity and Treasury Risk
Measurement and Management
<S>GARP

2020
(S)

EXAM PART II
Liquidity and Treasury Risk
Measurement and Management

Pearson
Copyright © 2020 by Pearson Education, Inc.
All rights reserved.
Pearson Custom Edition.

This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual
selections herein that first appeared elsewhere. Permission to reprint these has been obtained by Pearson Education, Inc. for this edition only. Further
reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must
be arranged with the individual copyright holders noted.

Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled by them:

"Liquidity Risk," by John C. Hull, reprinted from Risk Management and
Financial Institutions, 5th Edition (2018), by permission of John Wiley &
Sons, Inc.
"Liquidity and Leverage" by Allan M. Malz, reprinted from Financial Risk
Management: Models, History, and Institutions (2011), by permission of
John Wiley & Sons, Inc.
"Early Warning Indicators" by Shyam Venkat and Stephen Baird,
reprinted from Liquidity Risk Management: A Practitioner's Perspective
(2016), by permission of John Wiley & Sons, Inc.
"The Investment Function in Financial Services Management" and
"Liquidity and Reserves Management: Strategies and Policies," by Peter
S. Rose and Sylvia C. Hudgins, reprinted from Bank Management &
Financial Services, Ninth Edition (2013), by permission of the McGraw Hill
Companies, Inc.
"Intraday Liquidity Risk Management," by Shyam Venkat and Stephen
Baird, reprinted from Liquidity Risk Management: A Practitioner's
Perspective (2016), by permission of John Wiley & Sons, Inc.
"Monitoring Liquidity," by Antonio Castagna and Francesco Fede,
reprinted from Measuring and Managing Liquidity Risk (2013), by
permission of John Wiley & Sons, Inc.
"Liquidity Stress Testing" by Shyam Venkat and Stephen Baird, reprinted
from Liquidity Risk Management: A Practitioner's Perspective (2016), by
permission of John Wiley & Sons, Inc.
"The Failure Mechanics of Dealer Banks," by Darrell Duffie, reprinted
from the Journal of Economic Perspectives, vol. 24, no. 1, Winter 2010,
by permission from Journal of Economic Perspectives.
"Liquidity Risk Reporting and Stress Testing," by Moorad Choudhry,
reprinted from The Principles of Banking (2012), by permission of John
Wiley & Sons, Inc.
"Contingency Funding Planning" by Shyam Venkat and Stephen Baird,
reprinted from Liquidity Risk Management: A Practicioner's Perspective
(2016), by permission of John Wiley & Sons, Inc.
"Liquidity Transfer Pricing: A Guide to Better Practice," Financial
Stability Institute Occasional Paper No. 10, by Joel Grant, June 2011,
by permission of the Bank for International Settlements. Information
retrieved from the Bank for International Settlements is freely available at
their website: www.bis.org.
"The US Dollar Shortage in Global Banking and the International Policy
Response," BIS Working Paper No. 291, by Patrick McGuire and Gotz
von Peter, October 2009, by permission of the Bank for International
Settlements. Information retrieved from the Bank for International
Settlements is freely available at their website: www.bis.org.
"Covered Interest Rate Parity Lost: Understanding the Cross-Currency
Basis," by Claudio Borio, Robert McCauley, Patrick McGuire, and
Vladyslav Sushko, BIS Quarterly Review, September 2016, by permission
of the Bank for International Settlements. Information retrieved from the
Bank for International Settlements is freely available at their website:
www.bis.org.
"Risk Management for Changing Interest Rates: Asset-Liability
Management and Duration Techniques," by Peter S. Rose and Sylvia C.
Hudgins, reprinted from Bank Management & Financial Services, Ninth
Edition (2013), by permission of the McGraw Hill Companies, Inc.
"Illiquid Assets," by Andrew Ang, reprinted from Asset Management: A
Systematic Approach to Factor Investing (2014), by permission of Oxford
University Press.
Learning Objectives provided by the Global Association of Risk
Professionals.
All trademarks, service marks, registered trademarks, and registered
service marks are the property of their respective owners and are used
herein for identification purposes only.
Pearson Education, Inc., 330 Hudson Street, New York, New York 10013
A Pearson Education Company
www.pearsoned.com
Printed in the United States of America

"Managing and Pricing Deposit Services" and "Managing Nondeposit

ScoutAutomatedPrintCode
Liabilities," by Peter S. Rose and Sylvia C. Hudgins, reprinted from Bank 000200010272212706
Management & Financial Services, Ninth Edition (2013), by permission of
EEB/KW
the McGraw Hill Companies, Inc.

"Repurchase Agreements and Financing," by Bruce Tuckman and Angel

Serrat, reprinted from Fixed Income Securities: Tools for Today's Markets,
3rd Edition (2011), by permission of John Wiley & Sons, Inc.

Pearson ISBN 10: 0136499104

ISBN 13: 9780136499107
Chapter 1 Liquidity Risk 1 Chapter 2 Liquidity and
Leverage 17
1.1 Liquidity Trading Risk 2
1.1.1 The Importance of Transparency 3 2.1 Funding Liquidity Risk 18
1.1.2 Measuring Market Liquidity 4 Maturity Transformation 18
1.1.3 Liquidity-Adjusted VaR 5 Liquidity Transformation 19
1.1.4 Unwinding a Position Optimally 5 Bank Liquidity 20
1.1.5 Other Measures of Market Liquidity 6 Structured Credit and Off-Balance-Sheet
Funding 22
1.2 Liquidity Funding Risk 6
Funding Liquidity of Other Intermediaries 23
1.2.1 Sources of Liquidity 6
Systematic Funding Liquidity Risk 24
1.2.2 Reserve Requirements 9
1.2.3 Regulation 9 2.2 Markets for Collateral 26
1.3 Liquidity Black Holes 11 Structure of Markets for Collateral 26
1.3.1 Positive and Negative Feedback Economic Function of Markets for Collateral 28
Traders 11 Prime Brokerage and Hedge Funds 29
1.3.2 Leveraging and Deleveraging 12 Risks in Markets for Collateral 29
1.3.3 Irrational Exuberance 13 2.3 Leverage and Forms of Credit
1.3.4 The Impact of Regulation 14 in Contemporary Finance 31
1.3.5 The Importance of Diversity 14 Defining and Measuring Leverage 31
Summary 14 Margin Loans and Leverage 33
Short Positions 34
Further Reading 15
Derivatives 35
Practice Questions and Problems 15 Structured Credit 36
Further Questions 16 Asset Volatility and Leverage 37
 2.4 Transactions Liquidity Risk 37 4.3 Popular Money Market
Causes of Transactions Liquidity Risk 37 Investment Instruments 57
Characteristics of Market Liquidity 38 Treasury Bills 57
Short-Term Treasury Notes and Bonds 59
2.5 Liquidity Risk Measurement 38
Federal Agency Securities 59
Measuring Funding Liquidity Risk 38
Certificates of Deposit 59
Measuring Transactions Liquidity Risk 39
International Eurocurrency Deposits 59
2.6 Liquidity and System Risk 41 Bankers' Acceptances 59
Funding Liquidity and Solvency 41 Commercial Paper 60
Funding and Market Liquidity 42 Short-Term Municipal Obligations 60
Systemic Risk and the "Plumbing" 42
"Interconnectedness" 43
4.4 Popular Capital Market
Investment Instruments 60
Further Reading 43 Treasury Notes and Bonds 60
Municipal Notes and Bonds 60
Corporate Notes and Bonds 61
Chapter 3 Early Warning 4.5 Investment Instruments
Indicators 45 Developed More Recently 61
Structured Notes 61
Securitized Assets 61
3.1 Early Warning Indicators:
Mechanism to Signal Upcoming 4.6 Investment Securities Held
Liquidity Crisis 46 by Banks 63
Introduction: Dashboard and Beyond 46 4.7 Factors Affecting Choice
Regulatory Emphasis in Recent Times 46 of Investment Securities 64
Key Supervisory Guidelines 46 Expected Rate of Return 65
Risk Identification and EWIs 47 Tax Exposure 65
Framework Components: M.E.R.I.T. 47 Interest Rate Risk 69
Illustrative EWI List 51 Credit or Default Risk 69
Business Risk 70
Conclusion 54
Liquidity Risk 71
Call Risk 71
Prepayment Risk 71
Chapter 4 The Investment
Inflation Risk 72
Function in Pledging Requirements 72
Financial-Services
4.8 Investment Maturity
Management 55 Strategies 73
4.9 Maturity Management Tools 76
4.1 Introduction 56 The Yield Curve 76
Duration 77
4.2 Investment Instruments
Available to Financial Firms 57 Summary 78

iv ■ Contents
 Key Terms 79 5.7 Factors in Choosing among
Problems and Projects 80 the Different Sources of Reserves 110

Internet Exercises 82 5.8 Central Bank Reserve

Requirements Around the Globe 111
Case Assignment for
Chapter 4 82 Summary 111

Selected References 85 Key Terms 112

Problems and Projects 113
Internet Exercises 116
Chapter 5 Liquidity and
Case Assignment
Reserves for Chapter 5 116
Management:
Selected References 118
Strategies and
Policies 87
Chapter 6 Intraday Liquidity Risk
5.1 Introduction 88 Management 119
5.2 The Demand for and Supply
of Liquidity 88
6.1 Introduction 120
5.3 Why Financial Firms Often
Face Significant Liquidity Problems 90 6.2 Uses and Sources of Intraday
Liquidity 121
5.4 Strategies for Liquidity Managers 91
Asset Liquidity Management (or Asset
6.3 Risk Management,
Conversion) Strategies 91 Measurement and Monitoring
Borrowed Liquidity (Liability) Tools for Financial Institutions 125
Management Strategies 92 Governance of Intraday LRM 125
Balanced Liquidity Management Strategies 93 Measurement of Intraday Liquidity 126
Guidelines for Liquidity Managers 93 Measures for Understanding Intraday
Flows 127
5.5 Estimating Liquidity Needs 94 Measures for Quantifying and
The Sources and Uses of Funds Approach 94 Monitoring Risk Levels 127
The Structure of Funds Approach 97 Role of Stress Testing 128
Liquidity Indicator Approach 100
6.4 Risk Management,
The Ultimate Standard for Assessing
Measurement, Monitoring Tools
Liquidity Needs: Signals from the
Marketplace 101 for FMUs 129
Overview of FMU Risk Management 129
5.6 Legal Reserves and Money FMU Tools to Manage Intraday
Position Management 103 Settlement Risk 130
Regulations on Calculating Legal Reserve
Requirements 103 Conclusion 131
Factors Influencing the Money Position 106 Glossary 131

Contents ■ v
Chapter 7 Monitoring Chapter 9 Liquidity Stress
Liquidity 133 Testing 171

7.1 A Taxonomy of Cash Flows 134 9.1 Measuring Contingent

7.2 Liquidity Options 135 Liquidity Requirements 173

7.3 Liquidity Risk 137 9.2 Overview of the Model 174

7.4 Quantitative Liquidity Risk 9.3 Design of the Model 175

Measures 138 Organizational Scope 175
7.4.1 The Term Structure of Expected Cash Planning Horizon 176
Flows and the Term Structure of Expected 9.4 Testing Techniques 176
1
Cumulated Cash Flows 138
7.4.2 Liquidity Generation Capacity 141 9.5 Baseline Scenario 177
7.4.3 The Term Structure of Available Assets 143 9.6 Scenario Development 177
7.5 The Term Structure of Historical Scenarios 177
Expected Liquidity 149 Hypothetical Scenarios 177

7.6 Cash Flows at Risk and the 9.7 Development of Assumptions 178
Term Structure of Liquidity at Risk 150 9.8 Outputs of the Model 180
9.9 Governance and Controls 181
9.10 Liquidity Optimization 182
Chapter 8 The Failure Mechanics 9.11 Funding Optimization 183
of Dealer Banks 155
9.12 Establishing a Sustainable
Infrastructure 183
8.1 What Large Dealer Banks Do 157 9.13 Integration of Liquidity
Securities Dealing, Underwriting, and Trading 158 Stress Testing with Related Risk
Over-the-Counter Derivatives 158 Models 184
Prime Brokerage and Asset Management 160 Conclusion 185
Off-Balance-Sheet Financing 160
8.2 Failure Mechanisms for
Dealer Banks 161 Chapter 10 Liquidity Risk
The Flight of Short-Term Creditors 161
Reporting and Stress
The Flight of Prime Brokerage Clients 162
T1p ^ t ir1m
1v| 187
1U#
When Derivatives Counterparties Duck
for Cover 164
Loss of Cash Settlement Privileges 165
w
10.1 Liquidity Risk Reporting 188
8.3 Policy Responses 165 Deposit Tracker Report 188
References 167 Daily Liquidity Report 188

vi ■ Contents
 Funding Maturity Gap ("Mismatch")
Report 192 Chapter 12 Managing and Pricing
Funding Concentration Report 192 Deposit Services 221
Undrawn Commitment Report 193
Liability Profile 193
Wholesale Pricing and Volume 200 12.1 Introduction 222
Summary and Qualitative Reports 201 12.2 Types of Deposits Offered
Frequency of Reporting 202 by Depository Institutions 222
Stress Test Reports 204 Transaction (Payments or Demand)
Deposits 222
Nontransaction (Savings or Thrift)
Deposits 224
Chapter 11 Contingency Funding Retirement Savings Deposits 224
Planning 209
12.3 Interest Rates Offered
on Different Types of Deposits 225
11.1 Actions in a Liquidity Crisis 210 The Composition of Deposits 225
The Ownership of Deposits 226
11.2 Evolving Capabilities and
Enhancements 210 The Cost of Different Deposit Accounts 228

11.3 Design Considerations 210 12.4 Pricing Deposit-Related

I. Align to Business and Risk Profiles 210 Services 229
II. Integrate with Broader Risk 12.5 Pricing Deposits at Cost
Management Frameworks 211 Plus Profit Margin 230
III. Operational, Actionable, but Flexible
Playbook 211 12.6 New Deposit Insurance Rules-
IV. Inclusive of Appropriate Stakeholder Insights and Issues 231
Groups 211 Summary of Deposit Insurance Coverage
V. Supported by a Communication Plan 211 Provided by the FDIC 231

11.4 Framework and Building 12.7 Using Marginal Cost to Set

Blocks 211 Interest Rates on Deposits 232
Governance and Oversight 212 Conditional Pricing 233
Scenarios and Liquidity Gap Analysis 213 12.8 Pricing Based on the Total
Contingent Actions 214 Customer Relationship and
Monitoring and Escalation 215 Choosing a Depository 237
Data and Reporting 218 The Role That Pricing and Other
11.5 Additional Considerations 218 Factors Play When Customers Choose a
Depository Institution to Hold Their
Different Types of Institutions 218
Accounts 237
Organizational Structure of the CFPs 218
Liquidity and Capital 219 12.9 Basic (Lifeline) Banking: Key
Services for Low-Income Customers 239
Conclusion 219
References 219 Summary 240

Contents ■ v ii
 Key Terms 241 Case Assignment for Chapter 13 270
Problems and Projects 242 Selected References 271
Internet Exercises 243
Case Assignment for Chapter 12 244 Chapter 14 Repurchase
Selected References 246 Agreements
and Financing 273
Chapter 13 Managing
Nondeposit 14.1 Repurchase Agreements:
Liabilities 247 Structure and Uses 274
Repos and Cash Management 274
Repos and Long Financing 275
13.1 Introduction 248 Reverse Repos and Short Positions 276
13.2 Liability Management and the 14.2 Repo, Liquidity Management,
Customer Relationship Doctrine 248 and the Financial Crisis of
2007-2009 277
13.3 Alternative Nondeposit
Case Study: Repo Financing and the
Sources of Funds 250 Collapse of Bear Stearns 277
Federal Funds Market ("Fed Funds") 250 Case Study: JPMorgan Chase's Repo
Repurchase Agreements as a Source Exposure to Lehman Brothers 278
of Funds 252
Borrowing from Federal Reserve Banks 255
14.3 General and Special Repo
Rates 280
Advances from Federal Home Loan Banks 256
Special Spreads in the United States
Development and Sale of Large
and the Auction Cycle 281
Negotiable CDs 256
Special Spreads in the United States
The Eurocurrency Deposit Market 258
and the Level of Rates 284
Commercial Paper Market 259
Valuing the Financing Advantage
Long-Term Nondeposit Funds Sources 260 of a Bond Trading Special in Repo 285
13.4 Choosing among
Alternative Nondeposit Sources 261
Measuring a Financial Firm's Total Need Chapter 15 Liquidity Transfer
for Nondeposit Funds: The Available Pricing: A Guide
Funds Gap 261
Nondeposit Funding Sources: Factors
to Better Practice 287
to Consider 262
Summary 267 15.1 Introduction 288
Key Terms 267 15.1.1 A Summary of the Major
Lessons Learned 288
Problems and Projects 268 15.1.2 Regulatory Developments 289
Internet Exercises 269 15.1.3 The Need for More Guidance on LTP 290

v iii ■ Contents
15.2 Governing LTP 290
15.2.1 Management of the LTP
Chapter 16 The US Dollar
Process 291 Shortage in Global
15.2.2 Liquidity Management Banking and the
Information Systems (LMIS) 292
International Policy
15.2.3 Remuneration Practices 293
Response 309
15.3 LTP In Practice: Managing
On-Balance Sheet Funding
Liquidity Risk 294 16.1 Introduction 310
15.3.1 Why Banks Need LTP 294 16.2 Banks' International
15.3.2 An Example of What Can Positions: Concepts and Data 311
Go Wrong with Poor LTP 294
16.3 The Long and Short of Banks'
15.3.3 "Zero" Cost of Funds Global Balance Sheets 313
Approach - Liquidity as a "Free" Good 294
16.3.1 The Structure of Banks' Operations 313
15.3.4 Pooled "Average" Cost
of Funds Approach to LTP 295 16.3.2 Balance Sheet Expansion since 2000 316
15.3.5 Matched-Maturity Marginal 16.3.3 Cross-Currency Funding Positions 316
Cost of Funds Approach to LTP 297 16.3.4 Maturity Transformation across
15.3.6 Examples of Pricing Funding Banks' Balance Sheets 320
Liquidity Risk 298 16.4 The US Dollar Shortage 323
15.3.7 Summary 301 16.5 The International Policy
15.4 LTP In Practice: Managing Response 325
Contingent Liquidity Risk 301 16.6 Concluding Remarks 327
15.4.1 Liquidity Cushions: A Principle of Data Appendix 328
Liquidity Risk Management 301 Reconstructing Banks' Global Balance Sheets 328
15.4.2 Extant Guidance Focuses on Size, The BIS International Banking Statistics 328
Composition and Marketability 302
Construction of the Dataset 328
15.4.3 Problems with Banks Liquidity
Consistency Check and Data Limitations 329
Cushions Unveiled by the GFC 302
15.4.4 LTP and Liquidity Cushions - Both References 330
Principles, Both Treated Separately 302
15.4.5 Poor Attribution of Cost of
Carrying a Liquidity Cushion 302 Chapter 17 Covered Interest
15.4.6 Towards Better Management of Parity Lost:
Contingent Liquidity Risk 303 Understanding
15.4.7 Example of Pricing Contingent the Cross-Currency
Liquidity Risk 304
Basis 333
15.5 Conclusion 305
Appendix:
17.1 A Framework 334
LTP Principles and Demand for Currency Hedges:
Recommendations 307 Why the Basis Opens Up 337

Contents ■ ix
 Limits to Arbitrage: Why the Basis The Components of Interest Rates 353
Does Not Close 338 Rsesponses to Interest Rate Risk 355
17.2 The Currency Basis 18.4 One of the Goals of Interest
in the Cross Section 339 Rate Hedging: Protect the Net
Quantitative Indicators of Hedging Interest Margin 356
Demand 339 Interest-Sensitive Gap Management
17.3 The Currency Basis in the Time as a Risk-Management Tool 356
Series: The Yen/Dollar Case 343 Problems with Interest-Sensitive GAP
Management 362
Demand for Currency Hedges and
the Basis 343 18.5 The Concept of Duration
Tighter Limits to Arbitrage and as a Risk-Management Tool 365
the Basis 344 What Is Duration? 365
Regression Results 345 Price Sensitivity to Changes in
Conclusions 346 Interest Rates and Duration 366
Convexity and Duration 366
References 347
18.6 Using Duration to Hedge
Against Interest Rate Risk 367
18.7 The Limitations of Duration
Chapter 18 Risk Management GAP Management 372
for Changing
Summary 373
Interest Rates:
Key Terms 374
Asset-Liability
Management Problems and Projects 375
and Duration Internet Exercises 377
Techniques 349 Case Assignment for
Chapter 18 378
Selected References 380
18.1 Introduction 350
18.2 Asset-Liability Management
Strategies 350 Chapter 19 Illiquid Assets 381
Asset Management Strategy 350
Liability Management Strategy 350
Funds Management Strategy 351 19.1 Chapter Summary 382
19.2 Liquidating Harvard 382
18.3 Interest Rate Risk: One of
the Greatest Management 19.3 Illiquid Asset Markets 383
Challenges 351 Sources of Illiquidity 383
Forces Determining Interest Rates 351 Characteristics of Illiquid Markets 383
The Measurement of Interest Rates 352 Summary 385

x ■ Contents
19.4 Illiquid Asset Reported Rebalancing 395
Returns Are Not Returns 385 Summary 395
Survivorship Bias 385
19.6 Portfolio Choice with
Infrequent Trading 386 Illiquid Assets 395
Unsmoothing Returns 386 Asset Allocation with Transactions Costs 395
Selection Bias 389 Asset Allocation with Infrequent Trading 396
Summary 390 Summary 397
19.5 Illiquidity Risk Premiums 390 19.7 Liquidating Harvard Redux 397
Illiquidity Risk Premiums across The Case for Illiquid Asset Investing 397
Asset Classes 391
Investment Advice for Endowments 398
Illiquidity Risk Premiums within
Asset Classes 392 Liquidate Harvard? 399
Market Making 393 Index 401

Contents ■ xi
 FRM
C O M M IT T EE

Chairman
Dr. Rene Stulz
Everett D. Reese Chair of Banking and Monetary Economics,
The Ohio State University

Members
Richard Apostolik Dr. Attilio Meucci, CFA
President and CEO, Global Association of Risk Professionals Founder, ARPM

Michelle McCarthy Beck, SMD Dr. Victor Ng, CFA, MD

Chief Risk Officer, TIAA Financial Solutions Chief Risk Architect, Market Risk Management and Analysis,
Goldman Sachs
Richard Brandt, MD
Operational Risk Management, Citigroup Dr. Matthew Pritsker
Senior Financial Economist and Policy Advisor/ Supervision,
Julian Chen, FRM, SVP
Regulation, and Credit, Federal Reserve Bank of Boston
FRM Program Manager, Global Association of Risk Professionals
Dr. Samantha Roberts, FRM, SVP
Dr. Christopher Donohue, MD
Balance Sheet Analytics & Modeling, PNC Bank
GARP Benchmarking Initiative, Global Association of Risk
Professionals Dr. Til Schuermann
Partner, Oliver Wyman
Donald Edgar, FRM, MD
Risk & Quantitative Analysis, BlackRock Nick Strange, FCA
Director, Supervisory Risk Specialists, Prudential Regulation
Herve Geny
Authority, Bank of England
Group Head of Internal Audit, London Stock Exchange Group
Dr. Sverrir Porvaldsson, FRM
Keith Isaac, FRM, VP
Senior Quant, SEB
Capital Markets Risk Management, TD Bank Group

William May, SVP

Global Head of Certifications and Educational Programs, Global
Association of Risk Professionals

xii ■ FRM® Committee

Liquidity Risk
Learning Objectives
After completing this reading you should be able to:

Explain and calculate liquidity trading risk via cost of liqui­ Evaluate Basel III liquidity risk ratios and BIS principles for
dation and liquidity-adjusted VaR (LVaR). sound liquidity risk management.

Identify liquidity funding risk, funding sources, and lessons Explain liquidity black holes and identify the causes of
learned from real cases: Northern Rock, Ashanti Gold­ positive feedback trading.
fields, and Metallgesellschaft.

Excerpt is Chapter 24 of Risk Management and Financial Institutions, 5th Edition, by John C. Hull.

1
The credit crisis that started in the middle of 2007 has empha­
sized the importance of liquidity risk for both financial institu­
tions and their regulators. Some financial institutions that relied
on wholesale deposits for their funding experienced problems
as investors lost confidence in financial institutions. Moreover,
financial institutions found that some instruments for which
there had previously been a liquid market could only be sold at
fire-sale prices during the crisis.
It is important to distinguish solvency from liquidity. Solvency
refers to a company having more assets than liabilities, so that
the value of its equity is positive. Liquidity refers to the ability of
a company to make cash payments as they become due. Finan­
cial institutions that are solvent can—and sometimes do—fail
because of liquidity problems. Consider a bank whose assets
are mostly illiquid mortgages. Suppose the assets are financed
90% with deposits and 10% with equity. The bank is comfortably
solvent. But it could fail if there is a run on deposits with 25%
of depositors suddenly deciding to withdraw their funds. In this
chapter we will examine how Northern Rock, a British bank spe­
cializing in mortgage lending, failed largely because of liquidity
problems of this type.
It is clearly important for financial institutions to manage liquid­
ity carefully. Liquidity needs are uncertain. A financial institution
should assess a worst-case liquidity scenario and make sure that
it can survive that scenario by either converting assets into cash
or raising cash in some other way. The new Basel III require­
ments are designed to ensure that banks do this.
Liquidity is also an important consideration in trading. A liq­
uid position in an asset is one that can be unwound at short
notice. As the market for an asset becomes less liquid, traders
are more likely to take losses because they face bigger bid-
offer spreads.
For an option or other derivative, it is important for there to be
a liquid market for the underlying asset so that the trader has
no difficulty in doing the daily trades necessary to maintain
delta neutrality.
This chapter discusses different aspects of liquidity risk. It con­
siders liquidity trading risk and liquidity funding risk. It also looks
at what are termed "liquidity black holes." These are situations
where a shock to financial markets causes liquidity to almost
completely dry up.
1.1 LIQUIDITY TRADING RISK
If a financial institution owns 100, 1,000, 10,000, or even
100,000 shares in IBM, liquidity risk is not a concern. Several
million IBM shares trade on the New York Stock Exchange
2 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
every day. The quoted price of the shares is very close to the
price that the financial institution would be able to sell the
shares for. However, not all assets are as readily convertible into
cash. For example, a $100 million investment in the bonds of a
noninvestment-grade U.S. company might be quite difficult to
sell at close to the market price in one day. Shares and debt of
companies in emerging markets are likely to be even less easy
to sell.
The price at which a particular asset can be sold depends on
1. The mid-market price of the asset, or an estimate of its
value
2. How much of the asset is to be sold
3. How quickly it is to be sold
4. The economic environment
When there is a market maker who quotes a bid and offer
price for a financial asset, the financial institution can sell
the asset at the bid and buy at the offer. However, it is usu­
ally stated (or understood) that a particular quote is good for
trades up to a certain size. Above that size, the market maker
is likely to increase the bid-offer spread. This is because the
market maker knows that, as the size of a trade increases,
the difficulty of hedging the exposure created by the trade
also increases.
When there is no market maker for a financial instrument,
there is still an implicit bid-offer spread. If a financial institution
approaches another financial institution (or an interdealer bro­
ker) to do a trade, the price depends on which side of the trade
it wants to take. The bid-offer spread for an asset can vary from
0.05% of the asset's mid-market price to as much as 5%, or even
10%, of its mid-market price.
The general nature of the relationship between bid quotes, offer
quotes, and trade size is indicated in Figure 1.1. The bid price
tends to decrease and 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.
Figure 1.1 describes the market for large deals between
sophisticated financial institutions. It is interesting to note that
bid-offer spreads in the retail market sometimes show the
opposite pattern to that in Figure 1.1. Consider, for example,
an individual who approaches a branch of a bank wanting to do
a foreign exchange transaction or invest money for 90 days. As
the size of the transaction increases, the individual is likely to
get a better quote.
The price that can be realized for an asset often depends
on how quickly it is to be liquidated and the economic

Fiqure 1.1 and offer prices as a function of
quantity transacted.
environment. Suppose you want to sell your house. Sometimes
the real estate market is referred to as a "seller's market."
Almost as soon as you put the house on the market, you can
expect to get several offers and the house will be sold within a
week. In other markets, it may take six months or more to sell
the house. In the latter case, if you need to sell the house imme­
diately, you will have to reduce the asking price well below the
estimated market value.
Financial assets are similar to real assets as far as this is con­
cerned. Sometimes liquidity is tight (e.g., after the Russian
default of 1998 and after the subprime crisis of 2007-2008).
Liquidating even a relatively small position can then be time-
consuming and is sometimes impossible. On other occasions,
there is plenty of liquidity in the market and relatively large posi­
tions can be unwound without difficulty.
Liquidating a large position can be affected by what is termed
predatory trading. This occurs when a market participant, say
Company X, has a large position and other market participants
guess that it will have to be unwound in the near future. The
other market participants attempt to profit by doing similar
trades to those they expect from Company X. For example, if it
is expected that Company X will have to sell a large position in
a particular stock, they short the stock in anticipation of a price
decline. This makes it more difficult than it would otherwise be
for Company X to exit from its position at competitive prices.
To avoid predatory trading, financial institutions emphasize to
employees the importance of keeping their positions and their
future trading plans confidential. Predatory trading was an
issue for the trader known as the London Whale in 2012 and for
Metallgesellschaft. In the case of Long-Term Capital Manage­
ment positions were unwound slowly over a period of time
under the supervision of the Federal Reserve to avoid preda­
tory trading.
Another problem in the market for financial assets is that,
when one financial institution finds that it needs to unwind a
position, it is often the case that many other financial institutions
with similar positions need to do the same thing. The liquid­
ity normally present in the market then evaporates. This is the
"liquidity black hole" phenomenon that will be discussed later in
this chapter.
1.1.1 The Importance of Transparency
One thing that the market has learned from the credit crisis of
2007 is that transparency is important for liquidity. If the nature
of an asset is uncertain, it is not likely to trade in a liquid market
for very long.
It had become common practice in the years prior to 2007 to
form portfolios of subprime mortgages and other assets and to
create financial instruments by securitizing, re-securitizing, and
re-re-securitizing the credit risk. Many of the financial instru­
ments were even more complicated. Sometimes the ABS CDOs
that were created included non-mortgage assets and even
tranches from other ABS CDOs. After August 2007, market par­
ticipants realized that they knew very little about the risks in the
instruments they had traded. Moreover, it was very difficult for
them to find out very much about this. Belatedly, they realized
they had been using credit ratings as a substitute for an under­
standing of the instruments.
After August 2007, the instruments created from subprime
mortgages became illiquid. Financial institutions had no idea
how to mark to market investments that they had been scram­
bling to buy a few months earlier. They realized that they had
purchased highly complicated credit derivatives and that they
did not have the tools to value them. They lacked both the
necessary models and solid information about the assets in the
portfolios underlying the derivatives.
Other well-defined credit derivatives, such as credit default
swaps, continued to trade actively during the credit crisis. The
lesson from all this is that the market can sometimes get car­
ried away trading complex products that are not transparent,
but, when it comes to its senses, liquidity for the products soon
disappears. When the products do trade again, prices are likely
to be low and bid-offer spreads are likely to be high. In July
2008 Merrill Lynch agreed to sell $30.6 billion of ABS CDO
tranches (previously rated AAA) to Lone Star Funds for
22 cents on the dollar.
C h ap ter 1 Liquidity Risk ■ 3
1.1.2 Measuring Market Liquidity
One measure of the market liquidity of an asset is its bid-offer
spread. This can be measured either as a dollar amount or as a
proportion of the asset price. The dollar bid-offer spread is
p = Offer price - Bid price
The proportional bid-offer spread for an asset is defined as
Offer price - Bid price
s = ------- ------ - ------------
Mid-market price
where the mid-market price is halfway between the bid and the offer
price. Sometimes it is convenient to work with the dollar bid-offer
spread, p, and sometimes with the proportional bid-offer spread, s.
The mid-market price can be regarded as the fair price. In liqui­
dating a position in an asset, a financial institution incurs a cost
equal to sa/2 where a is the dollar (mid-market) value of the
position. This reflects the fact that trades are not done at the
mid-market price. A buy trade is done at the offer price and a
sell trade is done at the bid price.
One measure of the liquidity of a book is how much it would
cost to liquidate the book in normal market conditions within a
certain time. Suppose that s, is an estimate of the proportional
bid-offer spread in normal market conditions for the /th finan­
cial instrument held by a financial institution and a ,■is the dollar
value of the position in the instrument. Then
JL S jOCj
Cost of liquidation (normal market) = - (1.1)
(=1 2
where n is the number of positions. Note that although diversifi­
cation reduces market risk, it does not necessarily reduce liquid­
ity trading risk. However, as explained earlier, s, increases with
the size of position /'. Holding many small positions rather than
a few large positions therefore tends to entail less liquidity risk.
Setting limits to the size of any one position can therefore be
one way of reducing liquidity trading risk.
Example 1.1
Suppose that a financial institution has bought 10 million shares
of one company and 50 million ounces of a commodity. The
shares are bid $89.5, offer $90.5. The commodity is bid $15,
offer $15.1. The mid-market value of the position in the shares
is 90 X 10 — $900 million. The mid-market value of the position
in the commodity is 15.05 X 50 = $752.50 million. The propor­
tional bid-offer spread for the shares is 1/90 or 0.01111. The
proportional bid-offer spread for the commodity is 0.1/15.05 or
0.006645. The cost of liquidation in a normal market is
900 X 0.01111/2 + 752.5 X 0.006645/2 = 7.5
or $7.5 million.
4 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Another measure of liquidity is the cost of liquidation in
stressed market conditions within a certain time period. Define
fij and (Tj as the mean and standard deviation of the propor­
tional bid-offer spread for the /th financial instrument held.
Then:
Cost of liquidation (stressed market)
The parameter A gives the required confidence level for the
spread. If, for example, we are interested in considering "worst
case" spreads that are exceeded only 1% of the time, and
if it is assumed that spreads are normally distributed, then
A = 2.326.
Example 1.2
Suppose that in Example 1.1 the mean and standard devia­
tion for the bid-offer spread for the shares are $1.0 and $2.0,
respectively. Suppose further that the mean and standard
deviation for the bid-offer spread for the commodity are
both $0.1. The mean and standard deviation for the pro­
portional bid-offer spread for the shares are 0.01111 and
0.02222, respectively. The mean and standard deviation for
the proportional bid-offer spread for the commodity are both
0.006645. Assuming the spreads are normally distributed,
the cost of liquidation that we are 99% confident will not be
exceeded is
0.5 x 900 x (0.01111 + 2.326 x 0.02222)
+ 0.5 X 752.5 X (0.006645 + 2.326 X 0.006645) = 36.58
or $36.58 million. This is almost five times the cost of liquidation
in normal market conditions.
In practice, bid-offer spreads are not normally distributed and it
may be appropriate to use a value of A that reflects their empiri­
cal distribution. For example, if it is found that the 99 percentile
point of the distribution is 3.6 standard deviations above the
mean for a particular category of financial instruments, A can be
set equal to 3.6 for those instruments.
Equation (1.2) assumes that spreads in all instruments are
perfectly correlated. This may seem overly conservative, but
it is not. When liquidity is tight and bid-offer spreads widen,
they tend to do so for all instruments. It makes sense for a
financial institution to monitor changes in the liquidity of its
book by calculating the measures in equations (1.1) and (1.2)
on a regular basis. As we have seen, the bid-offer spread
depends on how quickly a position is to be liquidated. The
measures in equations (1.1) and (1.2) are therefore likely to
be decreasing functions of the time period assumed for the
liquidation.
1.1.3 Liquidity-Adjusted VaR
Market value at risk is designed to calculate an estimate of a
"worst case" change in the mark-to-market valuation of the
trading book. The measures in equations (1.1) and (1.2) are
designed to calculate the cost of liquidating a book if market
prices do not change. Although VaR and liquidity risk measures
deal with different types of risks, some researchers have sug­
gested combining them into a liquidity-adjusted VaR measure.
One definition of liquidity-adjusted VaR is regular VaR plus the
cost of unwinding positions in a normal market. From equation
(1.1) this gives
Liquidity-Adjusted VaR = VaR + (1.3)
/=1 2
Alternatively it can be defined as regular VaR plus the cost of
unwinding positions in a stressed market. From equation (1.2)
this gives1
21 (ijL; + AC T j ) a ;
Liquidity-Adjusted VaR = VaR + ^ ----- ------
i=i 2
1.1.4 Unwinding a Position Optimally
A trader wishing to unwind a large position in a financial instru­
ment has to decide on the best trading strategy. If the position
is unwound quickly, the trader will face large bid-offer spreads,
but the potential loss from the mid-market price moving against
the trader is small. If the trader chooses to take several days to
unwind the position, the bid-offer spread the trader faces each
day will be lower, but the potential loss from the mid-market
price moving against the trader is larger.
This type of problem is discussed by Almgren and Chriss
(2001).2 Suppose that the size of a position is V units and that a
trader has to decide how to liquidate it over an n-day period. In
this case, it is convenient to define the bid-offer spread in dol­
lars rather than as a proportion. Define the dollar bid-offer
spread when the trader trades q units in one day as p(q) dollars.
Define q, as the units traded on day / and x, as the size of the
trader's position at the end of day / (1 < i < n). It follows that
x, = x,-_-| - qj for 1 < / < n where x0 is defined as the initial
position size, V.
Each trade costs half the bid-offer spread. The total of the costs
related to the bid-offer spread is therefore
^ p(q,)
1 This was suggested in A. Bangia, F. Diebold, T. Schuermann, and
J. Stroughair, "Liquidity on the Outside," Risk 12 (June): 68-73.
2 See R. Almgren and N. Chriss, "Optimal Execution of Portfolio Trans­
actions," journal o f Risk 3 (Winter 2001): 5-39.
Suppose that the mid-market price changes are normally distrib­
uted with a standard deviation of a per day and trading takes
place at the beginning of a day. The variance of the change in
the value of the traders position on day / is a 1
2xf. Assuming that
price changes on successive days are independent, the vari­
ance of the change in the value of the position applicable to the
unwind is therefore
2> W
/=1
A trader might reasonably wish to minimize VaR after trading
costs have been considered. This corresponds to minimizing
something similar to the liquidity-adjusted VaR measure in equa­
tion (1.3). The trader's objective is to choose the q,- so that
is minimized subject to
= V
1=1
with the x, being calculated from V and the q,-, as indicated
above. The parameter A measures the confidence level in the
VaR estimate. For example, when the confidence level is 99%,
and daily price changes are assumed to be normally distributed,
A = 2.326. Once the p(q) function has been estimated, Excel's
Solver can be used for the optimization.
Example 1.3
A trader wishes to unwind a position of 100 million units in an
asset over five days. Suppose that the bid-offer spread p (mea­
sured in dollars) as a function of the daily trading volume is
p(q) = a + becq
where a = 0.1, b = 0.05, and c = 0.03 and the amount traded,
q, is measured in millions of units.
The standard deviation of the price change per day is $0.1. A
spreadsheet for calculating the optimal strategy can be down­
loaded from the author's website: www2.rotman.utoronto.ca/
~hull/riskman. When the confidence level is 95%, the amounts
that should be traded on days 1,2, 3, 4, and 5 are 48.9, 30.0,
14.1, 5.1, and 1.9 million units, respectively. As the VaR confidence
level is reduced, the amounts traded per day show less vari­
ability. For example, when the confidence level is 90%, they are
45.0, 29.1, 15.6, 7.0, and 3.3 million units, respectively. When
the confidence level is 75% they are 36.1, 26.2, 17.7, 11.6, and
8.4 million units, respectively. In the limit when the confidence
level is set equal to 50%, so that the trader is interested only in
expected costs, not in the standard deviation of costs, 20 million
units should be traded each day.
C h ap ter 1 Liquidity Risk ■ 5
As this example illustrates, when a position is to be closed out
over n days, more than 11n of the position should be traded on
the first day. This is because the longer any part of the position
is held, the greater the risk of adverse market moves.
1.1.5 Other Measures of Market Liquidity
So far we have focused on bid-offer spread as a measure of
market liquidity. Many other measures have been proposed. The
volume of trading per day (i.e., the number of times the asset
trades in a day) is an important measure. When an asset is highly
illiquid, the volume of trading in a day is often zero. The price
impact of a trade of a certain size is another measure. A mea­
sure somewhat similar to this, but more easily calculated, was
proposed by Amihud (2002).3 It is the average of
Absolute value of daily return
Daily dollar volume
over all days in the period considered. This measure is widely
used by researchers. Amihud shows that an asset's expected
return increases as its liquidity decreases. In other words, inves­
tors do get compensated for illiquidity.
1.2 LIQUIDITY FUNDING RISK
We now move on to consider liquidity funding risk. This is the
financial institution's ability to meet its cash needs as they arise.
As mentioned at the outset of this chapter, liquidity is not the
same as solvency. Financial institutions that are solvent (i.e.,
have positive equity) can, and sometimes do, fail because of
liquidity problems. Northern Rock, a British mortgage lender, is
a case in point (see Business Snapshot 1.1).
Liquidity funding problems at a financial institution can be
caused by:
1. Liquidity stresses in the economy (e.g., a flight to quality
such as that seen during the 2007 to 2009 crisis). Investors
are then reluctant to provide funding in situations where
there is any credit risk at all.
2. Overly aggressive funding decisions. There is a tendency
for all financial institutions to use short-term instruments to
fund long-term needs, creating a liquidity mismatch. Finan­
cial institutions need to ask themselves: "How much of a
mismatch is too much?"
3. A poor financial performance, leading to a lack of confi­
dence. This can result in a loss of deposits and difficulties in
rolling over funding.
3 See Y. Amihud, "Illiquidity and Stock Returns: Cross-Section and Time-
Series Effects "Journal of Financial Markets 5 (2002): 31-56.
6 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Often, when a company experiences severe liquidity problems,
all three of these have occurred at the same time. The key to
managing liquidity risk is predicting cash needs and ensuring
that they can be met in adverse scenarios. Some cash needs
are predictable. For example, if a bank has issued a bond, it
knows when coupons will have to be paid. Others, such as
those associated with withdrawals of deposits by retail custom­
ers and drawdowns by corporations on lines of credit that the
bank has granted, are less predictable. As the financial instru­
ments entered into by financial institutions have become more
complex, cash needs have become more difficult to predict. For
example, downgrade triggers, guarantees provided by a finan­
cial institution, and possible defaults by counterparties in deriva­
tives transactions can have an unexpected impact on
cash resources.
1.2.1 Sources of Liquidity
The main sources of liquidity for a financial institution are:
1. Holdings of cash and Treasury securities
2. The ability to liquidate trading book positions
3. The ability to borrow money at short notice
4. The ability to offer favorable terms to attract retail and
wholesale deposits at short notice
5. The ability to securitize assets (such as loans) at short notice
6. Borrowings from the central bank
We now consider each of these in turn.
Cash and Treasury Securities Cash and Treasury securities are
excellent sources of liquidity. Cash is of course always avail­
able to meet liquidity needs and Treasury securities issued by
countries such as the United States and the United Kingdom
can generally be converted into cash at short notice without any
problem. However, cash and Treasury securities are relatively
expensive sources of liquidity. There is a trade-off between the
liquidity of an asset and the return it provides. In order to be
profitable, a financial institution needs to invest in assets such as
loans to corporations that provide a higher rate of return than
Treasury instruments. There is therefore a limit to the cash and
Treasury securities that can reasonably be held.
Liquidating Trading Book Positions Liquidity funding risk is
related to liquidity trading risk, considered in Section 1.1,
because one way a financial institution can meet its funding
requirements is by liquidating part of its trading book. It is there­
fore important for a financial institution to quantify the liquidity
of its trading book so that it knows how easy it would be to use
the book to raise cash. The financial institution wants to make
sure that it will be able to survive stressed market conditions
 BUSINESS SNAPSHOT 1.1 NORTHERN ROCK
Northern Rock, a British bank, was founded in 1997 when
the Northern Rock Building Society floated shares on the
London Stock Exchange. In 2007, it was one of the top
five mortgage lenders in the United Kingdom. It had 76
branches and offered deposit accounts, savings accounts,
loans, and house/contents insurance. The bank grew rapidly
between 1997 and 2007. Some of its mortgages were secu­
ritized through a subsidiary, Granite, that was based in the
Channel Islands.
Northern Rock relied on selling short-term debt instru­
ments for much of its funding. Following the subprime crisis
of August 2007, the bank found it very difficult to replace
maturing instruments because institutional investors became
very nervous about lending to banks that were heavily
involved in the mortgage business. The banks assets were
sufficient to cover its liabilities so it was not insolvent. To
quote from the Financial Services Authority (FSA) in Septem­
ber 2007: "The FSA judges that Northern Rock is solvent,
exceeds its regulatory capital requirement, and has a good
quality loan book." But Northern Rock's inability to fund itself
was a serious problem. It approached the Bank of England
for funding on September 12, 2007, and borrowed about
£3 billion from the Tripartite Authority (Bank of England, the
Financial Services Authority, and HM Treasury) in the follow­
ing few days.
On September 13, 2007, the BBC business editor Robert
Peston broke the news that the bank had requested emer­
gency support from the Bank of England. On Friday, Septem­
ber 14, there was a run on the bank. Thousands of people
lined up for hours to withdraw their funds. This was the first
run on a British bank in 150 years. Some customers held their
funds in an "Internet-only" account, which they were unable
where there is a general shortage of liquidity. The financial insti­
tution's analysis should therefore be based on stressed market
conditions, not normal market conditions. This is the reason why
the measures discussed in the previous section concerned with
bid-offer spreads in stressed markets are important.
Ability to Borrow When markets are unstressed, a creditworthy
bank usually has no problem in borrowing money, but in stressed
market conditions there is a heightened aversion to risk. This
leads to higher interest rates, shorter maturities for loans, and in
some cases a refusal to provide funds at all. Financial institutions
should monitor the assets that can be pledged as collateral for
loans at short notice. A financial institution can (at a cost) miti­
gate its funding risks somewhat by arranging lines of credit. For
example, Countrywide, an originator of mortgages in the United
States, had a syndicated loan facility of $11.5 billion, which it was
able to use during the credit crisis of 2007. (This helped keep the
to access due to the volume of customers trying to log on.
On Monday, September 17, worried savers continued to
withdraw their funds. An estimated £2 billion was withdrawn
between September 12 and September 17, 2007.
Depositor insurance in the UK guaranteed 100% of the first
£2,000 and 90% of the next £33,000. Late on September
17, 2007, the British Chancellor of the Exchequer, Alistair
Darling, announced that the British government and the
Bank of England would guarantee all deposits held at North­
ern Rock. As a result of this announcement and subsequent
advertisements in major UK newspapers, the lines outside
Northern Rock's branches gradually disappeared. Northern
Rock's shares, which had fallen from £12 earlier in the year to
£2.67, rose 16% son Mr. Darlings announcement.
During the months following September 12, 2007, Northern
Rock's emergency borrowing requirement increased. The
Bank of England insisted on a penalty rate of interest to dis­
courage other banks from taking excessive risks. Northern
Rock raised some funds by selling assets, but by February
2008 the emergency borrowing reached £25 billion. The
bank was then nationalized and the management of the bank
was changed. It was split into Northern Rock pic and North­
ern Rock (Asset Management), with the company's bad debt
being put in Northern Rock (Asset Management). In Novem­
ber 2011, Northern Rock pic was bought from the British
government for £747 million by the Virgin Group, which is
headed by the colorful entrepreneur Sir Richard Branson.
The Northern Rock story illustrates just 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.
company afloat, but it still experienced significant problems and
was taken over by Bank of America in January 2008.) As Business
Snapshot 1.1 shows, Northern Rock, a similar British mortgage
lender, did not fare so well.
Wholesale and Retail Deposits Wholesale deposits are a more
volatile source of funding than retail deposits and can disappear
quickly in stressed market conditions. Even retail deposits are
not as stable as they used to be because it is very easy to com­
pare interest rates offered by different financial institutions and
make transfers via the Internet. Unfortunately, liquidity problems
tend to be market-wide rather than something that affects one
or two financial institutions. When one financial institution wants
to increase its retail or wholesale deposit base for liquidity rea­
sons by offering more attractive rates of interest, others usually
want to do the same thing and the increased funding is likely to
be difficult to achieve.
Chapter 1 Liquidity Risk ■ 7
Securitization Banks have found the "originate-to-distribute"
model attractive. Rather than keep illiquid assets such as loans
on their balance sheet, they have securitized them. Prior to
August 2007, securitization was an important source of liquidity
for banks. However, this source of liquidity dried up almost over­
night in August 2007 as investors decided that the securitized
products were too risky. "Originate-to-distribute" was no longer
a viable strategy, and banks had to fund their loans. Not surpris­
ingly, banks became a lot less willing to lend.
Securitization led to other liquidity problems in August 2007.
Banks had entered into liquidity backstop arrangements on the
asset-backed commercial paper (ABCP) that was used to fund
debt instruments, such as mortgages, prior to their securitiza­
tion. When buyers could not be found, they had to buy the
instruments themselves. In some cases, in order to avoid their
reputations being adversely impacted, they had to provide
financial support to conduits and other off-balance-sheet vehi­
cles that were involved in securitization, even though they were
not legally required to do so.
Central Bank Borrowing Central banks (e.g., 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 commercial banks are experienc­
ing financial difficulties, central banks are prepared to lend
money to maintain the health of the financial system. Collateral
has to be posted by the borrowers and the central bank typi­
cally applies a haircut (i.e., it lends less than 100% of the value
of the collateral) and may charge a relatively high rate of inter­
est. In March 2008, after the failure of Bear Stearns (which was
taken over by JPMorgan Chase), the Federal Reserve Board
extended its borrowing facility to investment banks as well as
commercial banks.4 Later, it also made the facility available to
Fannie Mae and Freddie Mac (which were taken over by the
government in September 2008).
Different central banks apply different rules. Following the
credit crisis of August 2007, the haircuts used by the Euro­
pean Central Bank (ECB) were lower than those of other
central banks. As a result, some British banks preferred to
borrow from the European Central Bank (ECB) rather than the
Bank of England. (There are even stories of North American
banks contemplating the setting up of subsidiaries in Ireland
4 Central banks are concerned about the failure of investment banks
because of systemic risk. Investment banks have derivatives contracts
with other investment banks and with commercial banks. There is a
danger that, because of the huge amount of trading between banks, a
failure by an investment bank will have a ripple effect throughout the
financial sector leading to a failure by commercial banks.
8 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
BUSINESS SNAPSHOT 1.2 ASHANTI
GOLDFIELDS
Ashanti Goldfields, a West African gold-mining company
based in Ghana, experienced problems resulting from
its hedging program in 1999. It had sought to protect
its shareholders from gold price declines by selling gold
forward. On September 26, 1999, 15 European central
banks surprised the market with an announcement that
they would limit their gold sales over the following five
years. The price of gold jumped up over 25%. Ashanti was
unable to meet margin calls and this resulted in a major
restructuring, which included the sale of a mine, a dilution
of the interest of its equity shareholders, and a restructur­
ing of its hedge positions.
to access the ECB.) By September 2008, the ECB had lent
467 billion euros and announced that it would apply larger
haircuts in the future.
Banks try to keep their borrowing from a central bank a secret.
There is a danger that the use of central bank borrowings will
be interpreted by the market as a sign that the bank is experi­
encing financial difficulties with the result that other sources of
liquidity dry up. As Business Snapshot 1.1 discusses, news that
Northern Rock required emergency borrowing led to an imme­
diate run on the bank, exacerbating its liquidity problems.
Hedging Issues Liquidity problems are liable to arise when
companies hedge illiquid assets with contracts that are sub­
ject to margin requirements. Gold-mining companies often
hedge their risks by entering into agreements with financial
institutions to sell gold forward for two or three years. Often
the gold-mining company is required to post margin and the
amount of the margin required is calculated every day to
reflect the value of its forward agreements. If the price of gold
rises fast, the forward agreements lose money and result in
big margin calls being made by the financial institution on the
gold-mining company. The losses on the forward agreements
are offset by increases in the value of the gold in the ground—
but this is an illiquid asset. As discussed in Business Snap­
shot 1.2, Ashanti Goldfields was forced to undertake a major
restructuring when it could not meet margin calls after a sharp
rise in the price of gold.
Another extreme example of a liquidity funding problem caused
by hedging is provided by a German company, Metallgesell-
schaft, that entered into profitable fixed-price oil and gas
contracts with its customers (see Business Snapshot 1.3). The
lesson from the Ashanti and Metallgesellschaft episodes is not
that companies should not use forward and futures contracts

BUSINESS SNAPSHOT 1.3
METALLGESELLSCHAFT
In the early 1990s, Metallgesellschafi: (MG) sold a huge
volume of 5- to 10-year heating oil and gasoline fixed-
price supply contracts to its customers at six to eight cents
above market prices. It hedged its exposure with long
positions in short-dated futures contracts that were rolled
forward. As it turned out, the price of oil fell and there
were margin calls on the futures positions. MG's trading
was made more difficult by the fact that its trades were
very large and were anticipated by others.
Considerable short-term cash flow pressures were placed
on MG. The members of MG who devised the hedging
strategy argued that these short-term cash outflows were
offset by positive cash flows that would ultimately be real­
ized on the long-term fixed-price contracts. However, the
company's senior management and its bankers became
concerned about the huge cash drain. As a result, the com­
pany closed out all the hedge positions and agreed with
its customers that the fixed-price contracts would be aban­
doned. The outcome was a loss to MG of $1.33 billion.
for hedging, but rather that they should ensure that they have
access to funding to handle the cash flow mismatches that
might arise in extreme circumstances.
1.2.2 Reserve Requirements
In some countries there are reserve requirements that require
banks to keep a certain percentage of deposits as cash in the
bank's vault or on deposit with the central bank. The reserve
requirement applies only to transaction deposits (in essence,
those made to a checking account). For large banks in the
United States, the reserve requirement is currently about 10%.
Some countries, such as Canada and the United Kingdom, have
no compulsory reserve requirements. Others have higher com­
pulsory reserve requirements than the United States.
In addition to ensuring that banks keep a minimum amount of
liquidity, reserve requirements affect the money supply. When
the reserve requirement is 10%, a $100 deposit leads to $90 of
lending, which leads to a further $90 of deposits in the banking
system, which leads to further $81 of lending, and so on. As this
process continues, the total money supply (Ml) that is created
is 90 + 81 + 72.9 + . . . or $900. If the reserve requirement is
20%, a $100 deposit leads to $80 of lending, which leads to $64
of lending, and so on. The total increase in the money supply is
80 + 64 + 51.2 + . . . or $400. Most countries do not use the
reserve requirement as a way of controlling the money supply.
An exception appears to be China, where the reserve require­
ment is changed frequently,
1.2.3 Regulation
Basel III introduced two liquidity risk requirements: the liquidity
coverage ratio (LCR) and the net stable funding ratio (NSFR).
The LCR requirement is
High-quality liquid assets o
Net cash outflows in a 30-day period
The 30-day period considered in the calculation of LCR is one
of acute stress involving a downgrade of three notches (e.g.,
from AA+ to A+), a partial loss of deposits, a complete loss of
wholesale funding, increased haircuts on secured funding, and
drawdowns on lines of credit. LCR was implemented in stages
between 2015 and 2019. (The required ratio was 60% in 2015
and 100% in 2019.)
The NSFR requirement is
Amount of stable fundinq
----------;---------------- , a --- > 100%
Required amount of stable funding
The numerator is calculated by multiplying each category of
funding (capital, wholesale deposits, retail deposits, etc.) by an
available stable funding (ASF) factor, reflecting their stability. The
denominator is calculated from the assets and off-balance-sheet
items requiring funding. Each category of these is multiplied by a
required stable funding (RSF) factor to reflect the permanence of
the funding. The implementation date for the NSFR requirement
is January 1, 2018.
Following the liquidity crisis of 2007, bank regulators issued a
revised set of principles on how banks should manage liquidity.5
These are as follows:
1. A bank is responsible for the sound management of liquidity
risk. A bank should establish a robust liquidity risk manage­
ment framework that ensures it maintains sufficient liquidity,
including a cushion of unencumbered, high-quality liquid
assets, to withstand a range of stress events, including those
involving the loss or impairment of both unsecured and
secured funding sources. Supervisors should assess the ade­
quacy of both a bank's liquidity risk management framework
and its liquidity position and should take prompt action if a
bank is deficient in either area in order to protect depositors
and to limit potential damage to the financial system.
2. A bank should clearly articulate a liquidity risk tolerance that
is appropriate for its business strategy and its role in the
financial system.
5 See Bank for International Settlements, "Principles for Sound Liquidity
Risk Management and Supervision," September 2008.
Chapter 1 Liquidity Risk ■ 9
 3. Senior management should develop a strategy, policies,
and practices to manage liquidity risk in accordance with
the risk tolerance and to ensure that the bank maintains
sufficient liquidity. Senior management should continuously
review information on the bank's liquidity developments
and report to the board of directors on a regular basis. A
bank's board of directors should review and approve the
strategy, policies, and practices related to the management
of liquidity at least annually and ensure that senior manage­
ment manages liquidity risk effectively.
4. A bank should incorporate liquidity costs, benefits, and risks
in the internal pricing, performance measurement, and new
product approval process for all significant business activi­
ties (both on- and off-balance-sheet), thereby aligning the
risk-taking incentives of individual business lines with the
liquidity risk exposures their activities create for the bank as
a whole.
5. A bank should have a sound process for identifying, mea­
suring, monitoring, and controlling liquidity risk. This
process should include a robust framework for comprehen­
sively projecting cash flows arising from assets, liabilities,
and off-balance-sheet items over an appropriate set of time
horizons.
6 . A bank should actively monitor and control liquidity risk
exposures and funding needs within and across legal enti­
ties, business lines, and currencies, taking into account
legal, regulatory, and operational limitations to the transfer-
ability of liquidity.
7. A bank should establish a funding strategy that provides
effective diversification in the sources and tenor of funding.
It should maintain an ongoing presence in its chosen fund­
ing markets and strong relationships with funds providers
to promote effective diversification of funding sources.
A bank should regularly gauge its capacity to raise funds
quickly from each source. It should identify the main factors
that affect its ability to raise funds and monitor those fac­
tors closely to ensure that estimates of fund-raising capacity
remain valid.
8 . A bank should actively manage its intraday liquidity posi­
tions and risks to meet payment and settlement obligations
on a timely basis under both normal and stressed conditions
and thus contribute to the smooth functioning of payment
and settlement systems.
9. A bank should actively manage its collateral positions, dif­
ferentiating between encumbered and unencumbered
assets. A bank should monitor the legal entity and physical
location where collateral is held and how it may be mobi­
lized in a timely manner.
10 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
10. A bank should conduct stress tests on a regular basis for a
variety of short-term and protracted institution-specific and
market-wide stress scenarios (individually and in combina­
tion) to identify sources of potential liquidity strain and to
ensure that current exposures remain in accordance with
a bank's established liquidity risk tolerance. A bank should
use stress test outcomes to adjust its liquidity risk manage­
ment strategies, policies, and positions and to develop
effective contingency plans.
11. 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 invoca­
tion and escalation procedures, and be regularly tested and
updated to ensure that it is operationally robust.
12. A bank should maintain a cushion of unencumbered, high-
quality liquid assets to be held as insurance against a range
of liquidity stress scenarios, including those that involve
the loss or impairment of unsecured and typically available
secured funding sources. There should be no legal, regula­
tory, or operational impediment to using these assets to
obtain funding.
13. A bank should publicly disclose information on a regular
basis that enables market participants to make an informed
judgment about the soundness of its liquidity risk manage­
ment framework and liquidity position.
Recommendations for banks supervisors are:
14. Supervisors should regularly perform a comprehensive
assessment of a bank's overall liquidity risk management
framework and liquidity position to determine whether they
deliver an adequate level of resilience to liquidity stress
given the bank's role in the financial system.
15. Supervisors should supplement their regular assessments of
a bank's liquidity risk management framework and liquidity
position by monitoring a combination of internal reports,
prudential reports, and market information.
16. Supervisors should intervene to require effective and timely
remedial action by a bank to address deficiencies in its
liquidity risk management processes or liquidity position.
17. Supervisors should communicate with other supervisors
and public authorities, such as central banks, both within
and across national borders, to facilitate effective coopera­
tion regarding the supervision and oversight of liquidity risk
management. Communication should occur regularly during
normal times, with the nature and frequency of the informa­
tion sharing increasing as appropriate during times of stress.
1.3 LIQUIDITY BLA CK HOLES
It is sometimes argued that technological and other develop­
ments have led to an improvement in the liquidity of financial
markets. This is questionable. It is true that bid-offer spreads
have on average declined. But there has also been an increasing
tendency for situations to develop where almost everyone
wants to do the same type of trade at the same time. The result
has been that what are referred to as "liquidity black holes"
occur with increasing frequency.6 A liquidity black hole
describes a situation where liquidity has dried up in a particular
market because everyone wants to sell and no one wants to
buy, or vice versa. It is sometimes also referred to as a
"crowded exit."7
In a well-functioning market, the market may change its opinion
about the price of an asset because of new information. How­
ever, the price does not overreact. If a price decrease is too
great, traders will quickly move in and buy the asset and a new
equilibrium price will be established. A liquidity black hole is
created when a price decline causes more market participants to
want to sell, driving prices well below where they will eventually
settle. During the sell-off, liquidity dries up and the asset can be
sold only at a fire-sale price.8
1.3.1 Positive and Negative
Feedback Traders
Changes in the liquidity of financial markets are driven by the
behavior of traders. There are two sorts of traders in the market:
negative feedback traders and positive feedback traders.9 Neg­
ative feedback traders buy when prices fall and sell when prices
rise; positive feedback traders sell when prices fall and buy
when prices rise.
In liquid markets, negative feedback traders dominate the
trading. If the price of an asset gets unreasonably low, trad­
ers will move in and buy. This creates demand for the asset
that restores the price to a more reasonable level. Similarly, if
the price of an asset gets unreasonably high, traders will sell.
This creates supply of the asset that also restores the price to
6 See A. D. Persaud, ed., Liquidity Black Holes: Understanding, Quantify­
ing and Managing Financial Liquidity Risk (London: Risk Books, 1999).
7 See, for example, J. Clunie, Predatory Trading and Crowded Exits: New
Thinking on Market Volatility (Petersfield, UK: Harriman House, 2010).
8 Liquidity black holes tend to be associated with price decreases, but it
is in theory also possible for them to occur when there are price increases.
9 This is a simplification of reality to help understand the dynamics of
markets. Some traders follow complicated strategies that cannot be
classified as positive feedback or negative feedback.
a more reasonable level. The result is that the market is liquid
with reasonable prices and a good balance of buyers
and sellers.
When positive feedback traders dominate the trading, market
prices are liable to be unstable and the market may become
one-sided and illiquid. A reduction in the price of an asset
causes traders to sell. This results in prices falling further and
more selling. An increase in the price of an asset causes traders
to buy. This results in the price of the asset increasing further
and more buying.
There are a number of reasons why positive feedback trading
exists. For example:
1. Trend trading. Trend traders attempt to identify trends in
an asset price. They buy when the asset price appears to be
trending up and sell when it appears to be trending down.
A related strategy is breakout trading, which involves trad­
ing when an asset's price moves outside an established
range. For example, if a stock has been trading in the range
of $25 to $30 for the last six months, traders might be
inclined to buy it as soon as it moves above $30 and sell it
as soon as it moves below $25.
2. Stop-loss rules. Traders often have rules to limit their
losses. When the price of an asset that is owned falls
below a certain level, they automatically sell to limit their
losses. These rules are known as "stop-loss" rules and are
a source of positive feedback trading that is always present
in the market.
3. Dynamic hedging. Hedging a short option position (call
or put) involves buying after a price rise and selling after
a price decline. This is positive feedback trading that has
the potential to reduce liquidity. (By contrast, dynamically
hedging a long position in a call or put option involves sell­
ing after a price rise and buying after a price decline. This
is negative feedback trading and should not interfere with
market liquidity.) Any situation where banks have a large
short option position has the potential to destabilize the
market and cause illiquidity. At one point banks sold a huge
volume of options on long-term interest rates to British
insurance companies. As the banks hedged their risks, the
behavior of long-term interest rates in the UK was dramati­
cally affected.
4. Creating options synthetically. Hedging a short position in
an option is equivalent to creating a long position in the
same option synthetically. It follows that a financial institu­
tion can 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. This leads to positive feedback
Chapter 1 Liquidity Risk ■ 11
 trading that can cause market instability and illiquidity. The
classic example here is the stock market crash of October
1987. In the period leading up to the crash, the stock mar­
ket had done very well. Increasing numbers of portfolio
managers were using commercially available programs to
synthetically create put options on their portfolios. These
programs told them to sell part of their portfolio immedi­
ately after a price decline and buy it back immediately after
a price increase. The result, as indicated in Business Snap­
shot 1.4, was a liquidity black hole where prices plunged on
October 19, 1987. In this case, the liquidity black hole was
relatively short-lived. Within four months the market recov­
ered to close to its pre-crash level.
5. Margins. A big movement in market variables, particularly
for traders who are highly leveraged, may lead to margin
calls that cannot be met. This forces traders to close out
their positions, which reinforces the underlying move in the
market variables. It is likely that volatility increases. This
may exacerbate the situation because it leads to exchanges
increasing their margin requirements.
6 . Predatory trading. This was mentioned in Section 1.1. If
traders know that an investor must sell large quantities of a
certain asset, they know that the price of the asset is likely
to decrease. They therefore short the asset. This reinforces
the price decline and results in the price falling even further
than it would otherwise do. To avoid predatory trading,
large positions must usually be unwound slowly.
BUSINESS SNAPSHOT 1.4 THE CRASH OF 1987
On Monday, October 19, 1987, the Dow Jones Industrial
Average dropped by more than 20%. Portfolio insurance
played a major role in this crash. In October 1987, portfolios
involving over $60 billion of equity assets were being man­
aged with trading rules that were designed to synthetically
create put options on the portfolios. These trading rules
involved selling equities (or selling index futures) when
the market declined and buying equities (or buying equity
futures) when the market rose.
During the period Wednesday, October 14, 1987, to Friday,
October 16, 1987, the market declined by about 10%, with
much of this decline taking place on Friday afternoon. The
portfolio insurance rules should have generated at least
$12 billion of equity or index futures sales as a result of this
decline. In fact, portfolio insurers had time to sell only
$4 billion and they approached the following week with huge
amounts of selling already dictated by their models. It is esti­
mated that on Monday, October 19, sell programs by three
portfolio insurers accounted for almost 10% of the sales on
the New York Stock Exchange, and that portfolio insurance
12 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
7. LTCM. The failure of the hedge fund Long-Term Capital
Management (LTCM) provides an example of positive
feedback trading. One type of LTCM's trade was "relative
value fixed income." LTCM would take a short position
in a liquid bond and a long position in a similar illiquid
bond, and wait for the prices to move close together.
After the Russian default in 1998, the prices of illiquid
instruments declined relative to similar liquid instruments.
LTCM (and other companies that were following similar
strategies to LTCM) were highly leveraged and unable
to meet margin calls. They were forced to close out their
positions. This involved buying the liquid bonds and sell­
ing the illiquid bonds. This reinforced the flight to quality
and made the prices of illiquid and liquid bonds diverge
even further.
1.3.2 Leveraging and Deleveraging
A phenomenon in the market is leveraging and deleverag­
ing. This is illustrated in Figures 1.2 and 1.3. When banks are
awash with liquidity (e.g., because they have developed ways
of securitizing assets or because deposit levels are higher
than usual), they make credit easily available to businesses,
investors, and consumers. Credit spreads decrease. The easy
availability of credit increases demand for both financial and
nonfinancial assets and the prices of these assets rise. Assets
are often pledged as collateral for the loans that are used to
finance them. When the prices of the assets rise, the collateral
sales amounted to 21.3% of all sales in index futures markets.
It is likely that the decline in equity prices was exacerbated
by investors other than portfolio insurers selling heavily
because they anticipated the actions of portfolio insurers.
Because the market declined so fast and the stock exchange
systems were overloaded, many portfolio insurers were
unable to execute the trades generated by their models
and failed to obtain the protection they required. Needless
to say, the popularity of portfolio insurance schemes has
declined significantly since 1987. One of the lessons from
this story is that it is dangerous to follow a particular trading
strategy—even a hedging strategy—when many other mar­
ket participants are doing the same thing. To quote from a
report on the crash, "Liquidity sufficient to absorb the limited
selling demands of investors became an illusion of liquidity
by massive selling, as everyone showed up on the same side
of the market at once. Ironically, it was this illusion of liquidity
which led certain similarly motivated investors, such as port­
folio insurers, to adopt strategies which call for liquidity far in
excess of what the market could supply."

underlying loans (when measured at market prices) is greater
and borrowing can increase further. This leads to further asset
purchases and a repeat of the cycle. This cycle is referred to as
"leveraging" because it leads to more borrowing throughout
the economy.
Deleveraging is the opposite process to leveraging. Banks find
themselves less liquid for some reason (e.g., because there is
less demand for the products of securitization). They become
more reluctant to lend money. Credit spreads increase. There is
less demand for both nonfinancial and financial assets and their
prices decrease. The value of the collateral supporting loans
decreases and banks reduce lines of credit. This leads to asset
sales being necessary and a further reduction in asset prices.
The period leading up to 2007 was characterized by leverag­
ing for many of the world's economies. Credit spreads declined
and it was relatively easy to borrow money for a wide range of
different purposes. From the middle of 2007 onward, the situa­
tion changed and the deleveraging process shown in Figure 1.3
started. Credit spreads increased, it became much less easy to
borrow money, and asset prices decreased.
Hedge funds are particularly affected by the leveraging­
deleveraging cycle. Consider a hedge fund that is able to borrow
20 times its equity during the pre-2007 period. Soon after the mid­
dle of 2007, the hedge fund might get a call from its prime broker
telling it to reduce leverage to, say, five times equity. It can only
do this by selling assets. Asset prices decrease as a result of what
this hedge fund, and other hedge funds, are doing. The hedge
fund's equity declines and further sales are necessary.
1.3.3 Irrational Exuberance
The term "irrational exuberance" was used by Alan Greenspan,
Federal Reserve Board chairman, in a speech in December 1996
when, in reference to the stock market, he asked, "How do we
know when irrational exuberance has unduly escalated asset
values?" (The phrase has been remembered because the speech
was followed by declines in stock prices worldwide.) Most liquid­
ity black holes can be traced to irrational exuberance of one sort
or another. What happens is that traders working for many dif­
ferent financial institutions become irrationally exuberant about
a particular asset class or a particular market variable. The bal­
ance sheets of financial institutions then become overextended
through the accumulation of exposure to this asset class or mar­
ket variable. Often the process is self-reinforcing. When many
financial institutions choose to take a particular position, prices
increase, making the position look profitable. This creates extra
desire on the part of financial institutions to take the position
and yet more profits. Risk managers working for the financial
institution should (and probably will) complain about the risks
being taken, but in many instances senior management are likely
to ignore their concerns because high profits are being made.
To quote Chuck Prince, ex-CEO of Citigroup, on July 10, 2007:
"When the music stops, in terms of liquidity, things will be com­
plicated. But as long as the music is playing, you've got to get
up and dance. Were still dancing."
At some stage the bubble must burst. Many traders then try
to get out of their positions at the same time, causing illiquid
markets and huge losses. Volatility increases and the risk man­
agement procedures used within the financial institution (e.g.,
the calculation of market VaR from historical data) can cause
many financial institutions to try to unwind a wide range of
risky positions at the same time. This can lead to further losses
and more serious illiquidity problems. There may be failures
(or rumors of failures) by some banks. Most banks are likely to
experience liquidity funding problems and as a result lending
may be curtailed.
The classic example of what has been described above is the
subprime crisis that started in 2007. Other examples are the 1987
stock market crash, the 1994 bond market crash, the 1997-1998
Chapter 1 Liquidity Risk ■ 13
Asian monetary crisis, and the 1998 Long-Term Capital Manage­
ment failure. Irrational exuberance is part of human nature and to
some extent is inevitable. It is exacerbated by the way traders are
paid. A large part of the compensation comes from a bonus at
year-end, which depends on performance during the year. A trader
may be savvy enough to know that a market is irrationally exuber­
ant and that there will be a correction. However, if there is a good
chance that the correction will be delayed until next year, the trader
is motivated to continue building up his or her position to maximize
short-term compensation.
1.3.4 The Impact of Regulation
In many ways it is a laudable goal on the part of regulators to seek
to ensure that banks throughout the world are regulated in the
same way. Capital requirements and the extent to which they were
enforced varied from country to country prior to Basel I. Banks were
competing globally and as a result a bank subject to low capital
requirements, or capital requirements that were not strictly enforced,
found it easier to take risks and was therefore able to be more com­
petitive in the pricing of some products.
However, a uniform regulatory environment comes with costs. All
banks tend to respond in the same way to external events. Con­
sider for example market risk. When volatilities and correlations
increase, market risk VaR and the capital required for market
risks increase. Banks then take steps to reduce their exposures.
Since banks often have similar positions to each other, they try to
do similar trades. A liquidity black hole can develop.
There is a similar issue as far as credit risk is concerned. During
the low point of the economic cycle, default probabilities are rel­
atively high and capital requirements for loans under the Basel II
internal-ratings-based models tend to be high. As a result, banks
may be less willing to make loans, creating problems for small
and medium-sized businesses. During the high point of the busi­
ness cycle, default probabilities are relatively low and banks may
be too willing to grant credit. (This is similar to the phenomenon
described in Figures 1.2 and 1.3.) The Basel Committee has rec­
ognized this problem and has dealt with it by asserting that the
probability of default should be an average of the probability of
default through the economic or credit cycle, rather than an esti­
mate applicable to one particular point in time.
Should other financial institutions such as life insurance compa­
nies and pension funds be regulated in the same way as banks?
It is tempting to answer "yes" so that one financial institution
is not given an advantage over others. But the answer should
be "no." These financial institutions have longer time horizons
than banks. They should not be penalized for investing in illiq­
uid assets. Also, they should not be required to adjust their
14 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
portfolios when volatilities and correlations increase. These
parameters tend to be mean reverting and so they eventually
decrease again.
1.3.5 The Importance of Diversity
Models in economics usually assume that market participants act
independently of each other. We have argued that this is often
not the case. It is this lack of independence that causes liquid­
ity black holes. Traders working for financial institutions tend to
want to do the same trades at the same time. To solve the prob­
lem of liquidity black holes, we need more diversity in financial
markets. One way of creating diversity is to recognize that dif­
ferent types of financial institutions have different types of risks
and should be regulated differently.
Hedge funds have become important market participants. They are
much less regulated than banks or insurance companies and can
follow any trading strategy they like. To some extent they do add
diversity (and therefore liquidity) to the market. But, as mentioned
earlier, hedge funds tend to be highly leveraged. When liquidity
tightens as it did in the second half of 2007, all hedge funds have
to unwind positions accentuating the liquidity problems.
One conclusion from the arguments we have put forward is
that a contrarian investment strategy has some merit. If mar­
kets overreact for the reasons we have mentioned, an investor
can do quite well by buying when everyone else is selling and
there is very little liquidity. However, it can be quite difficult for
a financial institution to follow such a strategy if it is subject to
short-term VaR-based risk management.
SUM MARY
There are two types of liquidity risk: liquidity trading risk and
liquidity funding risk. Liquidity trading risk is concerned with the
ease with which positions in the trading book can be unwound.
The liquidity trading risk of an asset depends on the nature of
the asset, how much of the asset is to be traded, how quickly it
is to be traded, and the economic environment. The credit crisis
of 2007 emphasizes the importance of transparency. Assets that
are not well defined or well understood are unlikely to trade in
a liquid market for long. The liquidity of an asset at a particu­
lar time can be measured as the dollar bid-offer spread or as
the proportional bid-offer spread. The latter is the difference
between the bid and offer price divided by the average of the
bid and offer price. The cost of unwinding a position in the asset
is half of the bid-offer spread. Financial institutions should moni­
tor the cost of unwinding the whole trading book in both normal
market conditions and stressed market conditions.
A trader, when faced with the problem of unwinding a large posi­
tion in an asset, has a trade-off between the bid-offer spread and
market risk. Unwinding quickly leads to high bid-offer spreads, but
low market risk. Unwinding slowly leads to lower bid-offer spreads,
but more market risk. The optimal trading strategy depends on
(a) the dollar bid-offer spread as a function of the quantity traded
in a day and (b) the probability distribution for daily changes in
the asset price. For any particular unwind strategy, the trader can
choose a confidence level and calculate the unwind cost that will
not be exceeded with the confidence level. The unwind strategy
that minimizes this cost can then be determined.
Liquidity funding risk management is concerned with being able
to meet cash needs as they arise. It is important for a financial
institution to forecast its cash needs in both normal market con­
ditions and stressed market conditions to ensure that they can be
met with almost total certainty. Cash needs depend on deposi­
tor withdrawals, drawdowns on lines of credit, guarantees that
have been made, defaults by counterparties, and so on. Sources
of cash are instruments that can be readily converted into cash,
borrowings in the wholesale market, asset securitizations, new
depositors, cash itself, and (as a last resort) borrowings from a
central bank. In June 2008, bank regulators issued a list of
17 principles describing how banks should manage their liquidity
and indicated that they would be monitoring the liquidity man­
agement procedures of banks more carefully in the future.
The most serious liquidity risks arise from what are sometimes
termed liquidity black holes. These occur when all traders want
to be on the same side of the market at the same time. This
may be because they have similar positions and manage risks
in similar ways. It may also be because they become irrationally
exuberant, overexposing themselves to particular risks. What
is needed is more diversity in the trading strategies followed
by market participants. Traders who have long-term objectives
should avoid allowing themselves to be influenced by the short­
term over reaction of markets.
Further Reading
Almgren, R., and N. Chriss. "Optimal Execution of Portfolio
Transactions." Journal of Risk 3 (Winter 2001): 5-39.
Bangia, A., F. Diebold, T. Schuermann, and J. Stroughair.
"Liquidity on the Outside." Risk 12 (June 1999): 68-73.
Bank for International Settlements. "Liquidity Risk Management
and Supervisory Challenges," February 2008.
Bank for International Settlements. "Principles for Sound Liquid­
ity Risk Management and Supervision," September 2008.
Brunnermeier, M. K., and L. H. Pedersen. "Market Liquidity and
Funding Liquidity." Review of Financial Studies 22, no. 6 (2009):
2201-2238.
Brunnermeier, M. K, and L. H. Pedersen. "Predatory Trading."
Journal of Finance 60, no. 4 (2005): 1825-1863.
Clunie, J. Predatory Trading and Crowded Exits: New
Thinking on Market Volatility. Petersfield, UK: Harriman
House, 2010.
Persaud, A. D., ed. Liquidity Black Holes: Understanding, Quan­
tifying and Managing Financial Liquidity Risk. London: Risk
Books, 1999.
PRACTICE Q U ESTIO N S
AND PROBLEM S
1.1 What was the transparency problem in the subprime cri­
sis of 2007?
1.2 An asset is quoted bid 50, offer 55. What does this
mean? What is the proportional bid-offer spread?
1.3 Suppose that an investor has shorted shares worth
$5,000 of Company A and bought shares worth $3,000
of Company B. The proportional bid-offer spread for
Company A is 0.01 and the proportional bid-offer spread
for Company B is 0.02. What does it cost the investor to
unwind the portfolio?
1.4 Suppose that in Problem 1.3 the bid-offer spreads for
the two companies are normally distributed. For Com­
pany A the bid-offer spread has a mean of 0.01 and a
standard deviation of 0.01. For Company B the bid-offer
spread has a mean of 0.02 and a standard deviation of
0.03. What is the cost of unwinding that the investor is
95% confident will not be exceeded?
1.5 A trader wishes to unwind a position of 60 million units
in an asset over 10 days. The dollar bid-offer spread as
a function of daily trading volume, q, is a + becq where
a = 0.2, b = 0.1, and c = 0.08 and q is measured in mil­
lions. The standard deviation of the price change per day
is $0.1. What is the optimal strategy that minimizes the
95% confidence level for the costs?
1.6 Explain the difference between the liquidity coverage
ratio (LCR) and the net stable funding ratio (NSFR).
1.7 Why is it risky to rely on wholesale deposits for funding?
1.8 What was the nature of the funding risk problems of
Ashanti Goldfields and Metallgesellschaft?
Chapter 1 Liquidity Risk ■ 15
 1.9 What is meant by (a) positive feedback trading and
(b) negative feedback trading? Which is liable to lead to
liquidity problems?
1.10 What is meant by liquidity-adjusted VaR?
1.11 Explain how liquidity black holes occur. How can regula­
tion lead to liquidity black holes?
1.12 Why is it beneficial to the liquidity of markets for traders
to follow diverse trading strategies?
1.15 A trader wishes to unwind a position of 200,000 units in
FURTHER QUESTIONS
1.13 Discuss whether hedge funds are good or bad for the
liquidity of markets.
1.14 Suppose that a trader has bought some illiquid shares. In
particular, the trader has 100 shares of A, which is bid $50
16 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
and offer $60, and 200 shares of B, which is bid $25 and
offer $35. What are the proportional bid-offer spreads?
What is the impact of the high bid-offer spreads on the
amount it would cost the trader to unwind the portfolio?
If the bid-offer spreads are normally distributed with
mean $10 and standard deviation $3, what is the 99%
worst-case cost of unwinding in the future as a percent­
age of the value of the portfolio?
an asset over eight days. The dollar bid-offer spread, as
a function of daily trading volume q, is a + becq where
a = 0.2, b = 0.15, and c = 0.1 and q is measured in
thousands. The standard deviation of the price change per
day is $1.50. What is the optimal trading strategy for mini­
mizing the 99% confidence level for the costs? What is the
average time the trader waits before selling? How does
this average time change as the confidence level changes?
Liquidity and
Leverage
Learning Objectives
After completing this reading you should be able 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.
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.

Compare transactions used in the collateral market and Discuss interactions between different types of liquid­
explain risks that can arise through collateral market ity risk and explain how liquidity risk events can increase
transactions. systemic risk.

Describe the relationship between leverage and a firm's

return profile (including the leverage effect), and distin­
guish the impact of different types of transactions on a
firm's leverage and balance sheet.

Excerpt is Chapter 12 of Financial Risk Management: Models, History, and Institutions, by Allan M. Malz.

17
One of the most important aspects of the subprime crisis was
the sudden reluctance of financial institutions to lend money,
and the increased reluctance to borrow on the part of financial
as well as nonfinancial businesses and households, a develop­
ment called "The Great Deleveraging." It contributed to the
rapid decline in the market prices of risky assets and was self-
perpetuating. In this chapter, we try to disentangle the concepts
of liquidity and leverage. We give definitions of each, showing
how they are related.
The term "liquidity" has been defined in myriad ways that ulti­
mately boil down to two properties, transactions liquidity, a
property of assets or markets, and funding liquidity, which is
more closely related to credit-worthiness. Transaction liquidity
is the property of an asset being easy to exchange for other
assets. Most financial institutions are heavily leveraged; that
is, they borrow heavily to finance their assets, compared to
the typical nonfinancial firm. Funding liquidity is the ability to
finance assets continuously at an acceptable borrowing rate.
For financial firms, many of those assets include short positions
and derivatives.
As with "liquidity," the term "liquidity risk" is used to describe
several distinct but related phenomena:
Transaction liquidity risk is the risk of moving the price
of an asset adversely in the act of buying or selling it.
Transaction liquidity risk is low if assets can be liquidated
or a position can be covered quickly, cheaply, and with­
out moving the price "too much." An asset is said to
be liquid if it is "near" or a good substitute for cash.
An asset is said to have a liquidity premium if its price
is lower and expected return higher because it isn't
perfectly liquid. A market is said to be liquid if market
participants can put on or unwind positions quickly,
without excessive transactions costs and without
excessive price deterioration.
Balance sheet risk or funding liquidity risk. Funding
liquidity risk is the risk that creditors either withdraw
credit or change the terms on which it is granted in such
a way that the positions have to be unwound and/or
are no longer profitable. Funding liquidity can be put at
risk because the borrower's credit quality is, or at least
perceived to be, deteriorating, but also because financial
conditions as a whole are deteriorating.
Systemic risk refers to the risk of a general impairment
of the financial system. In situations of severe financial
stress, the ability of the financial system to allocate
credit, support markets in financial assets, and even
administer payments and settle financial transactions
may be impaired.
18 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
These types of liquidity risk interact. For example, if a counter­
party increases collateral requirements or otherwise raises the
cost of financing a long position in a security, the trader may
have to unwind it before the expected return is fully realized. By
shrinking the horizon of the trade, the deterioration of funding
liquidity also increases the transaction liquidity risk. The interac­
tion also works the other way. If a leveraged market participant
is perceived to have illiquid assets on its books, its funding will
be in greater jeopardy.
We begin our discussion of liquidity risk by discussing its credit
aspect, funding liquidity risk, and the ways in which this risk can
manifest itself, in more detail. Later sections discuss transactions
liquidity. The discussion of liquidity risk will provide important
background for understanding financial panics.
2.1 FUNDING LIQUIDITY RISK
Maturity Transformation
Funding liquidity risk arises for market participants who bor­
row at short term to finance investments that require a longer
time to become profitable. Many traders and investors, such as
banks, securities firms, and hedge funds, are largely short-term
borrowers, so their capacity to maintain long-term positions
and their flexibility when circumstances or expectations change
is limited. The balance-sheet situation of a market participant
funding a longer-term asset with a shorter-term liability is called
a maturity mismatch.
Managing maturity mismatches is a core function of banks
and other financial intermediaries. All financial and economic
investment projects take time, in some cases a very long time,
to come to fruition. To provide the needed capital, financial
intermediaries effect a maturity transformation and possi­
bly also a liquidity transformation; they obtain shorter-term
funding and provide longer-term funding to finance projects.
Funding longer-term assets with longer-term debt is called
matched funding.
Intermediaries engage in maturity mismatch because it is gener­
ally profitable. Every market participant has a cost of capital,
the rate of return on all its liabilities, including equity. The most
"expensive" capital is equity, because it takes the most risk;
it has no contractually stipulated remuneration and is the first
liability to bear losses. To convince providers of capital to place
equity with a firm, they must be promised a high expected
return. At the other end of the spectrum, short-term debt instru­
ments generally have lower required returns and contribute less
to the cost of capital, as long as the borrower's credit risk is per­
ceived to be low.
The spread between the interest intermediaries pay—their
funding cost—and the interest they earn is called the net interest
margin. Yield curves are typically upward sloping. Intermediaries
therefore have a powerful incentive to introduce maturity mis­
matches into their balance sheets. In the aftermath of economic
downturns and financial crises, the yield curve typically has a
sharper upward slope, increasing net interest margin, which
becomes an important part of banks' rebuilding following the
downturn.
Because short-term rates are generally lower than long-term
rates, there is a powerful incentive to borrow short-term if pos­
sible. Funding long-term assets with short-term debt exposes
an intermediary to rollover risk, the risk that the short-term debt
cannot be refinanced, or can be refinanced only on highly disad­
vantageous terms. In a rollover risk event, cash flow can become
negative. For example, an investor may be financing bonds with
short-term borrowing at a positive spread. If the debt cannot
be refinanced at an interest rate below the bond yield, negative
cash flow and losses result.
Funding conditions can change rapidly. A firm or investor can,
after a long period of short-term funding with positive cash
flow, suddenly find himself in a negative cash flow situation from
which there is no obvious escape if short-term funding is sud­
denly closed to him or its costs escalate. Because of this binary
character, rollover risk is sometimes called "cliff risk." The liquid­
ity condition of a market participant relying heavily on short­
term funding can reach a state of distress very quickly.
Liquidity Transformation
Intermediaries earn net interest margin from maturity transfor­
mation because short-term debt generally carries lower interest
than longer-term debt. Very short-term yields—money-market
rates—are almost invariably lower. But the short-term funding of
an intermediary is the short-term asset of the lender, and may
provide liquidity and payment services to the investor as well as
a flow of interest payments. Money-market instruments such as
short-term interbank loans to sound banks, commercial paper of
creditworthy issuers, repos with adequate haircuts, and govern­
ment bills, are not generally classified as money, but have cer­
tain characteristics of money. They can be readily exchanged for
cash, and roll off into cash within a short time. Short-term yields
are lower because short-term debt partially satisfies the need for
liquidity as well as having far less interest-rate risk.
The major exception to this general observation are short-term
interest rates on currencies in imminent danger of devaluation.
Because a discrete depreciation causes an instantaneous capital
loss to market participants long the currency, short-term yields
of currencies under pressure can rise to extremely high levels,
limited only by uncertainty about whether and when the depre­
ciation will take place.
Some forms of very short-term debt serve the means-of-
payment function of money, particularly those forms that are
checkable, that is, can be very easily transferred to a third party:
demand deposits and money market mutual fund (MMMF)
liabilities. These types of debt have even lower yields than can
be explained by their short maturities because of their useful­
ness as means of payment and settling debts. Providing liquidity
and payment services contributes to intermediaries' net interest
margin. The liquidity transformation bundled with maturity trans­
formation has long made banks more efficient intermediaries.
The process by which financial intermediaries use their balance
sheets to create assets that can be used as money goes back
to the origins of banking. Prior to the mid-1970s, this activity
was the almost exclusive province of commercial banks. Nowa­
days, the money supply is defined to include certain nonbank
liabilities such as those of MMMFs, as well as banknotes and
bank deposits. They have in common that, in contrast to other
short-term debt instruments, their values don't depend on
interest rates, and they can be used to buy both goods and
assets. To the extent that an asset has the characteristics of
immediacy and certainty, they resemble money and are said
to be liquid.
Deposit liabilities of banks were at one time the main form of
money not created by central banks. In the contemporary finan­
cial system, the core banking functions of maturity and liquidity
transformation are increasingly carried out by other means and
other institutions, such as the commercial paper markets and
MMMFs. With the introduction and growth of money market
funds, an important new type of short-term assets that could be
used as money was created. In the United States, retail MMMF
balances are included in the M2 measure of the money sup­
ply, accounting for roughly 10 percent of the total. Institutional
MMMF balances are about twice as large as retail, but are not
included in U.S. monetary aggregates.
Market participants hold money to conduct transactions and for
speculative reasons. In Keynes' well-known explanation of the
demand for money, balances held for the purpose of conduct­
ing transactions include a portion attributable to uncertainty
about the timing and volume of cash flows. But market partici­
pants also hold money out of a speculative motive which is a
function of current asset prices, especially interest rates, uncer­
tainty about future asset prices, and risk preferences. Keynes
denoted this motive as "speculative" because of his focus on
one of the key phenomena in financial crises, namely, asset-
price spirals in which market participants want to hold cash
Chapter 2 Liquidity and Leverage ■ 19
because they expect asset prices to be lower in the future, thus
driving prices lower in fact. 1
Uncertainty of value is a property even of assets that have mini­
mal credit risk, but mature in the future, such as U.S. Treasury
bills, because their values depend on interest rates. Interest rates
fluctuate, and affect the price even of short-term T-bills; hence
T-bills are not money. However, if, like T-bills, their interest-rate
risk is very low, and they also have little or no credit risk, they are
viewed as relatively liquid and thus close in character to money.
Keynes's term for the demand for money, liquidity preference,
has become particularly pertinent during the subprime crisis. In
normal times, the desire for liquidity is counterbalanced by the
zero or low yields earned by cash and liquid assets. In crises,
risk-aversion and uncertainty are high, so market participants
wish to hold a much larger fraction of their assets in liquid form,
and are relatively indifferent to the yield. In the terminology of
economics, the velocity of money declines drastically. Market
participants desire larger liquidity portfolios, they prefer cash to
money-market instruments, and become abruptly more sensitive
to even the relatively low credit and counterparty risk of instru-
9
ments other than government bills.
Bank Liquidity
The core function of a commercial bank is to take deposits and
provide commercial and industrial loans to nonfinancial firms.
In doing so, it carries out a liquidity and maturity, as well as a
credit, transformation. It transforms long-term illiquid assets—
loans to businesses—into short-term liquid ones, including
deposits and other liabilities that can be used as money.
Liquidity Transformation by Banks
Banks carry out their functions through operations on both sides
of the balance sheet. Prior to the advent of shadow banking
and the incursion of commercial banks into investment banking,
depository institutions generally earned most of their revenues
from net interest margin. In contemporary finance, banks earn
a higher proportion of revenues from origination, investment
banking, and other fees. They also have important revenues
from market making, that is, earning the bid-ask spread on
transactions executed for customers, and proprietary trading,
taking risky positions in assets with their own capital. But net
interest margin remains a crucial source of revenues.
1 In his typically memorable phrasing, these motives were the answer to
the question, "Why should anyone outside a lunatic asylum wish to use
money as a store of wealth?" (Keynes [1937], p. 216).
9
In the older economics literature, this urge is called hoarding.
20 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The balance sheet of a "classic bank," that is, one chiefly reliant
on deposits for funding, might look like this:
Assets Liabilities
Cash and government bonds $15 Common equity $10
5-year corporate loans $85 Deposits $90
Banks and similar intermediaries are depository institutions,
that is, institutions that borrow from the public in the form
of liabilities that must be repaid in full on demand, instantly,
in cash, on a first-come first-served basis. This aspect of the
deposit contract is called the sequential service constraint, and
contrasts sharply with bankruptcy, in which claims are paid pro
rata. Deposits pay zero or relatively low rates of interest, though
one of the main areas of financial innovation over the past few
decades has been in making it possible for lenders to earn inter­
est while still enjoying such benefits of liquidity as check-writing,
for example, in MMMFs.
Banks can also tap the broader capital markets and raise funds
by issuing bonds, commercial paper, and other forms of debt.
These sources of wholesale funding are, on the one hand, gen­
erally of longer term than deposits, which can be redeemed at
short notice. However, deposits are considered "sticky." Deposi­
tors tend to remain with a bank unless impelled to switch by a
life change such as moving house; bankers joke that deposi­
tors are more apt to divorce than remove deposits. Depositors
are also a naturally diversified set of counterparties, so a large
deposit base reduces reliance on a small number of lenders.
Shorter-term forms of wholesale funding such as commercial
paper are less reliable and potentially more concentrated
sources of longer-term liquidity than a solid deposit base.
These funding decisions are nowadays also heavily influenced
by regulatory capital requirements, which can favor or disfavor
particular types of assets and thus influence their funding costs
as liabilities.
The borrowing firms invest the loan proceeds in physical and
other capital. A span of time and many stages are needed, in
addition to the capital resources, before these projects produce
goods and services that can be sold to repay the loans that
finance them. Until then, the invested capital can be sold only at
a loss, so the firms cannot in general repay the loans in full prior
to maturity.
The bank could borrow at a longer term to match the maturity
of its assets, but this would reduce its net interest margin. The
bank would still be rewarded for another important set of bank­
ing functions, namely selecting worthy projects that are likely to
repay loans fully and timely, and monitoring borrowers' financial
condition and timely payment of principal and interest. And to
the extent that the banks' delegated monitoring function does
not produce added value, borrowers could turn directly to the
bond markets themselves.
The investments on the asset side of the bank's balance sheet
not only have longer terms to maturity than their liabilities, they
are also less liquid; deposits in contrast are very close substi­
tutes for cash. The liquidity transformation function of banks
has been described as "turning illiquid assets into liquid ones."
However, this transformation depends on confidence in the
bank's solvency.
How, then, can the liquidity and maturity transformations be
made to work? Only a small fraction of deposits and other short­
term funding are expected to be redeemed at any one time.
Banks engage in asset-liability management (ALM). This is a
technique for aligning available cash and short-term assets with
expected requirements. A well-managed bank leaves an ample
buffer of cash and highly liquid assets for unexpected redemp­
tions of deposits and other funding.
Fragility of Commercial Banking
The classic depository institution we have been describing is a
fractional-reserve bank, that is a bank that lends deposits. The
alternative to a fractional-reserve bank is a 1 0 0 percent reserve
bank, which lends only its own capital, or funds raised in capital
markets, and keeps a reserve of cash and highly liquid securities
equal to its entire deposit base. Throughout the history of bank­
ing, almost all banks have been fractional-reserve banks. Bank­
ing originated in the Low Countries, and a bit later in Italy, in
the thirteenth century. In its earlier stages, customers of banks
deposited money in the form of gold and silver coin for safe­
keeping. The warehouse receipts the bank issued as evidence
of a deposit could be used as money, as long as the bank was
trusted to return the coin on demand, and receipts were easier
and safer to transport and exchange.
As long as warehouse receipts were issued only against the coin
brought to the bank for safekeeping, commercial loans could
only be made with the owners' equity or with capital-market
borrowing. Eventually, banks discovered that they could issue
warehouse receipts, and later private banknotes, in a greater
volume than the amount of coin deposited with them; that is,
loans were made by issuing banknotes. In a fractional-reserve
banking system, if depositors wish to make withdrawals in
excess of a bank's reserves, and the bank cannot liquidate
enough loans or other assets to meet the demand immediately,
it is forced into suspension of convertibility; that is, it will not be
able to convert its deposits and notes into money immediately.
At the extreme, all or a large number of depositors may ask
for the return of their money simultaneously, an event called a
bank run. Depositors and other short-term creditors are aware
the banks cannot meet large-scale redemption requests. If they
are concerned about banks' liquidity, they will endeavor to
redeem before other depositors and lenders.
No asset-liability management system can protect a fractional-
reserve bank against a general loss of confidence in its ability to
pay out depositors. As long as the bank carries out a liquidity
and maturity transformation, and has liabilities it is obligated to
repay at par and on demand, no degree of liquidity that a bank
can achieve can protect it completely against a run. Fragility can
be mitigated through higher capital, which reduces depositors'
concern about solvency, the typical trigger of a run, and higher
reserves, which reduces concern about liquidity. Historically,
banks have also protected themselves against runs through
individual mechanisms such as temporary suspension of convert­
ibility, and collective mechanisms such as clearing-houses.
Because banking is fragile, there have from time to time been
calls to abolish traditional, deposit-dependent commercial bank­
ing, and replace it with a more robust type of financial institu­
tion. An alternative view is that depository institutions must be
restricted in their activities and closely supervised to prevent
them from taking risks that could jeopardize their ability to meet
withdrawals. Under the rubric "Volcker Rule," it has been incor­
porated in the regulatory restructuring mandated by the 2 0 1 0
Dodd-Frank Act.
Apart from deposits, banks are generally dependent on short­
term financing, exposing them to rollover risk events that,
while less extreme than runs, can be costly or increase fragility.
Commercial banks' main source of funding is deposits; in the
United States, deposits account for about 60 percent of banks'
liabilities. Banks rely on capital markets for much of the rest of
their funding. Commercial paper is an important component
and accounts for roughly 1.5 percent of U.S. banks' liabilities.
The commercial paper market in the immediate aftermath of
the Lehman bankruptcy provides an example of how quickly
funding conditions can change, and of the fragility of bank
funding. The upper panel of Figure 2.1 displays the volume
outstanding of commercial paper by AA-rated financial firms, a
category comprised mostly of banks, but also including nonbank
intermediaries such as GE Capital. Financial firms' issuance of
commercial paper had grown rapidly between 2004 and the
end of 2007, as their leverage and balance-sheet expansion
increased. The amount borrowed via commercial paper became
more volatile, but continued to grow, as banks sought to finance
previously off-balance-sheet assets and credit lines they granted
earlier were drawn upon. Commercial paper borrowing declined
precipitously following the Lehman bankruptcy, as it could no
longer be placed.
C h ap ter 2 Liquidity and Leverage ■ 21
 The Federal Reserve intervened following the
Lehman bankruptcy and amid subsequent fears
0.8 -
of a run on MMMFs to support liquidity via the
Commercial Paper Funding Facility (CPFF), which
purchased commercial paper from issuers unable
0.7 -
to roll paper over, and the Asset-Backed Commer­
cial Paper Money Market Mutual Fund Liquidity
0.6 -
Facility (AMLF), which lent to financial institutions
purchasing ABCP from MMMFs.

0.5 -
Structured Credit and
2002 2004 2006 2008 2010
Off-Balance-Sheet Funding
Structured credit products per se do not face
funding liquidity problems, as they are maturity
matched. Asset-backed securities (ABS), mortgage-
0.8 based securities (MBS), and commercial mortgage-
based securities (CMBS) themselves primarily carry
out a credit and liquidity, rather than a maturity
0.6 -

transformation. They can be viewed as providing

matched funding for the assets in the collateral
pool. The securities issued typically include at least
0.4 -
some longer-term bonds.
h ini i ;• ; \WH\A Mv The way the securitization liabilities themselves
0.2
are financed by investors can, however, introduce
-

r liquidity risk. The difficulties experienced by securi­

L_L
2002 2004 2006 2008 2010 tization have been related not only to the question­
able credit quality of underlying assets such as real
Fiqure 2.1 Short-term commercial paper of financial institutions.
estate loans. Prior to mid-2008, the liabilities were
Upper panel: Amount outstanding of AA financial commercial paper, weekly, beginning held substantially by investors relying on short-term
of 2001 to end-April, 2011, trillions of US$.
financing, increasing the fragility of the financial
Lower panel: Shares (summing to 1) of total dollar amount issued of AA financial com­
mercial paper with original maturities between one and nine days (solid line, marked system.
"<10 days") and maturities of 10 days or more (dashed line, marked ">10 days"), weekly.
The short-term financing of securitizations played a
Source: Federal Reserve Board, available at www.federalreserve.gov/releases/cp/. crucial role in the subprime crisis and in the opaque
increase in financial system leverage prior to the
The lower panel displays the shares in total issuance of shorter- subprime crisis. There were two major forms of such financing,
and longer-term commercial paper. With the onset of the securities lending, the use of structured credit products as col­
subprime crisis, financial firms attempted to reduce the volume of lateral for short-term loans, which we discuss in detail later in
both, and to "term out" the issuance, that is, increase the average this chapter, and off-balance-sheet vehicles.
term of the smaller total. The share of very short-term paper in
Like securitizations themselves, off-balance-sheet vehicles are
total issuance declined from about 80 to about 60 percent during
"robot companies" or special-purpose vehicles (SPVs) that are
the 18 months preceding the Lehman bankruptcy. After the
defined by their assets and liabilities. They issue asset-backed com­
Lehman event, banks faced difficulty in rolling over longer-term
mercial paper (ABCP), which, in contrast to most commercial paper,
commercial paper, and more generally in obtaining funding with
is secured rather than unsecured debt. The two major types are:
maturities of more than a few weeks. The share of very short-term
issuance rose dramatically, to near 90 percent, as financial firms 1. Asset-backed commercial paper conduits purchase vari­
had few other alternatives. The European debt crisis had a simi­ ous types of assets, including securities as well as whole
lar, but more muted, impact in the spring of 2010. The funding loans and leases, and finance the assets by issuing ABCP.
difficulty was reflected also in the Libor-OIS spread. They typically enjoy explicit credit and liquidity support

22 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 from the sponsors in the form of credit guarantees and
liquidity support should the conduit be unable to roll over
the debt. Because of the guarantees, ABCP conduits gener­
ally have little equity.
2. Structured investment vehicles (SIVs) are similar to ABCP
conduits in some respects, but differ in the crucial matter
of credit and liquidity support. SIVs typically did not enjoy
full explicit support by sponsors. They invested primarily
in highly rated securitized credit products, and to a lesser
extent in whole loans. Their funding mix was also generally
somewhat different from that of ABCP conduits. In addi­
tion to ABCP, many SIVs issued medium-term notes (MTNs),
which are at least somewhat less vulnerable to rollover risk.
They also typically had larger equity cushions.
In spite of their differences, the two types were economically simi­
lar in many ways. Both types of vehicles profited from the spread
between the asset yields and the funding cost. Another similarity
is their economic function of maturity and liquidity transformation.
The assets in the vehicles have longer, and possibly much longer,
maturities than the commercial paper with which they are funded.
This is typical for a bank; indeed, this maturity intermediation is
the essence of what a bank does. However, instead of carrying
out this function on its own balance sheet, the sponsoring bank
has been able to reduce its balance sheet and its regulatory capi­
tal, while still deriving the economic benefits.
The vehicles also carried out liquidity transformation, creating
ABCP, which is not only a much shorter-term, but, until the sub­
prime crisis, was a more liquid asset than the underlying assets
in the conduit or SIV. The final step in the liquidity transforma­
tion was the purchase of ABCP and money-substitute creation
by MMMFs.
These financial innovations were accompanied and enabled by
changes in regulatory capital and accounting rules that permit­
ted firms to hold less capital against given levels of economic
risk. The use of these vehicles did not lead to bona fide risk
transfer. Even in the absence of explicit guarantees, sponsors
that were large intermediaries felt obliged to provide support
or assume the assets onto their balance sheets when the ABCP
could no longer be rolled over. In spite of the fact that the vehi­
cles were off-balance-sheet from an accounting and regulatory
perspective, they contributed greatly to the leverage and fragil­
ity of the sponsors, largely banks.
Funding Liquidity of Other Intermediaries
Depository institutions and MMMFs are at an extreme position,
because they must repay depositors instantly on demand. But
other types of financial intermediaries face similar problems.
These examples focus on the liquidity risk events they experi­
enced during the subprime crisis.
Securities Firms
Securities firms hold inventories of securities for sale, and
finance them by borrowing at short term. The collapse of Bear
Stearns in March 2008 was an extreme case of a securities firm's
lenders abruptly withdrawing credit. Bear Stearns, like other
large broker-dealers, had relied to a large extent on short-term
borrowing. Bear was particularly dependent on free cash depos­
its of the firm's large base of brokerage and clearing customers,
including many hedge funds. These cash deposits were often
collateralized, but generally not by better-quality collateral.
Hedge funds withdrew deposits—and their business—rapidly
towards the end of Bear's existence, in what was essentially a
run. Bear also issued MTNs and commercial paper to fund its
activities. We discuss these forms of borrowing in more detail
later in this chapter.
Money Market Mutual Funds
MMMFs provide instant liquidity for their investors by giving
them the ability to draw on their accounts via checks and
electronic bank transfers. MMMFs are designed to invest in
money market securities of high credit quality with just a few
weeks or months to maturity. In this design, the market and
credit risks of the assets are low, but still material. The assets
can fluctuate in value, so the ability to offer unlimited instanta­
neous withdrawals is potentially limited if asset values fall. They
are thus similar to banks in that their investments are less liquid
than their liabilities. The liabilities of an MMMF are, however,
quite different from those of banks. The account holders' claims
are not first-priority unsecured debt, like those of bank deposi­
tors, but rather equity. A further structural feature is therefore
required for these liabilities to become money substitutes.
MMMFs are similar in many ways to other mutual funds, which
are organized in the United States under the Investment
Company Act of 1940. This permits the instantaneous with­
drawal of equity. But in contrast to other mutual funds, equity
is not added or withdrawn at a fluctuating market-determined
net asset value (NAV). Under the U.S. Securities and Exchange
Commission's (SEC) Rule 2a-7, they are permitted to use a
form of accounting, the "amortized cost method," that further
reduces the tension—in normal times—between instant with­
drawal and fluctuating asset value. The rule permits MMMFs to
use the historical or acquisition cost of the money-market paper
they purchase, plus any accrual gains. The reasoning is that, as
long as the short-term debt is expected to be redeemed at par
within a short time, it is not necessary to revalue it in response
to fluctuations in interest rates and credit spreads. Because the
Chapter 2 Liquidity and Leverage ■ 23
paper is short-term, these fluctuations are likely in any case to
be relatively small.
Other mutual funds must mark assets to market each day. This
daily NAV is the price at which investors can contribute and
withdraw equity. MMMFs, in contrast, are able to set a notional
value of each share equal to exactly $ 1 . 0 0 , rather than an
amount that fluctuates daily. The residual claim represented by
the shares is paid the net yield of the money market assets, less
fees and other costs. MMMF shares thereby become claims on
a fixed nominal value of units, rather than proportional shares
of an asset pool. Their equity nature is absorbed within limits by
fluctuations in the net yield.
This structure only works if market, credit, and liquidity risks are
managed well. Some losses cannot be disregarded under the
amortized cost method, particularly credit writedowns. These
losses can cause the net asset value to fall below $ 1 . 0 0 , a phe­
nomenon called "breaking the buck."
Liquidity risk can also jeopardize the ability of an MMMF to
maintain a $1.00 net asset value. In this respect, it is much like
a classic commercial bank, and similarly vulnerable to runs. If a
high proportion of shareholders attempt to redeem their shares
simultaneously under adverse market conditions, the fund may
have to liquidate money market paper at a loss, forcing write­
downs and potentially breaking the buck. An episode of this
kind involving credit writedowns by an MMMF, the Reserve
Fund, was an important event in the subprime crisis.
Hedge Funds
Hedge funds face liquidity risk all through their capital struc­
tures. In contrast to the equity capital of corporations, which
may be traded but not withdrawn, but much like mutual fund
investments, hedge fund capital can be redeemed. Hedge funds
permit investors to withdraw their funds at agreed intervals.
Quarterly withdrawals are the rule, though some funds have
annual and a very small number of monthly withdrawals. These
withdrawal terms, colloquially called the "liquidity" of the fund,
are subject in general to additional restrictions called "gates,"
that permit a suspension or limitation of withdrawal rights if
investors collectively request redemptions in excess of
some limit. 3
The potential extent of liquidity demands by investors is
shown in the decline in assets under management by hedge
funds during the subprime crisis; the decline in assets was a
result of both investment losses and redemptions of capital.
3 Similar mechanisms have been used by commercial banks; for example
in eighteenth-century Scotland, to limit the impact of bank runs by
depositors in the absence of public-sector deposit insurance.
24 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
These redemptions hit not only those hedge funds experiencing
or expected to experience large losses. Redemption requests
were submitted also to hedge funds that were profitable or
had low losses. Investors sought at the onset of the crisis to
marshal cash balances from all possible sources, among which
were intact hedge fund investments. Hedge funds were obliged
to liquidate assets, or impose barriers to redemptions so far as
offering documents permitted. Hedge funds were in essence
being asked to become liquidity providers to investors, a func­
tion for which they are not well-designed and were never
intended, rather than to the markets.
Like other intermediaries, hedge funds also face short-term
funding risk on their assets. Hedge funds typically have no
access to wholesale funding and rely entirely on collateral mar­
kets, short positions, derivatives, and other mechanisms we
describe below to take on leverage.
Systematic Funding Liquidity Risk
Funding liquidity is a latent risk factor in major corporate finan­
cial transactions. A dramatic example are leveraged buyouts
(LBOs). LBOs are generally financed by large loans, called lever­
aged loans. As LBOs and private equity funds grew, leveraged
loans became the dominant type, by volume, of syndicated
loans, originated by banks, but distributed to other inves­
tors and traded in secondary markets. Many leveraged loans
became part of CLO pools, and tranches of CLOs were impor­
tant in CDO pools. The shadow banking system and the "CDO
machine" were important providers of funding to private equity
and LBOs. Other corporate events, such as mergers and acquisi­
tions, are also dependent on financing.
The funding liquidity risk in corporate transactions is both idio­
syncratic and systematic. Funding for a particular LBO or merger
might fall through, even if the deal would otherwise have been
consummated. But funding conditions generally can change
adversely. This occurred in mid-2007 as the subprime crisis took
hold. Many LBO and merger deals fell apart as financing came
to a halt. Banks also incurred losses on inventories of syndicated
loans, called "hung loans," that had not yet been distributed to
other investors or into completed securitizations. As risk aver­
sion and demand for liquidity increased, the appetite for these
loans dried up, and their prices fell sharply.
Apart from providers of financing, other participants in these
transactions, such as hedge funds involved in merger arbitrage,
also experienced losses. Mergers typically result in an increase in
the target acquisition price, though not usually all the way to the
announced acquisition price, and in a decrease in the acquirer's
price, since the acquirer often takes on additional debt to
finance the acquisition. Merger arbitrage exploits the remaining
gap between the current and announced prices. The risk arises
from uncertainty as to whether the transactions will be closed. In
the early stages of the subprime crisis, merger arbitrage strate­
gies generated large losses as merger plans were abandoned
for lack of financing.
Investors taking on exposure to such transactions are therefore
exposed not only to the idiosyncratic risk of the deal, but to the
systematic risk posed by credit and funding conditions generally.
This risk factor is hard to relate to any particular time series of asset
returns. Rather, it is a "soft factor," on which information must be
gathered from disparate sources ranging from credit and liquidity
spreads to quantitative and anecdotal data on credit availability.
Systematic funding liquidity risk is pervasive. Other asset
types or strategies that are good examples of sensitivity to the
"latent" factor of economy-wide financing conditions include
real estate, convertible bonds, and statistical arbitrage. Real
estate is one of the longest-lived assets. Mortgages—loans
collateralized by real estate—are therefore traditionally and
most frequently originated as long-term, amortizing, fixed-rate
loans. The typical home mortgage, for example, is a 30-year
amortizing, fixed-rate loan. When lending practice departs from
this standard and shorter-term loans predominate, lenders and
borrowers both face funding liquidity risk, as borrowers are
unlikely to be in a position to repay unless they can refinance.
This risk is primarily systematic, as it is likely to affect all borrow­
ers and lenders at the same time.
Convertible bond prices are generally only slightly lower than
their theoretical prices based on the replicating
portfolio of plain-vanilla equity options and bonds
that should mimic convert bonds' values. Traders,
many of them at hedge funds and dependent on
credit extended by broker-dealers, take advantage
of this gap to earn excess returns. The strategy is
only attractive with leverage, as it has relatively low
unlevered returns, but is generally also relatively
low-risk given the arbitrage relationship between
the convert bonds and the replicating portfolio.
develops an aversion to the product during a period of market
stress, it is difficult to move the product smoothly into new
hands without large price declines.
Figure 2.2 displays a measure of arbitrage opportunities in
the convertible bond market: the cheapness of bonds to their
theoretical replicating portfolios. At the height of the pre-crisis
boom, the gap had not only disappeared, but became negative.
In a sense, investors were overpaying for the package in their
search for yield. As the subprime crisis evolved, the positive
discount to theoretical was first reestablished, and eventually
widened to an unprecedented extent. Viewed from a different
angle, under conditions of severe liquidity stress, even a large
gap between convert prices and their replicating portfolio did
not bring arbitrage capital into the market.
A similar problem occurred for securitized credit products in the
fall of 2008. The clientele for the bonds had relied to a large
extent on short-term finance via repo, SIVs, and other mecha­
nisms. When financing for the SIVs disappeared, a new inves­
tor base for the bonds could not be established quickly, and
spreads on securitized credit products widened dramatically.
A final example is statistical arbitrage. Like convert arbitrage,
statistical arbitrage requires some degree of leverage for profit­
ability. In August 2007, as the subprime crisis got underway, one
of its first effects was on statistical arbitrage strategies. Curtail­
ing the liquidity of these strategies caused losses and return
volatility that were extremely far outside the range of historical
experience. In fact, this episode was one of the first overt signs
of how severe the crisis could potentially become.

Convert returns do, however, have a systematic

extreme-loss risk. When the financing becomes
unavailable because of credit conditions in the
economy, converts cheapen dramatically. This
effect is compounded by redemptions from 1995 2000 2005 2010
convertible-bond funds, compounding the funding
Fiaure 2.2 Convertible bond cheapness.
iquidity problem with a market liquidity problem.
Difference between theoretical and market prices of convertible bonds in the Merri
These episodes of convert bond illiquidity also Lynch All U.S. Convertibles Index (VXA0), weekly through 1997 and daily through July
illustrate the effect of concentrated positions. 2010, in percent. The theoretical price is the value of the replicating portfolio, taking the
credit, risk-free rates, and the embedded option into account.
Convertible bonds have a limited "clientele"
among investors. When the existing clientele Source: Bank of America Corp.

Chapter 2 Liquidity and Leverage ■ 25

2.2 M ARKETS FO R CO LLATERAL
Markets for collateral are formed when securities are used as
collateral to obtain secured loans of cash or other securities. The
loans are used to finance securities holdings or otherwise invest,
often as part of a larger trade. Securities used as collateral "cir­
culate," since the borrower of securities can typically lend them
to another, a practice called rehypothecation or repledging of
collateral. In this way, the supply of securities that can be used
as collateral is an important element in facilitating leverage in
the financial system.
Collateral has always played an important role in credit transac­
tions by providing security for lenders and thus ensuring the
availability of credit to borrowers. The role of collateral has
changed and expanded in contemporary finance, hand in hand
with the development of securitization, but also with the grow­
ing volume and transactions liquidity of securities trading.
The obvious and direct effect of securitization is to remove
credit intermediation from the balance sheets of financial
intermediaries. However, it also creates securities that can be
pledged as collateral in further credit transactions. Securities
have additional economic value to the extent that they not only
throw off cash flows and may appreciate in value, but can be
used as collateral to obtain credit.
Collateral markets are an important institutional element sup­
porting the growth of nonbank intermediation. Participants in
these markets include:
• Firms such as life insurance companies may own portfolios of
high-quality securities that can be used as collateral to bor­
row cash at the low interest rates applicable to well-collater­
alized loans. The motivation is to borrow cash at a low rate,
which it can then reinvest, earning a spread.
• Firms such as hedge funds have inventories of securities that
they finance by pledging the securities as collateral. The
motivation is to obtain financing of the portfolio at a lower
rate than unsecured borrowing, if the latter is available at all.
• Firms may have excess cash that they are willing to lend
out at a low interest rate, as long as they are appropriately
secured by collateral.
The securitization process relied heavily on rating agencies to
create bonds "with the highest credit rating," which could then
be lent, repoed out, or pledged as collateral by their owners.
Structure of Markets for Collateral
Firms can borrow or lend collateral against cash or other securi­
ties. A haircut ensures that the full value of the collateral is not
26 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
lent. A haircut of 10 percent, for example, means that if the bor­
rower of cash wants to buy $ 1 0 0 of a security, he can borrow
only $90 from the broker and must put $10 of his own funds in
the margin account by the time the trade is settled. Similarly,
the lender of cash will be prepared to lend $90 against $100 of
collateral.
Borrowing may be at short term, such as overnight, or for longer
terms. Overnight borrowing may be extended automatically
until terminated. As the market value of the collateral fluctuates,
variation margin may be paid. Most collateralized borrowing
arrangements provide for such remargining. The total margin at
any point in time, if adequate, provides a liquidation cushion to
the lender. If, for example, the loan has a maturity of (or cannot
be remargined for the duration of) one week, a 1 0 percent hair­
cut ensures that the value of the securities held as collateral can
fall 10 percent and still leave the loan fully collateralized. The
variation margin protects the lender of cash against fluctuations
in the value of the collateral.
Markets for collateral have existed for a long time in three basic
forms that are economically very similar, although they differ in
legal form and market practice.
Margin Loans
Margin lending is lending for the purpose of financing a security
transaction in which the loan is collateralized by the security. It is
generally provided by the broker intermediating the trade, who
is also acting as a lender. Margin lending is generally short term,
but rolled over automatically unless terminated by one of the
counterparties.
Collateralization for the loan is achieved by having the broker
retain custody of the securities in a separate customer account,
but in "street name," that is, registered in the name of the
broker rather than in the name of the owner. This simplifies the
process of seizing the securities and selling them to cover the
margin loan if it is not repaid timely. But registration in street
name also lets the broker use the securities for other purposes,
for example, lending the securities to other customers who want
to execute a short sale.
In practice, the most important purpose for which the broker
is likely to use the customer's collateral is to borrow money in
the secured money market to obtain the funds it lends to mar­
gin customers. The repledged securities become the collateral
for a margin loan to the broker, and the collateral is moved to
the broker's customer account with its creditor. Collateral may,
however, also be repledged in order to borrow another security
rather than cash collateral. This will typically be done in order
to short the borrowed security or to facilitate a client's short
position. In extreme market conditions, such as the subprime
crisis, the practice of rehypothecation of securities can become
quite important, as it introduces additional risk for the broker's
customers.
In the United States, initial haircuts on equity purchases are set
at 50 percent by the Federal Reserve Board's Regulation T ("Reg
T"), but, as we will see, derivatives can be used to increase the
amount implicitly borrowed. Many transactions occur outside
U.S. jurisdiction in order to obtain lower haircuts.
Reg T governs initial margin for common stock and other listed
securities. After a position is established, the margin will be
adjusted as the value of the security fluctuates. As the market
value of a long position declines, the broker loses the protection
the collateral provides against the customer defaulting on the
margin loan, so he will issue a margin call to the customer. Most
customers have portfolios of long and short positions in cash
securities, so cross-margining agreements are put in place to
govern the net margin assessed.
Repurchase Agreements
Repurchase agreements or repos are matched pairs of the
spot sale and forward repurchase of a security. Both the spot
and forward price are agreed now, and the difference between
them implies an interest rate. The collateralization of the loan
is achieved by selling the security temporarily to the lender.
The collateralization is adjusted for the riskiness of the security
through the haircut.
Repos are also a fairly old form of finance, but have grown sig­
nificantly in recent decades. More significantly, the range of col­
lateral underlying repos has widened. At one time, repo lending
could be secured only by securities with no or de minimis credit
risk. A few decades ago, repo began to encompass high-yield
bonds and whole loans, and more recently, structured credit
products. It has been a linchpin of the ability of large banks and
brokerages to finance inventories of structured credit products,
facilitated also by extending high investment-grade ratings to
the senior tranches of structured credit products such as ABS
and CDOs.
The mechanics of repo lending are similar to margin loans. Like
margin lending, repo creates a straightforward liability on the
economic balance sheet. However, under certain circumstances,
such as back-to-back security lending and borrowing for cus­
tomers, transactions can be combined so as to permit the gross
economic exposure to remain off-balance-sheet.
Securities Lending
In a securities lending transaction, one party lends a security to
another in exchange for a fee, generally called a rebate. The
security lender, rather than the borrower, continues to receive
dividend and interest cash flows from the security. A common
type of securities lending is stock lending, in which shares of
stock are borrowed.
As in repo transactions, the "perfection" of the lien on the col­
lateral is enhanced by structuring the transaction as a sale, so
that the lender holding the collateral can rehypothecate it or, in
the event that the loan is not repaid, sell it with minimal delay
and transactions costs.
There are a few typical patterns of securities lending:
• In a stock lending transaction, the source of the securities is
a large institutional investor in equities or a hedge fund. The
investor makes the equities available for lending by hold­
ing them at the custodian or prime broker in "street name,"
so that they can be rehypothecated to a trader who wishes
to sell the securities short. The owner receives a rebate
in exchange. A securities lending transaction is generally
"born" on the broker's balance sheet; that is, the securities
are already in a margin account when a customer indicates a
desire to go short.
• A typical fixed-income securities lending transaction aims to
earn a spread between less- and more-risky bonds. The trans­
action would again typically start with an institutional inves­
tor in, say, U.S. Treasury or agency bonds that can be used
as collateral for a short-term loan at a rate lower than other
money-market rates, and a low haircut. The investor receives
cash collateral in exchange for the loan of the Treasury
bonds. The cash can then be used to invest in other, higher-
yielding securities.
Much securities lending is carried out via agency securities
lending programs, whereby a third party, usually a large broker-
dealer, or a custodial bank with many institutional clients (e.g.,
State Street), intermediates between the lender and borrower of
securities.
Total Return Swaps
The ability to short equities depends on the ability to
borrow and lend stock. An important instrument of many
short stock trades are total return swaps (TRS), in which one
party pays a fixed fee and receives the total return on a
specified equity position on the other. TRS are OTC deriva­
tives in which one counterparty, usually a bank, broker-dealer
or prime broker, takes on an economic position similar to
that of a stock lender, enabling the other counterparty, often
a hedge fund, to establish a synthetic short stock position,
economically similar to that of a borrower of stock. The
broker then needs either to lay off the risk via a congruent
opposite TRS, or to hedge by establishing a short position in
the cash market.
Chapter 2 Liquidity and Leverage ■ 27
Economic Function of Markets
for Collateral
There are two main purposes served by collateral markets. First,
they create the ability to establish leveraged long and short
positions in securities. Without these markets, there would be
no way to short a cash security; short positions could only be
created synthetically.
Second, collateral markets enhance the ability of firms to borrow
money. In collateral markets, cash is just another—and not
necessarily the primary—asset to be borrowed and lent, along­
side securities of all types, hence the term "cash collateral."
It helps in understanding the risks of securities lending and
its role in the financial system to flesh out how it is embed­
ded in and has supported a number of important activities in
finance. Repo and securities lending are mechanically distinct,
but economically similar. They both enable market participants
to finance assets with borrowed funds using the assets as
collateral. They are both structured in such a way that the party
investing in the assets appears to have "borrowed" the assets,
though economically having bought them. However, in a repo
transaction, the assets are financed directly, while in a securi­
ties lending transaction, the investor starts off owning liquid
assets that are "good currency" and can be used to obtain
cash collateral with a relatively low haircut. The investor can
then step forward as a lender of cash against the securities in
which he wants to invest, or as an outright buyer, rather than,
as would be the case in a repo, as a borrower of cash to pur­
chase the securities.
Fixed-income securities lending, like repo programs, has histori­
cally functioned primarily as a source of short-term financing for
financial firms, and as an additional source of revenue for institu­
tional investors and insurance companies. In more recent years,
it has been an important element facilitating credit creation in
the bank and nonbank intermediation systems. It supported
the "manufacturing system" for securitized credit products.
The ability to finance positions in securitized credit products
via securities lending made the bonds more marketable and
increased their value, that is, decreased their required credit
spreads. These programs also provided a channel through which
firms using cash collateral to invest in higher-risk bonds could
increase leverage and returns.
Different forms of collateral markets serve different trading
motivations, but these forms are economically so similar that no
hard-and-fast distinctions can be drawn:
• Margin lending, the simplest form of a market for collateral,
is primarily used by investors wishing to take leveraged long
positions in securities, most often equities.
28 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
• Reverse repo transactions are similar, in that they are often
used to finance long positions in securities, typically bonds.
Repo transactions, in contrast, are usually intended to borrow
cash by owners of bonds.
• However, in some instances, a repo or reverse repo transac­
tion is focused on the need of one counterparty to establish
a long position in a particular security. An important example
is the U.S. Treasury specials market, in which a scarcity arises
of a particular bond. The mechanism by which the market is
cleared is a drop in the implied interest rate for loans against
a bond "on special," which can become zero or even nega­
tive. Recently issued U.S. Treasury notes typically go on spe­
cial when dealers sell them to customers prior to the issue
date on a when-issued basis, and have underestimated the
demand. Following the next U.S. government bond auction,
when the bond is issued, the dealer must borrow it to deliver
to the customer at a penalty rate, expressed in the cheap
rate at which the dealer must lend cash collateral to borrow
the security.
• Securities lending has typically been focused on the securi­
ties rather than the cash collateral, typically to establish short
positions. In recent years, the focus of their use has shifted to
borrowing cash collateral.
High-quality bonds that can be readily used as collateral com­
mand higher prices than bonds that cannot be used in this way.
This creates additional demand for high-quality collateral; their
utility as collateral adds to the value of securitized credit prod­
ucts, and provided an additional incentive to create them.
Collateral markets bring owners of securities, such as institu­
tional investors and insurance companies, into the financing
markets. They lend their securities to earn extra return. Whether
through repo or securities lending, they earn an extra return by
making their securities available for other market participants to
use as collateral.
A crucial element in permitting bonds to serve as collateral is
their credit quality. Credit-rating agencies are important partici­
pants in collateral markets because of the need for highly rated
bonds. Conversely, awarding high ratings to lower-quality bonds
added a large volume of collateral to these markets that evapo­
rated almost overnight during the subprime crisis.
These markets grew tremendously in volume in the years
preceding the subprime crisis, as the range and amount of
collateral that could be lent expanded. Figure 2.3 shows net
repo market borrowing by U.S. broker-dealers. The volumes
displayed in the graph are likely much smaller than the gross
amounts. Reported balance sheet volumes understate the
volume of repo lending and the amount of leverage intro­
duced into the financial system by excluding transactions in

Net liabilities under security repurchase agreements of U.S. broker-dealers, billions
of dollars.
Source: Federal Reserve Board, Flow of Funds Accounts of the United States (Z. 1),
Table L.129.
which a dealer hypothecates one security in order to borrow
a different security. Broker-dealers carry out a large volume of
such transactions on behalf of customers. Net repo use more
than tripled between mid-2004 and its peak in mid-2007.
During the subprime crisis, net repo liabilities contracted by
about two-thirds. The three-year spike is likely due in large
part to the expansion in use of non-Treasury securities as
collateral and the growth in hedge fund funding business,
which we now briefly discuss.
Prime Brokerage and Hedge Funds
Much of the growth in volume in collateral markets is intermedi­
ated through prime brokers, subsidiaries of large banks and bro­
ker dealers that have emerged as important service providers to
the hedge fund industry. They serve as a single point of service
that provides trading, clearing, custody, financing, and other
services. In some cases, prime brokers have been involved in the
hedge fund business itself through "capital introduction," that
is, arranging contact between funds and potential investors.
Hedge funds often maintain portfolios of long and short posi­
tions. For both the hedge fund and the prime broker providing
the financing, the net value may be quite small compare to the
gross volume of lending. Within a firm's account with a broker,
margin lending may be extended on a portfolio basis. This may
be as simple as reducing the margin for offsetting long and
short trades in the same security. Margin may also be reduced
for less direct portfolio effects. Some brokers use risk models
such as VaR to help determine the appropriate margin for an
account.
Prime brokerage businesses have been valuable to
large intermediaries not only because of the fees
and spreads they earn on the services and lend­
ing they provide. As noted above in discussing
the run on Bear Stearns, the intermediaries also
benefit from the cash balances the hedge funds
hold. Typically, even highly leveraged hedge funds
maintain cash balances with prime brokers, so the
prime brokerage business becomes an important
funding source, akin to retail deposits, but far less
"sticky." The cash balances at prime brokers are
part of the intermediaries' general liquidity pool.
They are available to finance any of the intermedi­
aries' other activities. Short positions also gener­
ate cash, not all of which can be freely devoted to
making additional investments.
The interest rates paid on these cash balances
are generally somewhat higher than the funds
could obtain from alternative money market
investments, such as Treasury bills, commercial
paper, and money market mutual funds. They are also, from the
standpoint of the funds, riskier than the alternatives, as they
are unsecured claims against the intermediary, or are secured
by possibly inadequate collateral. Conversely, prime brokers
are important intake points for banks and broker-dealers to
gather collateral and cash that can be used to finance their
activities. Earlier in this chapter, we observed that hedge funds
were drawn on as sources of liquidity by their investors during
the subprime crisis. Their prime brokerage relationships are
an equally counterintuitive instance of the "peacetime" role of
hedge funds as liquidity providers.
Risks in Markets for Collateral
The risks in markets for collateral are similar to those of other
leveraged positions. They comprise market, credit, and coun­
terparty risks. There are some risks in common for the borrower
and lender of securities, and some that are unique to only one
side of the transaction. The risks vary widely, depending on the
motivation of the trade, what type of collateral is involved, and
how the cash generated is deployed. For example, the market
risk of reversing in a bond is a rise in long-term interest rates.
A trader selling borrowed equities short will gain if the stock
price falls.
Prior to the subprime crisis, many institutional investors and
mutual funds maintained large securities lending programs, in
which they lent high-quality securities and received cash col­
lateral, which they invested in higher-yielding bonds. These
"sec-lending" programs invested heavily in structured credit
Chapter 2 Liquidity and Leverage ■ 29
products, as they had AAA ratings, thus satisfying investment
mandates, but had somewhat higher yields than the bonds lent.
These programs were intended to earn a narrow but steady
interest margin, but had severe losses during the crisis, as secu­
ritized product prices collapsed.
Another major market risk in markets for collateral is changes
in lending rates or other terms of margin, repo, or securities
loans. The loans themselves are generally short-term, so losses
to a borrower of securities in a decline in rates are generally
small. However, the transactions liquidity risk can be high. We
have already discussed one important example, the Treasury
specials market.
Another example is the phenomenon of hard-to-borrow securi­
ties in equity markets. In order to establish a short position, even
2 - Lehman
one expressed via TRS, stock must be located and borrowed.
Smaller stocks and stocks under price pressure can be difficult Paribas
to borrow, as many owners will not be willing to lend. 1 -

Collateral markets permit owners of high-quality collateral—or

collateral perceived by the market as high-quality—to borrow
or to finance positions in high-quality collateral at low interest
rates. The upper panel of Figure 2.4 displays the overnight repo
J_______I_______L 1_!__ I_____I___ U_____l____LL J_______I_______L
rate at which market participants can borrow against collateral 2006 2007 2008 2009 2010
consisting of U.S. Treasury obligations, the highest-quality col­
lateral available even after the S&P downgrade of the U.S.
long-term credit rating. In normal times, the repo rate is very
close to the yield of T-bills or other short-term lending rates, 2 - Lehman

and the spread between them is close to zero. However, when

times are not normal, for example during the subprime crisis, Paribas

rates on loans collateralized by the highest-quality securities 1 -

drop even faster than interest rates generally. Having the very
best collateral in a stressed market is almost as good as hav­
ing cash, because you can then borrow cash at a low or even
■y^N M -
zero rate using such collateral. Lenders will provide cash at a J______ I_______L J_____L J__ L J____i____i____i____L
low rate to gain custody of such collateral. This is evident in 2006 2007 2008 2009 2010
the upper panel, where one can see downward spikes in the Fiaure 2.4 Repo rates and spreads 2006-2010.
Treasury repo rate following the inception of each phase of the
Upper panel: Overnight repo rates collateralized by U.S. Treasury
subprime crisis.
securities, daily.
The center and lower panels of Figure 2.4 display the spread Center panel: Spread between one month OIS and overnight Treasury
repo rates (OIS minus Treasury repo), daily.
between overnight Treasury repo and interbank rates (center
Lower panel: Spread between overnight repo rates collateralized by
panel), and the spread between Treasury repo and repo rates for U.S. Treasury securities and by agency MBS (agency repo minus Treasury
loans collateralized by a different type of collateral, agency MBS repo), daily.
(lower panel). Agency MBS are also highly creditworthy, but not Source: Bloomberg Financial L.P.
quite as unquestionably so as Treasuries, and are also not as
liquid. In times of stress, rates on loans with agency MBS collat­
spreads. The data illustrate a key point regarding funding liquid­
eral will not fall quite as low as for the very best collateral. Both
ity risk: The higher the quality of the securities a market partici­
spreads are close to zero in normal times, widening and becom­
pant owns unencumbered, the more liquid he is.
ing highly volatile during the crisis. Questions about the solvency
of the issuers of agency bonds, the government-sponsored The owner of high-quality collateral who uses it to finance a
enterprices (GSEs), exacerbated the size and volatility of these position in lower-quality bonds can maintain a highly leveraged

30 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
position, since haircuts on the collateral lent are typically small.
When the subprime crisis began, and values of low-quality col­
lateral began to fall, investors engaged in this trade suffered
large losses via forced sales. The lenders demanded variation
margin in cash as specified in margin agreements. If the investor
was unable or unwilling to meet that demand, positions had to
be liquidated.
The size and structure of collateral markets also contributes to
systemic risk. Owners of lower-quality collateral may suddenly
have their loans terminated, or have the loans be subjected to
sudden and large increases in the margin demanded by lend­
ers of cash. Drastic remargining is tantamount to drastically
decreasing the loan proceeds available to the borrower on the
strength of the collateral. The owners of the collateral may then
be forced to liquidate the assets. In a distressed market, this
contributes to the rapid decline in asset prices.
Calling and remargining loans collateralized by securities gives
rise to a phenomenon similar to classic bank runs, but involv­
ing nonbank intermediaries as well as banks, and focused on
wholesale funding rather than deposits. One instance was the
March 2008 collapse of Bear Stearns. Bear had large expo­
sures to subprime residential mortgage debt in a number of
forms, and its vulnerability in this respect had become clear
in mid-2007 when several hedge funds that it sponsored col­
lapsed. Once its solvency was called into question, providers
of funding began to withdraw. As noted above, these included
commercial paper lenders and hedge funds with free cash
balances at Bear as part of its clearing and prime brokerage
businesses.
2.3 LEV ER A G E AN D FORM S
O F CREDIT IN CO N TEM PO RA RY
FIN A N CE
Defining and Measuring Leverage
So far in this chapter, we have seen how pervasive leverage
is in the financial system, and some of the new forms it takes.
Next, we look at the mechanics of leverage, particularly via the
economic, as opposed to the accounting, balance sheet of the
firm. We present the standard definition of leverage as the ratio
of the firm's assets to its equity. The schematic balance sheet of
the firm is
Assets Liabilities
Equity (E)
Value of the firm (A)
Debt (D)
The leverage ratio is defined as4
A E+ D D
l = e =— = 1 + e
The lowest possible value of leverage is 1, if there is no debt.
For a single collateralized loan, such as a mortgage or repo,
leverage is the reciprocal of one minus the loan-to-value ratio
(LTV). The borrower's equity in the position is one minus the LTV.
The equity at the time a collateralized trade is initiated is the ini­
tial margin. For a firm, equity is also referred to as net worth.
Leverage is important because it provides an opportunity to
increase returns to equity investors, the so-called leverage
effect, which can be exploited whenever the return on the firm's
assets is expected to exceed the cost of debt capital. The lever­
age effect is the increase in equity returns that results from
increasing leverage and is equal to the difference between the
returns on the assets and cost of funding.
The leverage effect can be seen by writing out the relation­
ship between asset returns r3, equity returns f , and the cost
of debt rd:
re = Lra - (L — 1)rd
The effect of increasing leverage is
Increasing leverage by one "turn," that is, increasing assets and
taking on an equal amount of additional debt that increases
leverage from an initial value Lq to L0 + 1 increases equity
returns by r3 - r6. By the same token, leverage will amplify
losses should the asset return prove lower than the cost of debt.
In foreign exchange trading, leveraged trades, called carry
trades, involve borrowing (going short) a low-interest rate cur­
rency, and using the proceeds to buy (go long) a higher-interest
rate currency. The net carry is ra - rd, with ra representing the
higher and rd the lower interest rate. Carry trades lose money
when the low-yielding currency appreciates enough to more
than offset the net carry.
The equity denominator of the leverage measure depends on
what type of entity we are looking at and the purpose of the
analysis. For an intermediary such as a bank or broker-dealer,
the equity might be the book or market value of the firm. These
firms also issue hybrid capital, securities such as subordinated
preference shares that combine characteristics of debt and
equity. Hybrid capital can be included or excluded from the
denominator of a leverage ratio depending on the purpose of
the analysis. Regulators have invested considerable effort in
4 The leverage ratio is sometimes defined as the debt-to-equity ratio —.
Chapter 2 Liquidity and Leverage ■ 31
ascertaining the capacity to absorb losses and thus nearness to
pure equity of these securities.
For a hedge fund, the appropriate equity denominator is the
net asset value (NAV) of the fund, the current value of the inves­
tors' capital. For any investment firm or investment vehicle,
the leverage of individual positions or of subportfolios can be
calculated using the haircut, margin, or risk capital, as the equity
denominator.
An alternative definition often used in fundamental credit analy­
sis relates the debt, not to the assets of the firm, but to its cash
flows. The cash flow measure typically used is earnings before
interest, taxes, depreciation, and amortization (EBITDA). This
measure of cash flow captures the net revenues of the firm,
while excluding costs that are particularly heavily influenced by
accounting techniques. It also excludes interest, which is deter­
mined less by the firm's business activities than by its choice of
capital structure. Leverage is then defined as the ratio of debt
to EBITDA.
Exam ple 2.1 Leverage and the Leverage Effect
Suppose the firm's return on assets is fixed at r3 = 0.10, while its
cost of debt is r = 0.05, and initially has this balance sheet:
Assets Liabilities
Equity E = 1
Value of the firm A = 2
Debt D = 1
Its leverage is then 2 and its return on equity is
2-0.10 - 0.05 = 0.15
Adding a turn of leverage, that is, borrowing an additional unit
of funds and investing it in an additional unit of assets, changes
the balance sheet to
Assets Liabilities
Equity E = 1
Value of the firm A = 3
Debt D = 2
and increases the equity return to 0 .2 0 .
In reality, of course, asset returns are not fixed, but risky. What
if asset returns end up a disappointing 0 percent? The equity
return with leverage of 2 will be a loss of 5 percent, and with
leverage of 3, a loss of 10 percent.
The effect of leverage depends as much on the cost of funding
as on the asset return. Investors sometimes choose a degree of
leverage based on the return they need to achieve. For a given
cost of debt, and a given asset return, there is a unique leverage
ratio that will permit the equity owners to "break even," in the
32 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
sense of reaching a given hurdle rate, or required rate of return
on equity. This orientation has surfaced in the debates on bank
regulatory capital, in which some bankers and observers have
stated that increased capital requirements will oblige banks to
reduce their return-on-equity (ROE) targets.
Example 2.2 Leverage and Required Returns
Continuing the previous example, suppose the firm's return
on assets is r3 = 0.10, while its cost of debt is r = 0.05. If the
hurdle rate or return on equity is 15 percent, the firm will choose
leverage of 2. If the hurdle rate, however, is 25 percent, then the
firm will choose a leverage ratio of 4:
4-0.10 - 3-0.05 = 0.25
Many leveraged fixed-income trades involve spreads. If a fixed-
income security has a coupon rate higher than the borrowing
rate on a loan collateralized by the security, for example via a
repo transaction, the rate of return to a leveraged purchase is
limited only by the haircut. To see this, denote the coupon rate
by c, the haircut by h, and the repo rate by r, and assume c > r
(all in percent). The coupon and repo rates have a time dimen­
sion; the haircut does not. For every $100 of par value, the inves­
tor puts up capital of h, earns a coupon of c, and pays ( 1 - h)r in
1
repo interest. The leverage is equal to —. The leveraged return,
measured as a decimal fraction of the investor's equity capital, is
c (1 h)r , 1-h ,
— h— = c+ — { c ~ r)
As h decreases, the levered return rises. The increase in returns
*\ — h
as the debt-to-equity ratio — -— rises is proportional to the
h
spread c - r. Conversely, the increase in returns as the spread
'j _
c - r rises is proportional to the debt-to-equity ratio — -— .
h
The tension between required returns and leverage played an
important role in creating the conditions of the subprime crisis,
in an environment in which prospective asset returns were falling
more rapidly than funding costs; the decline in credit spreads in the
years just prior to the subprime crisis is one example. Higher lever­
age is needed to achieve a given required rate of return on capital
as the spread c — r contracts, and mechanisms were found to
achieve it. For example, the net spreads earned by the off-balance-
sheet vehicles described earlier in this chapter, ABCP conduits and
SIVs, were extremely tight, often under 10 bps. But with sufficient
leverage, it could be turned into a substantial return stream.
The use of leverage applies not only to financial intermediaries,
but also to households able to borrow to finance asset pur­
chases. Most households that own homes, for example, have
borrowed at least part of the purchase price by means of a
mortgage loan. The down payment is the household's equity
and is a form of haircut. The leverage is the ratio of the value
of the house to the down payment (and inversely related to
the LTV). During the decade preceding the subprime crisis, the
terms on which mortgage credit was granted were loosened
to permit higher leverage and low initial interest rates, which
amplified the impact of the prevailing low-interest rate environ­
ment. As discussed, analysis of credit risk in residential mort­
gage loans assumed rising house prices. For households, equally
confident that house prices would rise, or at least not fall, easy
credit terms created strong incentives to make leveraged invest­
ments in housing, as shown in Example 2.3.
Exam ple 2.3 Leveraged Returns to Housing
Suppose house values are expected to rise 10 percent a year,
including, for simplicity, rental income and net of property main­
tenance costs. The following table shows the resulting annual
rate of return to the homeowner for different down payments
and loan rates (all data in percent):
Loan Rate %
Down Payment % 5 .5 8.0
1 0 .0 50.5 28.0
2 0 .0 28.0 18.0
The returns are calculated as
House price appreciation - (1 - Down payment)Loan rate
Down payment
Lowering the lending rate and the down payment or haircut
increases the leveraged return from 18 to over 50 percent per
annum.
Leverage ratios can amplify sensitivity to changes in cash flow. If
the net cash flow on a leveraged trade or of a leveraged firm is
positive, but small, a small change in interest rates can make the
cash flow negative.
These relationships show why firms or investors employ lever­
age. It also illustrates why leverage is often used as a measure of
risk, and why leverage is sometimes considered to be an inde­
pendent source of risk. These last two ideas can be misleading.
Leverage is not a well-defined risk measure. Part of the difficulty
is that financial accounting standards have been developed with
a view to solving a completely different set of problems, for
example, accurately recognizing profits, or accurately capturing
the explicit liabilities of the firm.
Although it is difficult to state an unambiguous definition of
leverage, it is an important concept. Most severe losses suffered
by financial intermediaries involve leverage in some way, and
it is important to understand the extent to which borrowing is
being used, implicitly or explicitly, to boost returns. To do so, we
can construct an economic balance sheet for a firm or an inves­
tor that captures the implicit or embedded leverage in short
positions, swaps, and options. This can at least provide a rea­
sonable answer to the question of how much he has borrowed
to finance positions.
We've reviewed some of the financial instruments by which
credit is extended outside the traditional bank lending and
bond markets in our discussion of collateral markets earlier in
this chapter. Here, we show, using T-accounts, the great extent
to which a financial firm can use them to take on leverage. Some
of these forms of credit are by no means new, but their volume
has grown enormously in recent decades with the rise in the
volume of trading in securities and OTC derivatives. Among the
reasons for their growth are:
• They have lower transactions costs than traditional bank or
capital markets debt. Originating a bank loan or security is a
cumbersome, slow, and expensive process. It requires under­
writing, syndication, and distribution by banks or securities
firms. Most of the forms of credit discussed here require only
a counterparty. But along with that cost saving, counterparty
risk has become more prevalent.
• The granting of credit is an inherent part of trading in the
assets being financed, and the amount of credit granted
adjusts naturally to the size of the position being financed.
• Collateralization of the loan and adjustments to the amount
lent occur naturally as part of trading and brokering trades.
These forms of borrowing are generally collateralized in
some way, which also affects the economic leverage. When
borrowing is explicit, as for example through taking loans
or deposits, or issuing bonds, the impact on leverage is
straightforward. In other forms of borrowing, some analysis
is required to measure leverage. For each of these forms, we
see how to determine the amount of borrowing or leverage
implicit in the position.
Margin Loans and Leverage
Margin lending has a straightforward impact on leverage. The
haircut determines the amount of the loan that is made: at a
haircut of h percent, 1 — h is lent against a given market value
of margin collateral, and h percent of the position's market value
is the borrower's equity in the position. The leverage on a posi-
1
tion with a haircut of h percent is —.
C h ap ter 2 Liquidity and Leverage ■ 33
 Haircut (%) Amount Borrowed (%) Leverage Exam ple 2.5 Leverage and Short Positions

10 90 10
Our starting point, as in Example 2.4, is a hedge fund with $100
in cash, corresponding to an initial placement of $ 1 0 0 in equity
50 50 2
by its owners.
90 10 1/0.9
To create a short position in a stock, Lever Brothers borrows
$100 of the security and sells it. It has thus created a liability
equal to the value of the borrowed stock, and an asset, equal
Exam ple 2.4 Leverage and Margin Loans
in value, consisting of the cash proceeds from the short sale.
We take as the starting point of this and the remaining examples The cash cannot be used to fund other investments, as it is col­
in this section a firm with $ 1 0 0 in cash, corresponding to an ini­ lateral; the broker uses it to ensure that the short stock can be
tial placement of $100 in equity by its owners. For concreteness, repurchased and returned to the stock lender. It remains in a
we imagine a hedge fund account, Lever Brothers Multistrategy segregated short account, offset by the value of the borrowed
Master Fund LP, with this economic balance sheet on opening stock. The stock might rise in price, in which case the $100 of
day: proceeds would not suffice to cover its return to the borrower.
Lever Brothers must therefore in addition put up margin of $50.
Assets Liabilities
Immediately following this trade, Lever Brothers' margin and
Cash Equity $100 short accounts have $50 in equity and a $50 loan from the
Debt $0 broker:
$ 1 0 0

Assume Lever Brothers finances a long position in $100 worth Assets Liabilities
of an equity at the Reg T margin requirement of 50 percent. It
$150 Due from broker: Equity $50
invests $50 of its own funds and borrows $50 from the broker.
$50 Margin Borrowed stock $100
Immediately following the trade, its margin account has $50 in
equity and a $50 loan from the broker: $100 Short sale proceeds

Lever Brothers' full economic balance sheet is

Assets Liabilities

Equity $50 Assets Liabilities

Stock value $100
Margin loan $50
$50 Cash Equity $100
The broker retains custody of the stock as collateral for the $150 Due from broker Borrowed stock $100
loan. Lever Brothers' full economic balance sheet, including the
entries in its margin account, is now The firm has gone from leverage of 1 to 2. Notice that the lever­
age in this example is higher than in the example of a long posi­
Assets Liabilities tion via margin lending. The reason is that in establishing a short
position, the securities must be borrowed; leverage is inherent
Cash $50 Equity $100 in short positions, but is a choice for long positions. In the exam­
Stock value $100 Margin loan $50 ple of the long position, only half the value of the purchased
stock was borrowed, so the leverage was 1.5. Here, the entire
The firm's leverage has risen from 1 to 1.5. stock position must be borrowed to execute the short. The fund
could reduce its overall leverage by reducing its borrowing to
finance long positions, but cannot reduce leverage in the short
Short Positions
position itself.
Short positions lengthen the balance sheet, since both the value
of the borrowed short securities and the cash generated by their
Cross and Net Leverage
sale appear on the balance sheet. They therefore increase lever­
age, which looks at the gross amount of assets, that is, longs Although, like any other risk asset, short positions generate
plus the absolute value of short positions. leverage, they reduce risk if there are long positions with which

34 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
they are positively correlated, or other short positions with
which they are negatively correlated. If short positions play a
hedging role in the portfolio, leverage will overstate the risk,
since adding the short positions increases leverage, but reduces
market risk.
This leads to a distinction between gross and net leverage.
Gross leverage is defined as the sum of all the asset values,
including cash generated by shorts or assets acquired with
that cash, divided by capital. It can be thought of as the total
"length" of the balance sheet divided by the capital. Net lever­
age is computed as the ratio of the difference between the mar­
ket values of the long and short positions to the capital.
The balance sheet alone will not tell the risk manager whether
the short positions are risk-augmenting or risk-reducing. Other
information in addition to the long and short leverage, such as
VaR and stress test reports, or a qualitative examination, are
needed. For this reason, in reporting leverage, long positions
and short positions should be reported separately. Leverage
reporting is important, but far from a complete view of the risks
of a portfolio.
Derivatives
Derivative securities are a means to gain an economic exposure
to some asset or risk factor without buying or selling it outright.
One motivation for market participants to use derivatives is as a
means of increasing leverage. Leveraged ETFs are an example
of an investment product that uses derivatives in order to create
the economics of leveraged investment in, say, an equity index.
Although derivatives are generally off-balance-sheet items in
standard accounting practice, they belong on the economic bal­
ance sheet, since they may have a large impact on returns. Each
side of a derivatives contract is synthetically long or short an
asset or risk factor. But the market values of derivative securities
are not equal to the value of the underlying asset, or the riski­
ness of the positions. Therefore, their market values or NPVs
are generally not the best values to represent them. Rather,
for purposes of measuring economic leverage, we wish to find,
for each type of derivative, a cash-equivalent market value. As
with most issues around the measurement and interpretation of
leverage, as much judgment as science is involved.
As we discussed, there are two basic types of derivatives,
futures, forwards, and swaps on the one hand, and options on
the other. Their use has a very different impact on leverage:
Futures, forwards, and swaps are linear and symmetric in
the underlying asset price and can be hedged statically.
Therefore, the amount of the underlying that the derivatives
contract represents is set once and for all at the initiation of
the contract, even though the net present value (NPV) may
vary over time. The cash-equivalent market value of futures,
forwards, and swaps can be represented on an economic
balance sheet by the market value of the underlying security,
rather than the NPV.
Options have a nonlinear relationship to the underlying
asset price and must be hedged dynamically. Therefore,
the amount of the underlying that the derivatives contract
represents varies over time. It can be fixed approximately at
any point in time by the option delta, or by a delta-gamma
approximation. In general, volatility is important in the value
of an option, so option contracts cannot generally have a
zero NPV at initiation. Rather, it has a market value that can
be decomposed into an intrinsic value, which may be zero,
and a time value, which is rarely zero.
The cash-equivalent market value of options can be
represented on an economic balance sheet by their delta
equivalents rather than their market values. As the underly­
ing price varies, the amount of the economic balance sheet
exposure, and the leverage, will vary. Measured this way, the
cash-equivalent market value doesn't take the time value and
volatility of the option into account, except insofar as it influ­
ences the option delta.
Like margin arrangements, derivatives also generate counter­
party credit risk. If the derivative creates a synthetic long (short)
position, the economic balance sheet entries mimic those of a
cash long (short) position. The implicit assets and liabilities cre­
ated on the economic balance sheet are vis-a-vis the derivatives
counterparties.
In the rest of this section, we illustrate these principles of how
best to represent derivatives positions for purposes of comput­
ing leverage.
Exam ple 2.6 Leverage and Derivatives
We again take as the starting point a hedge fund account with
$ 1 0 0 in cash, corresponding to an initial placement of $ 1 0 0 in
equity by investors. Suppose Lever Brothers now adds:
• A one month currency forward, in which Lever Brothers is
short $ 1 0 0 against the euro
• An at-the-money (currently 50-delta) three month long call
option on S&P 500 equity index futures, with an underlying
index value of $ 1 0 0
• A short equity position expressed via a three-month equity
total return swap (TRS), in which Lever Brothers pays the total
C h ap ter 2 Liquidity and Leverage ■ 35
 return on $100 market value of Intel and the short rebate, or
cost of borrowing Intel stock
• Short protection on Ford Motor Co. via a five-year credit
default swap, with a notional amount of $ 1 0 0
We assume that the nonoption positions are initiated at market-
adjusted prices and spreads, and therefore have zero NPV. We'll
also assume that the counterparty is the same for all the posi­
tions, namely the prime broker or broker-dealer with which they
are executed.
Let's look at the economic balance sheet for each position,
assuming there is no initial margin. Then we'll consolidate the
positions and add a margin requirement to find Lever Brothers'
overall leverage, as if margin were being assessed by a single
broker or counterparty on a portfolio basis.
We start with the currency forward, which is implicitly a pair of
money market positions, a long one-month euro-denominated
bank deposit with a value of $ 1 0 0 , financed by borrowing $ 1 0 0
for one month. Assuming the one month forward exchange rate
is $ 1 . 2 0 per euro, we have:
Assets Liabilities
$ 1 0 0 equivalent of € 80 bank $ 1 0 0 broker loan
deposit
The equity option, with a delta of 50 percent, is equivalent to
having bought $50 worth of the S&P 500 index with a broker
loan of $50:
Assets Liabilities
$50 long S&P 500 position $50 broker loan
The Intel TRS is equivalent to a short position in Intel stock
(ticker INTC), established with no initial margin. If the price of
INTC is $20, we have:
Note that the leverage in each of these transactions, if there is
no initial margin requirement, is infinite.
Now let's put these positions together to get Lever Brothers'
complete balance sheet. Recall that the account starts with $100
placed by investors. We make the additional assumption that the
initial margin on the portfolio of these derivatives positions is $50.
Assets Liabilities
Cash $50 Equity $100
$150 due from broker
$50 margin $150 short-term
$ 1 0 0 short sale proceeds broker loan
equivalent of
$ 1 0 0 term loan
$ 1 0 0
€ 80 bank deposit Borrowed stock
$50 long S&P 500 position (5 sh INTC)
$100 Ford FRN
The fund has attained leverage in its long positions of 3.5, plus
a short position with a magnitude equal to its NAV. It has thus
gained economic exposure to securities valued at $450, using
only $50 in cash.
These examples illustrate a serious issue in computing and
interpreting leverage ratios, which we alluded to in the context
of gross and net leverage: how to treat routine hedges such as
currency hedges for foreign currency-denominated positions,
and risk-free rate hedges for credit-risky fixed-income positions.
In general, these currency and rate exposures can be neutral­
ized quite accurately and reliably. The currency and rate hedges,
however, are of the same order of magnitude as the underlying
exposures themselves, and if carried on the economic balance
sheet will bloat it, distort the resulting leverage reports, and
obscure the more material risks in the portfolio.

Assets Liabilities Structured Credit

$ 1 0 0 due from broker (short Borrowed stock (5 sh INTC) Structured credit also provides embedded leverage. The bond
sale proceeds)
tranches take losses only in more extreme default and cor­
relation scenarios. The mezzanine tranche is relatively thin, so
The short CDS protection position, finally, is equivalent to a long
while it takes an extreme default scenario to cause any loss
position in a par-value five-year Ford floating-rate note (FRN),
at all to the mezzanine tranche, if a loss occurs, it is likely to
financed by borrowing at a floating rate at five years' term. We
be large. This property of thin subordinated securitization
assume that the financing can be terminated early without pen­
tranches is called "cuspiness," since it materializes when the
alty if there is a credit event. Its economic balance sheet is
attachment point of the bond is at the cusp of default losses in
the pool.
Assets Liabilities
The equity note bears most of the risk of loss. It has, however,
$100 Ford FRN $ 1 0 0 term loan
a notional amount of only $5,000,000, while the underlying

36 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
collateral pool is $ 1 0 0 , 0 0 0 , 0 0 0 , financed long-term through the
bond tranches. Implicitly, the balance-sheet leverage used is a
bit less than 2 0 turns, once we take account of the residual risk
borne by the bonds. If the equity note itself is financed in the
repo markets, with, say, an 80 percent haircut, the economic
leverage could easily reach 1 0 0 .
Asset Volatility and Leverage
Investing in assets with a higher return volatility is economically
quite similar to leverage. Ignoring the potential reputational
risk, losses beyond the investor's equity in a trade don't matter
to him. An asset with more volatile returns provides a higher
probability of higher leveraged returns to the investor, but also
a higher probability of losses to the provider of credit. The
upside adds to the investor's expected return, but the downside
doesn't diminish it. In other words, leverage adds optionality or
convexity to the return profile. Examples of the impact of the
convexity inherent in leveraged returns include:
1. An investor in assets financed with margin loans can system­
atically favor more-volatile over less-volatile assets within a
class with the same haircut. This behavior is also an example
of adverse selection.
2. Equity holders may favor greater risk-taking by a firm than
do its creditors because of risk-shifting incentives. Public
risk policy that leads creditors of financial intermediaries to
believe that they will be made whole in the event of a sys­
tematic risk event ("too-big-to-fail") reduces credit risk pre­
miums and makes leverage more economically appealing to
equity holders, compounding the effect.
Leverage ratios do not capture the effect of volatility on convex­
ity, which amplifies leverage economics and can make it more
attractive. At the same time, volatility estimates do not capture
the funding risk of a portfolio. Both are needed for genuine
insight into the risk of a portfolio.
2.4 TRAN SACTION S LIQUIDITY RISK
Next, we turn to market or transactions liquidity risk. We begin
by describing what is meant when we say an asset, as opposed
to a market or a market participant, is "liquid." An asset is liquid
if it resembles money, in that it can be exchanged without delay
for other goods and assets, and in that its value is certain. 5 Most
5 This is true even if there is inflation. At any moment, the holder of
money knows exactly how many nominal units he has, even if he can't be
quite sure what the real value of his money balances is.
assets other than money do not completely share these charac­
teristics of immediacy and certainty. They cannot be exchanged
directly for other goods and assets, because we don't live in a
barter economy; only money can do that. Nonmoney assets
must be sold or liquidated before they can be exchanged for
other goods or assets. This takes at least some time, and the
proceeds from the sale are uncertain to at least some extent.
Transactions liquidity includes the ability to buy or sell an asset
without moving its price. An order to buy an asset increases
demand and causes its price to increase. The effect is usually
small, but can be large when the order causes a large transitory
imbalance between the demand and supply of the asset at the
initial price. A market participant can thereby be locked into a
losing position by lack of market liquidity.
Causes of Transactions Liquidity Risk
Transaction liquidity risk is ultimately due to the cost of search­
ing for a counterparty, to the market institutions that assist in
search, and to the cost of inducing someone else to hold a posi­
tion. We can classify these market microstructure fundamentals
as follows:
Cost of trade processing. Facilitating transactions, like any
economic activity, has fixed and variable costs of processing,
clearing, and settling trades, apart from the cost of finding a
counterparty and providing immediacy. These costs are tied
partly to the state of technology and partly to the organiza­
tion of markets. While processing may be a significant part
of transaction costs, it is unlikely to contribute materially to
liquidity risk. An exception is natural or man-made disasters
that affect the trading infrastructure.
Inventory management by dealers. The role of dealers is to
provide trade immediacy to other market participants, includ­
ing other dealers. In order to provide this service, dealers
must be prepared to estimate the equilibrium or market­
clearing price, and to hold long or short inventories of the
asset. Holding inventories exposes dealers to price risk, for
which they must be compensated by price concessions. The
dealers' inventory risk is fundamentally a volatility exposure
and is analogous to short-term option risk.
Adverse selection. Some traders may be better informed
than others, that is, better situated to forecast the equi­
librium price. Dealers and market participants cannot dis­
tinguish perfectly between offers to trade arising from the
counterparty's wish to reallocate into or out of cash, or
responses to non-fundamental signals such as recent returns
("liquidity" or "noise" traders) from those who recognize that
the prevailing price is wrong ("information" traders). A dealer
Chapter 2 Liquidity and Leverage ■ 37
 cannot be sure for which of these reasons he is being shown
a trade and therefore needs to be adequately compensated
for this "lemons" risk through the bid-ask spread. A dealer
does, however, have the advantage of superior information
about the flow of trading activity, and learns early if there is a
surge in buy or sell orders, or in requests for two-way prices.
Differences of opinion. Investors generally disagree about the
"correct" price of an asset, or about how to interpret new
information, or even about whether new information is impor­
tant in assessing current prices. Investors who agree have less
reason to trade with one another than investors who disagree.
When agreement predominates, for example, when important
and surprising information is first made public, or during times
of financial stress, it is more difficult to find a counterparty.
These fundamentals take different forms in different types of
market organization:
• In a quote-driven system, certain intermediaries, who may be
dealers, market makers, or specialists, are obliged to publicly
post two-way prices or quotes and to buy or sell the asset at
those prices within known transaction size limits. These inter­
mediaries must be prepared to hold long or short inventories
of the asset and typically trade heavily among themselves
and with the "buy side" in order to redistribute inventories of
securities and reduce them overall. Quote-driven systems are
typically found in OTC markets.
• Order-driven systems come closest to the perfectly competi­
tive auction model. In this type of market clearing, market
participants transmit orders to an aggregation facility, for
example, a broker, specialist, or electronic trading system. In
some cases, a call auction is held in which the price is gradu­
ally adjusted until the volumes of bids and offers forthcoming
at that price are equated. More typically, a continuous auction
is conducted in which the best bids and offers are matched,
where possible, throughout the trading session. Order-driven
systems are typically found on organized exchanges.
Characteristics of Market Liquidity
A standard set of characteristics of market liquidity, focusing
primarily on asset liquidity, helps to understand the causes of
illiquidity:
Tightness refers to the cost of a round-trip transaction, and
is typically measured by the bid-ask spread and brokers'
commissions.
Depth describes how large an order it takes to move the
market adversely.
Resiliency is the length of time for which a lumpy order
moves the market away from the equilibrium price.
38 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The latter two characteristics of markets are closely related
to immediacy, the speed with which a market participant can
execute a transaction.
Lack of liquidity manifests itself in these observable, if hard-to-
measure ways:
Bid-ask spread. If the bid-ask spread were a constant, then
going long at the offer and short at the bid would be a pre­
dictable cost of doing the trade. However, the bid-ask spread
can fluctuate widely, introducing a risk.
Adverse price impact is the impact on the equilibrium price
of the trader's own activity.
Slippage is the deterioration in the market price induced by
the amount of time it takes to get a trade done. If prices are
trending, the market can go against the trader, even if the
order is not large enough to influence the market.
These characteristics, and particularly the latter two, are hard
to measure, making empirical work on market liquidity difficult.
Data useful for the study of market microstructure, especially
at high-frequency, are generally sparse. Bid-ask spreads are
available for at least some markets, while transactions volume
data is more readily available for exchange-traded than for
OTC securities.
2.5 LIQUIDITY RISK M EASU REM EN T
Measuring Funding Liquidity Risk
Asset-Liability Management
Remaining liquid in the sense of reducing funding liquidity risk
is part of the traditional asset-liability management function in
banks. This process includes measures such as
• Tracking and forecasting available cash and sources of fund­
ing on the one hand, and cash needs on the other
• Keeping certain ratios of ready cash and readily marketable
securities to meet unusual demands by depositors and other
short-term lenders for the return of their money
Example 2.7 Goldman Sachs Global Core Excess
Goldman Sachs, for example, describes its liquidity risk manage­
ment policy as maintaining a "Global Core Excess"
to pre-fund what we estimate will be our likely cash
needs during a liquidity crisis and hold such excess
liquidity in the form of unencumbered, highly liquid secu­
rities that may be sold or pledged to provide same-day
liquidity . . . to allow us to meet immediate obligations
 without needing to sell other assets or depend on addi­
tional funding from credit-sensitive markets.
The liquidity buffer accounts for about 20 percent of the balance
sheet. It includes cash and a portfolio of securities that can be
pledged as collateral rather than sold. 6
Apart from cash, liquidity portfolios can contain cash equiva­
lents, defined in the International Accounting Standards as
"short-term, highly liquid investments that are readily convert­
ible to known amounts of cash and which are subject to an insig­
nificant risk of changes in value."
Funding Liquidity Management for Hedge Funds
Hedge funds, even if only moderately leveraged, are vulner­
able to the withdrawal of liquidity, either by counterparties or
through withdrawals of investor capital. Both have the same
effect of potentially obliging the fund manager to unwind posi­
tions rapidly and generating exposure to transactions liquidity
risk. When this happens to many funds at the same time, it can
contribute to "fire sales."
Hedge funds have a number of sources of liquidity that can be
monitored as part of overall risk management:
Cash provides unfettered liquidity. It can be held in the form
of money market accounts or Treasury bills. Excess cash
balances with brokers and money market accounts are not
entirely riskless and therefore are not perfectly liquid. Broker
balances carry with them the counterparty risk of the bro­
ker; in the event the broker fails, the cash balances will be
immobilized for a time and only a fraction may ultimately be
paid out. Money market funds, as was demonstrated during
the subprime crisis, may suspend redemptions or "break the
buck" and pay out at less than 1 0 0 percent of par.
Unpledged assets (or assets "in the box") are unencumbered
assets not currently used as collateral. They are generally also
held with a broker, who in this case is acting only as a custo­
dian and not as a credit provider.
This source of liquidity is limited by the price volatility
of the assets and the ability to use the assets as collateral. In
a financial crisis, only U.S. Treasuries, particularly short-term
Treasuries, will be liquid enough to serve as near-cash assets.
Other high-credit quality assets, such as U.S. agency bonds,
that is, bonds issued by Fannie Mae and Freddie Mac, were
less reliable stores of value during the subprime crisis. The use­
fulness of bonds other than Treasuries and agencies to serve as
collateral and the ability to obtain funding by pledging them
6 See Goldman Sachs Group, Inc. (2010).
was also impaired during the crisis, as seen for agency debt in
Figure 2.4. Haircuts on such debt were reportedly also rising.
Assets can be sold rather than pledged. This alternative
route to liquidity is limited by the likely proceeds from a sale.
In a distressed market, these may be far lower than recent
market prices or a model-based fair value. Thus, as a source
of funding liquidity, unpledged assets are subject not only
to fluctuations in the amount of borrowing they can support,
but also to transactions liquidity risk.
Unused borrowing capacity on pledged assets can be used
to finance additional positions. Like unpledged assets, this
form of liquidity is not unfettered. Rather, it is subject to
revocation by counterparties, who may raise haircuts or
decline to accept the securities as collateral when the time
comes to roll over a collateralized securities loan. Since most
of these collateralized loans are very short term, credit can
disappear rapidly. This occurred for many lower-quality forms
of collateral during the subprime crisis.
However, a systemic risk event, in which hedge fund investments
are regarded as potential sources of liquidity by investors, will
be a challenge even for most effective liquidity risk manage­
ment. We referred to this phenomenon earlier in this chapter:
Many hedge funds that had not experienced large losses
received redemption requests for precisely that reason from
investors who were themselves seeking liquidity.
Measuring Transactions Liquidity Risk
There are two major types of quantitative liquidity risk measures.
They focus on the available data that are pertinent to liquidity risk:
• Bid-ask data
• Transaction or turnover volume data
• Data on the size outstanding of securities issues
Quantitative measures of transactions liquidity risk are not as
widely used as funding liquidity risk measures, and quantitative
liquidity risk measurement is generally less widely practiced than
quantitative market and credit risk. Partly, this is because they
have not been incorporated into the regulatory framework to
the same extent as have standard models of market and credit
risk measurement. Regulators have focused more intently on
banks' liquidity risk since the onset of the subprime crisis. Partly,
it is due to the measurement challenges alluded to above.
Transaction Cost Liquidity Risk
These measures focus on the risk of variation in transactions
costs. The starting point is a distributional hypothesis regarding
the future bid-ask spread.
Chapter 2 Liquidity and Leverage ■ 39
Daily changes in the relative bid-ask spread, that is, the spread
as a fraction of the price, can be assumed as a starting point to
be normally distributed with a mean of zero and a constant vari­
ance (estimated by the sample variance of the spread <rs). The
zero-mean assumption at least is unobjectionable, since bid-ask
spreads cannot rise indefinitely or shrink to zero. The expected
transactions cost is the half-spread or mid-to-bid spread
E[Pt+i] f
where
^ask price - bid price ask price - bid price
ask price + bid price midprice
s is an estimate of the expected or typical bid-ask spread, and P
is the asset midprice.
Under the zero-mean normality hypothesis, we set s = s, the
most recent observation on the relative spread. The 99 percent
confidence interval on the transactions cost, in dollars per unit
of the asset, is then
± p l ( s + 2.33<t s)
where P is an estimate of the next-day asset midprice. We typi­
cally set P = P, the most recent observation on price.
We referto ^ ^ + 2.33rjs j as the 99 percent spread risk factor.
The transactions cost risk at a 99 percent confidence level is
then measured by the current value of the spread risk factor,
that is, by the 99th percentile of the actual proportional daily
changes in the half-spread over a given historical period, say,
the past two years. It represents the worst case, at a 99 per­
cent confidence level, of the bid-ask spread cost of changing
a position.
Measuring the Risk of Adverse Price Impact
A tool for measuring the risk of adverse price impact is liquidity-
adjusted VaR. The starting point is an estimate of the number of
trading days, T, required for the orderly liquidation of a position.
If the position is liquidated in equal parts at the end of each day,
the trader faces a one-day holding period on the entire position,
T - 1
a two-day holding period on a fraction ——— of the position,
T - 2
a three-day holding period on a fraction ——— of the posi­
tion, and so forth if he wishes to liquidate the position with no
adverse price impact.
The next step is to arrive at an estimate of the one-day position
VaR. Suppose the entire position Xw ere being held for T days.
40 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The T-day VaR would be estimated by the familiar square-root-
of-time rule:
VaRt (a, t ) (X ) X Vf
However, this would be an overstatement of the VaR; the VaR
has to be greater than the one-day position VaR, but less than
the one-day position VaR X V T . We will be holding a sequence
T- 1 T- 2 T- 2
of position sizes 1 , , rather than 1 ,
T T T
1, . . . , 1, all with the same variance. The VaR is therefore
VaRt (X ) x
2
which simplifies to
(1 + T )( 1 + 2 T)
X
67
For example, suppose the trader estimates that a position can
be liquidated in T = 5 trading days. The adjustment to the over­
night VaR of the position is then 1.48324, that is, we increase
the VaR by 48 percent. For T ~ 10, the liquidity risk adjustment
doubles the overnight VaR of the position. These adjustments
are large by comparison with the transaction cost liquidity risk
measures of the previous section. Estimates of the time to liqui­
date or "time to escape" are usually based on a comparison of
the position size with the daily transactions volume.
In extreme cases, or during financial crises, there may be several
constraints on liquidation decisions. There may be trade-offs
among adverse price impact, funding liquidity, and solvency.
An example is that of a hedge fund facing redemptions. It must
liquidate some positions to meet redemptions. Suppose it liq­
uidates those with the smallest adverse price impact first, but
redemptions continue. The fund may face collapse because it
cannot meet the ongoing withdrawals by quickly selling the
remaining, relatively illiquid positions. If, on the other hand,
it sells the least liquid positions first, it will incur losses due to
adverse price impact, and likely post NAV losses earlier on,
which may accelerate redemptions.
Liquidation decisions may also interact with the incentive struc­
ture of credit markets. An example of this is the "sellers' strike"
observed early in the subprime crisis, in which banks were
reluctant to reduce leverage by selling certain positions, often
referred to as "toxic assets," primarily structured credit products
and mortgage loans. However, prices for these products were
falling rapidly, and the banks were reluctant to realize losses at
market valuations many considered to be well below fundamen­
tal value. The paradox of this phenomenon is that it was stron­
ger banks that were the most active sellers, while the weaker
banks were more inclined to hold back. By avoiding sales, weak
banks increased the probability of illiquidity and possibly failure
in the short run, but increased the potential profit from these
assets in the long run once their prices recovered. In other
words, they had an option-like position in the assets. The longer-
term profit was conditional on the banks' survival through the
crisis and on the fundamental values of the assets proving to be
higher than their current market prices.
2.6 LIQUIDITY AN D SYSTEM RISK
Systemic risk, the risk of severe, widespread financial stress and
intermediary failure, possibly including disruption of payment sys­
tems, is a function among other things of economy-wide liquidity.
Systemic risk can be thought of as resulting from external costs
in the production of financial services, analogous to pollution or
traffic jams. Market participants, in this approach, incur risks that
are partially shifted to the market as a whole. These collectively
borne risks are generated by correlation between the impact of
market events on different market participants. When general
market conditions deteriorate, many borrowers are affected in
the same way at the same time. One way this happens is when
the value of collateral declines, or lenders become more con­
cerned about the transactions liquidity risk of certain types of
collateral. Another way many borrowers can be affected at once
is when the market becomes more reluctant to finance certain
types of trades or lend to certain types of institutions. Finally,
asset price declines may contribute to the simultaneous deterio­
ration of different market participants' financial positions.
Liquidity is ephemeral for many securities. It tends to become
impaired at precisely the moments when market participants
most need it. Liquidity is a result of network effects and mutually
reinforcing expectations that are hard to capture quantitatively.
A well-functioning market can depend on whether the market
will "all hold hands," or not, and on whether enough market
makers will make two-way prices they would be willing to honor
in actual transactions.
Funding Liquidity and Solvency
Liquidity is the ability to meet immediate demand for cash. Sol­
vency is having a positive amount of equity capital, that is, assets
exceeding liabilities. Liquidity and solvency are closely related,
since both pertain to the ability to repay debts. But a firm can
be insolvent, yet able to continue for some time to roll over its
debts, or may funded largely by long-term debt, and thus not
face illiquidity. A firm may be solvent, that is, able to pay its long­
term debt, because its assets will ultimately be worth more than
its liabilities, but illiquid, since it cannot roll over short-term debt
or raise enough cash to repay it timely. Liquidity and solvency are
linked by asset values; large changes in the mark-to-market value
of assets can expose a solvent financial intermediary to illiquidity.
Illiquidity can become insolvency if it is extreme enough, as a
debtor can become unable to either borrow or realize the funds
required to meet debt obligations by selling assets. Because
intermediaries are not transparent, liquidity and solvency are
also linked by market perceptions about the state of intermedi­
aries. The suspicion by market participants that a financial firm
is insolvent can lead to that firm becoming illiquid. At the time
of the bankruptcies of Bear Stearns and Lehman Brothers, and
to this day, there was a great deal of debate of whether one or
both firms were insolvent, or merely illiquid.
During the financial crisis, both illiquidity and insolvency played
a role in causing the collapse of financial institutions. Schemati­
cally, the sequence of events in the collapse of an intermediary
can be described this way:
• Reports of losses at the intermediary, or even losses to other
institutions, raise questions about the firm's solvency. Actual
losses at the intermediary are not necessary to set the pro­
cess in motion.
• All firms, financial intermediaries as well as nonfinancial firms,
become more reluctant to lend to the intermediary. The
reluctance is reflected not only in higher credit spreads, but
more importantly, in an inability of the affected firm to obtain
the previous volume of loan proceeds.
• The intermediary is forced to raise cash by liquidating assets.
In a distressed market, the firm is likely to realize losses by
doing so.
• Lenders are aware that the intermediary's problems are now
being compounded by realized mark-to-market losses, fur­
ther reducing their willingness to extend credit.
• The process now accelerates, becoming a run. Lenders to the
intermediary act out of the belief that it is insolvent and that
they will be repaid in full only if they are repaid early. The
intermediary cannot instantly liquidate its remaining assets
for the full amount it owes. Within a very few days, the inter­
mediary will be unable to meet the demand for cash.
It is the drain of cash, not defaults, that destroy the firm. But it
is questionable whether a pure liquidity event, unaccompanied
by even the shadow of a doubt about its solvency, can occur for
one firm in isolation.
Chapter 2 Liquidity and Leverage ■ 41
Funding and Market Liquidity
A key mechanism linking funding and market liquidity is lever­
age. A market participant with a long position for which it can
no longer obtain funding is forced to sell. If funding has become
tight in the market as a whole, the set of potential holders of
the asset will be reduced. This mechanism depresses the asset
price, regardless of its expected future cash flows. The effect
may only be transitory, but "transitory" may be a relatively long
time, and may affect the solvency of the initial holder of the
asset during that period. This mechanism becomes most evident
during financial crises. Rapid deleveraging causes a "debt-
deflation crisis."
Mark-to-market risk combines aspects of market and credit risk.
It is often the case that the holding period of an asset, or the
time horizon of a trade, is quite long. The investor or trader,
however, may be required to report frequently the values of
assets and liabilities.
Market liquidity can constrain funding liquidity. As we saw just
above in describing the liquidation dilemma of a hedge fund
facing redemptions, a market participant obliged to sell assets
in order to raise cash faces a choice about what assets to sell
first: those with the greatest or the least market liquidity. Such
situations are most liable to arise during times of heightened
financial fragility and distress, when there are many other trad­
ers in a similar situation, and possibly with a similar portfolio.
The key trade-off is that by selling the most liquid assets first,
the market participant incurs the smallest adverse impact, but
left with a more illiquid portfolio with which to face any con­
tinuing 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 liquid­
ity pressure.
Systemic Risk and the "Plumbing"
An important channel through which liquidity risk events can
become systemic risk events is through problems in the pay­
ments, clearing, and settlements systems. Disruptions in these
systems, often called the "plumbing" of the financial system,
can be systemic risk events in their own right, or amplify an ini­
tial market or credit risk event into a systemic problem. These
systems, called financial market infrastructures or utilities in
contemporary regulatory parlance, include securities exchanges,
clearinghouses, securities depositories and settlement systems,
and payment systems. A disruption of any of these can impact
many market participants simultaneously, and illiquidity or insol­
vency of one counterparty can have downstream effects on oth­
ers through these systems.
42 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The tri-party repo system is a relatively recently developed
infrastructure that has rapidly gained in importance in the past
decade. It differs from conventional repo in that securities are
held in custody by a third party, almost always one of two major
clearing banks, Bank of New York Mellon (BNY) and JPMorgan
Chase. In the tri-party repo cycle, the counterparty borrowing
cash collateralized by securities deposits the securities with the
custodian, while the counterparty lending cash deposits the
funds with the custodian. The custodian sees to it that the funds
are made available to the borrower and maintains the securi­
ties in a segregated account so that they can be seized without
delay by the lender should the borrower default.
Most tri-party repo transactions are short-term, often overnight.
However, they are typically renewed regularly at maturity, so
they become a part of the longer-term financing mix of the
borrower. Tri-party repo is typically used by securities firms to
finance securities portfolios. Funding, that is, cash collateral,
is typically provided by money market mutual funds, insurance
companies, and other institutional investors.
Tri-party repo has grown enormously over the past two decades,
along with repo markets in general, as seen in Figure 2.3, reach­
ing a volume of $2 . 8 trillion of securities financed by early 2008,
encompassing a wide range of security types as collateral. Two
reasons for this growth are economies of scale in clearing, which
are generated in part by the greater scope for book-entry trans­
actions rather than delivering securities, and the desirability of
third-party custody of securities.
However, the mechanics of tri-party repo also involve liquidity
risks. Like most repo contracts, much tri-party repo has a one-
day term. Regardless of the term of the repo, each transaction
is unwound daily. The clearing bank returns the securities to
the account of the securities lender/borrower of cash, gener­
ally a large broker-dealer, and the cash to the account of the
securities borrower/lender of cash. The clearing bank in effect
finances the dealer, generally a broker-dealer financing its secu­
rities inventory, by permitting a daylight overdraft. Thus, apart
from clearing and custody services, the custodial bank provides
intraday credit to the borrower of cash, collateralized by the
securities. The custodial bank thereby assumes an exposure to
the cash borrower; that is, the counterparty credit risk that the
value of the collateral, if liquidated, will not be enough to cover
the debt.
A number of funding liquidity risks are inherent in this process.
A clearing bank might decline credit to one of its customers,
provoking or amplifying a rollover risk event for the customer.
The lenders of cash might decline to leave cash with a clear­
ing bank, or might withdraw from the repo market generally.
Tri-party repo is not only large, but concentrated; three dealers
accounted for 38 percent of outstanding tri-party repo in early
2010. The default of a large dealer would likely trigger the
immediate sale of the securities in its account that collateral­
ize its intraday overdraft. The mere possibility that the dealer's
account is undercollateralized would also call the clearing bank's
liquidity and solvency into question. While these systemic risk
events have not materialized, the risks were among the back­
ground factors in the Federal Reserve's introduction to the
Primary Dealer Credit Facility (PDCF) on March 17, 2008, during
the run on Bear Stearns. The PDCF provided primary dealers
with access to collateralized overnight funding.
"Interconnectedness"
Credit transactions, as we have now seen, take myriad forms.
The set of market participants involved as either borrowers or
lenders in at least some credit transactions includes most adults
and every firm, including nonfinancial firms, even in less-devel­
oped economies. Credit relationships form a network in which
each entity is a creditor and debtor of numerous other entities.
Each entity's creditworthiness depends, therefore, in part on the
creditworthiness of its obligors. If debts owed to a firm become
uncollectible, it may become unable to pay its own creditors.
Financial intermediaries are the most enmeshed entities in this
network, since they specialize in intermediating savings between
lenders and borrowers and have leveraged balance sheets in
which the bulk of the assets are debt of another entity. We have
discussed the counterparty risks that arise from these networks,
focusing on the standpoint of an individual firm managing these
risks. Counterparty risk also has an important systemic risk
aspect; a decline in the creditworthiness of its borrowers imper­
ils the financial intermediaries' own creditworthiness.
Another aspect of interconnectedness is the prevalence in con­
temporary finance of long intermediation chains involving secu­
ritization, off-balance sheet vehicles, and MMMFs, in addition
to traditional intermediaries. Some observers view these chains
as proliferating potential points of failure in the financial system.
The complexity of intermediation can make itself known in sur­
prising ways, drawing attention to vulnerabilities that had not
previously been widely identified, such as the hedge fund losses
on securities in custody with Lehman during its bankruptcy. The
web of credit thereby makes credit risk a matter of public policy
and concern.
Further Reading
Greenbaum and Thakor (2007) provides a textbook introduction
to financial intermediation by banks and other institutions. Much
of the literature on intermediation tries to explain why commer­
cial banks are so prominent in the financial landscape. Diamond
and Dybvig (1983) and Diamond (1984) are classic papers on
depository institutions. Diamond (1984) explains banks' promi­
nence in intermediation from an information cost viewpoint.
Diamond and Dybvig (1983) focuses on random fluctuations in
households' need for cash to explain the susceptibility of banks
to panics and runs. Diamond (1996, 2007) are accessible presen­
tations of the theory in these papers. A counterpoint is provided
by Calomiris and Kahn (1991) and Randall (1993), which argue
that uninsured depositors also provide some restraint on exces­
sive risk-taking by banks. Acharya, Gale, and Yorulmazer (2009)
presents a model of rollover risk and an application to the sub­
prime crisis. Goodhart (1990), and Cowen and Kroszner (1990)
discuss payment services provided by mutual funds with varying
market values as an alternative to deposit banking based on par-
value redemption.
Allen and Santomero (1997) and Dowd (1992) are critical surveys
of this literature, testing its relevance against the evolution of
finance from a banking-focused to a market-focused system.
The treatment of money as an asset among others in explaining
the demand for money—or, in any event, the term "liquidity pref­
erence"—goes back at least to Keynes (1936). Haberler (1958) is
a history, by a participant, in the debates on the theory of money
in their relationship to business cycles, up to and including
Keynes. The classic "modern" exposition is Tobin (1958).
Developments in the commercial paper market leading up
to and during the subprime crisis are discussed in Anderson
and Gascon (2009), and in Adrian, Kimbrough, and Marchioni
(2010). Pozsar, Adrian, Ashcraft, and Boesky (2010); Covitz,
Liang, and Suarez (2009); Arteta, Carey, Correa, and Kotter
(2010); and Acharya and Schnabl (forthcoming) provide details
on leverage through ABCP conduits and SIVs and examples of
specific vehicles. These papers also chronicle the unraveling of
these vehicles during the subprime crisis and their contribution
to its intensification.
Examples of the role of liquidity in the impact of the subprime
crisis on specific investment strategies can be studied in Mitch­
ell, Pedersen, and Pulvino (2007) (convertible bond arbitrage)
and Khandani and Lo (2008) (statistical arbitrage). Case stud­
ies of the relationship of payments, clearing, and settlements
system to systemic risk include Bernanke (1990) and Copeland,
Martin, and Walker (2010).
The development of collateral markets and their role in financial
developments leading up to the subprime crisis are reviewed
in a series of papers including Gorton (2008, 2009), and Gorton
and Metrick (2010). The role of rehypothecation in financial
Chapter 2 Liquidity and Leverage ■ 43
markets is emphasized in Singh and Aitken (2010). Shin (2009b)
discusses the impact of the supply of securitizations on the vol­
ume of credit and of aggregate leverage.
Institutional aspects of collateral markets, particularly the
mechanics of shorting and lending stock, are discussed in Weiss
(2006) and D'Avolio (2002). Institutional and legal aspects of
rehypothecation are discussed in Johnson (1997).
Breuer (2002) discusses the measurement of derivatives lever­
age. Carry trades in currency markets are discussed in Brun-
nermeier, Nagel, and Pedersen (2009), and in Clarida, Davis,
and Pedersen (2009). Adrian and Shin (2009a, 2009b), and King
(2008) discuss the increase in broker-dealer leverage during the
years leading up to the subprime crisis. King (2008) in particular,
explains how these transactions can be kept off-balance sheet,
and provides a guide to extracting additional information on
repo exposures from the footnotes to broker-dealer disclosures
other than the balance sheet.
Introductions to market microstructure are provided by Stoll
(2003) and O'Hara (1995). Demsetz (1968), Kyle (1985), and
Amihud and Mendelson (1986) are important early papers on
transactions liquidity. See Black (1986) and Shleifer and Sum­
mers (1990) on noise versus information trading. Madhavan
(2000) and Madhavan (2002) are good starting points for the
44 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
institutional background of transactions liquidity. Amihud, Men­
delson, and Pedersen (2005) is an extensive survey focusing on
transactions liquidity. Chordia, Roll, and Subrahmanyam (2001)
focuses on volume data. Committee on the Global Financial
System (1999b) is an introductory survey and review of policy
issues, while Basel Committee on Banking Supervision (2000)
presents recommendations on liquidity risk management.
Several papers, for example, Almgren and Chriss (2000, 2001),
discuss trading and investment in the presence of market liquid­
ity risk. Duffie and Ziegler (2003) treat the problem of whether
to liquidate more- or less-liquid assets first in a liquidity risk
event. Diamond and Rajan (2010) discuss the 2008 sellers strike.
See also Acerbi and Finger (2010).
Hicks (1962) is an early treatment of the relationship between
funding and market liquidity. Brunnermeier and Pedersen
(2009) present a model of their interaction in stress scenarios.
Brunnermeier, Nagel, and Pedersen (2009) discusses funding
liquidity, together with fat-tailed returns, as an explanation of
the option biases.
See Morgan Guaranty Trust Company (1996) and Marrison
(2002) for a discussion of asset-liability management. Senior
Supervisors Group (2009b) discusses liquidity risk management
lessons from the subprime crisis.
Early Warning
Indicators

Learning Objectives
After completing this reading you should be able to:

Evaluate the characteristics of sound Early Warning Indica­ Discuss the applications of EWIs in the context of the
tors (EWI) measures. liquidity risk management process.

Identify EWI guidelines from banking regulators and

supervisors (OCC, BCBS, Federal Reserve).

Excerpt is Chapter 6 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen Baird.

45
3.1 EARLY W ARNING INDICATORS:
M ECHANISM TO SIGN AL UPCOM ING
LIQUIDITY CRISIS
As an integral part of liquidity risk management (LRM), bank
leadership has the responsibility to both identify and manage
underlying liquidity risk factors. One of the critical aspects of a
bank's LRM involves first devising and then monitoring a set of
indicators to enable the risk identification process to spot the
emergence of new or increasing vulnerabilities. Negative trends
serve as early indicators that may warrant an assessment and
also a potential response by management in order to mitigate a
bank's exposure to any emerging risk.
This chapter provides an overview of the key aspects associated
with early warning indicators (EWIs).
Introduction: Dashboard and Beyond
Dashboard
EWIs may be viewed as analogous to warning lights on an auto­
mobile dashboard. The turning signals, low oil, and check engine
lights alert the driver of driving conditions. Continuing this anal­
ogy, a turn signal or "blinker" indicates an intentional risky activ­
ity of making a purposeful directional change. In the realm of
LRM, this might mean, for example, running a deposit special to
raise rate-sensitive liabilities. A low engine oil light indicates to
the driver that direct action may be needed in the near future to
prevent the engine from seizing up. Again in an LRM context, this
is analogous to noticing that the bank's Liquidity Coverage Ratio
(LCR) has dropped below a specified threshold. A check engine
light indicates further investigation is warranted for a yet to be
determined reason; the application of this aspect of the analogy
may mean, for example, that a dramatic increase in call center
volumes may portend a shift in the bank's liquidity position.
Most importantly EWI triggers are used to initiate management
discussions and actions that should be formally documented.
This could be as simple as an acknowledgment that the bank's
treasury is aware that a deposit campaign is underway by one
of the business lines so it can orchestrate a corrective action,
for example, by increasing the high quality liquid assets buffer
in a cost-efficient manner and continuing to comply with LCR
requirements.
Beyond
Holding liquid assets to ensure a bank can meet its financial
obligations is ultimately a cost-benefit decision. The protection
46 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
from the catastrophic impacts of not having enough liquidity is
offset by a significant drag on earnings if the buffer is too high.
A minimum standard for the liquidity buffer is set in accordance
with the risk appetite of the bank. However a basic "set and for­
get" approach does not allow for the strategic management of
this risk against a dynamic market.
Increasing buffers before times of stress can extend the survival
horizon in a cost-effective manner as a bank does not want to
be caught short of liquidity when the market freezes. Indeed,
being in a strong balance sheet position during times of stress
opens opportunities for significant gains in market share as well
as acquisitions that may not be otherwise available in the nor­
mal course of business. Strongly positioned companies can take
advantage of rare instances of market disruption. The manage­
ment tool that gives rise to this strategic advantage is the LRM
EWI framework.
Regulatory Emphasis in Recent Times
The global financial crisis of 2007-08 has put the spotlight on
LRM. The Basel Committee on Banking Supervision (BCBS)
issued its "Principles of Sound Liquidity Management and
Supervision" 1 (Sound Principles) in September 2008, followed
closely by details on standardized metrics such as the LCR and
the Net Stable Funding Ratio (NSFR). This overarching frame­
work includes the use of EWIs.
Table 3.1 is a non-exhaustive list of EWIs recommended by the
BCBS. It includes key indicators that are both qualitative and
quantitative in nature.
Key Supervisory Guidelines
National regulators have started to benchmark financial institu­
tions against these sound principles. The regulatory expecta­
tions for banks have gone up as a result. In particular, the data
needed to support a modern LRM framework, in terms of
quantity, quality, and timeliness, is an expensive investment. The
responses from banks span a range from those who aim to mini­
mize the cost of compliance to those who believe it can become
a strategic tool to guide future management decisions.
Table 3.2 summarizes key supervisory guidelines, which should
act as one of the core guiding principles for EWI selection and
monitoring at a bank.
1 BCBS, "Principles of Sound Liquidity Management and Supervision,"
Sept 2008, Early Warning Indicators.
Table 3.1 BCBS Recommended EW Is (EW Is may include but are not lim ited to the item s listed below)

Rapid asset growth, especially when funded with potentially volatile liabilities
Growing concentrations in assets or liabilities
Increases in currency mismatches
Decrease of weighted average maturity of liabilities
Repeated incidents of positions approaching or breaching internal or regulatory limits
Negative trends or heightened risk 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
Source: BCBS, "Principles of Sound Liquidity Management and Supervision," Sept 2008, Early Warning Indicators.

Risk Identification and EWIs Framework Components: M.E.R.l.T.

It is important to ensure that EWIs align to and are a natural
extension of the enterprise LRM framework.
According to Federal Reserve Board Supervisory Letter (FRB SR)
12-7 requirements, the LRM framework should be end-to-end
and ensure that the bank will "sufficiently capture the banking
organization's exposures, activities, and risks."
A comprehensive LRM framework begins by identifying liquid­
ity and funding risks that are inherent in the business activities
of the institution (Figure 3.1). These risks are then memorial­
ized in the firm's liquidity risk inventory and subjected to a risk
assessment process that includes the businesses, corporate
treasury, the independent risk management function, and
other relevant stakeholders. Once the institution has assessed
its liquidity risks, including their sources and drivers, the firm
can then develop a framework for measuring and monitoring
these risks, consisting of stress tests, EWIs, and a limit and
response framework.
The EWI framework can be summarized as M.E.R.l.T. (Mea­
sures, Escalation, Reporting, Integrated systems, and Thresh­
olds). While an appropriate set of measures is the first essential
building block for a robust EWI framework, it will be a mere
academic exercise if the framework is eventually not linked to
escalation processes. The journey from measures to escalation
is facilitated by timely reporting with the support of integrated
systems and data as well as relevant and properly calibrated
thresholds.
Measures
Principle 5 from the BCBS' Sound Principles articulates the
hallmarks of EWIs. The principle states that "to obtain a for­
ward looking view of liquidity risk exposures, a bank should
use metrics that assess (a) the structure of the balance sheet,
as well as metrics that (b) project cash flows and future
liquidity positions, taking into account (c) off-balance sheet

Chapter 3 Early W arning Indicators ■ 47

 GO
Table 3.2 Key Supervisory Guidelines
OCC-20122
• A bank should have EWIs that
signal whether embedded trig­
gers in certain products (i.e., call­
able public debt, OTC derivatives
transactions) are about to be
breached, or whether contingent
risks are likely to materialize.
• Early recognition of a potential
event allows a bank to enhance
a bank's readiness. EWI's may
include:
• A reluctance of traditional
fund providers to continue
funding at historic levels
• Pending regulatory action
(both formal and informal) or
CAMELS component or com­
posite rating downgrade(s)
• Widening of spreads on senior
and subordinated debts, credit
default swaps, and stock price
declines
• Difficulty in accessing long­
term debt markets
• Reluctance of trust managers,
money managers, public enti­
ties, and credit-sensitive funds
providers to place funds
• Rising funding costs in an
otherwise-stable market
• Counterparty resistance to
off-balance-sheet products or
increased margin requirements
• The elimination of committed
credit lines by counterparties
2 OCC: Liquidity booklet of the OCC's Comptroller's Handbook (2012)
BCBS: Basel Committee on Banking Supervision, "Principles for Sound Liquidity Risk Management and Supervision" (2008)
Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
4 BCBS: Basel Committee on Banking Supervision, "Monitoring Indicators for Intraday Liquidity" (2012)
5 Interagency Policy Statement on Funding and Liquidity Risk Management (2010)
BCBS-20083
• A bank should design a set of
indicators to identify the emer­
gence of increased risk or vul­
nerabilities in its liquidity risk
position or potential funding
needs.
• Early warning indicators can be
qualitative or quantitative in
nature and may include but are
not limited to
• Rapid asset growth, especially
when funded with potentially
volatile liabilities
• Growing concentrations in
assets or liabilities
• Increases in currency
mismatches
• Decrease of weighted average
maturity of liabilities.
• Repeated incidents of posi­
tions approaching or breach­
ing internal or regulatory limits
• Negative trends or heightened
risk associated with a particu­
lar product line
BCBS-20124
• Intraday liquidity monitoring indi­
cators include:
• Daily maximum liquidity
requirement
• Available intraday liquidity
• Total payments
• Time-specific and other critical
obligations
• Value of customer payments
made on behalf of financial
institutions customers
• Intraday credit lines extended
to financial institution
customers
• Timing of intraday payments
• Intraday throughput
SR 10-65
• Institution management should
monitor for potential liquid­
ity stress events by using
early-warning indicators and
event triggers. The institution
should tailor these indicators to
its specific liquidity risk profile.
• Early recognition of potential
events allows the institution to
position itself into progressive
states of readiness as the event
evolves, while providing a frame­
work to report or communicate
within the institution and to
outside parties.
• Early-warning signals may
include, but are not limited to:
• Negative publicity concerning
an asset class owned by the
institution
• Increased potential for dete­
rioration in the institution's
financial condition
• Widening debt or credit
default swap spreads
• Increased concerns over the
funding of off-balance-sheet
items
 1. Risks Identification 2. Risk 3. Risk 4. Contingency
Assessment Capture

Liquidity Stress Test

Modeling

Early Warning
Indicators

Limits and EWI

Thresholds

Figure 3.1 Risk identification and EWIs

risks." These measures should span vulnerabilities across

business-as-usual and stressed conditions over various time
horizons. " 6 Within Deteriorating asset Increased debt
the bank quality spreads
Forward Looking Bias/View
A suite of EWIs that includes internal and external metrics is
required for prudent risk management. These measures ideally need
to be leading (forward looking) and sharp (sufficiently granular). Outside Asset class
Country default
the bank liquidity failure
A leading indicator is one that will provide information and sig­
nal potential stress prior to the occurrence of an actual event.
This is particularly important in preparing for systemic scenarios.
"main "Wall
Rather than using lagging indicators which report on events street" street"
that have already occurred, such as government reported GDP
Figure 3.2 Early warning indicator dimensions.
figures, a bank can develop proxies for the performance of the
general economy from internal loan portfolio metrics.
The granularity and specificity of a particular indicator as it per­ understanding of risk drivers and trends than broad, lagging
tains to an institution's profile is known as its sharpness. Sharp indicators may otherwise provide.
indicators are signals that do not go unnoticed within the mass In additional to developing sharp leading indicators, banks
of data. For example, detecting a drop in overall deposit bal­ should also strike a balance between external and internal
ances is an acceptable EWI; however, detecting drops in deposit measures (Figure 3.2). Internal measures are customized to the
balances of more volatile segments, such as high-net worth bank's balance sheet and activities while external measures sig­
customers or rate-sensitive products balances, brings into focus nal systemic changes in the economy or market.
that certain important classes of customers are leaving the bank.
It is important to recognize that liquidity events can start either
Developing EWIs that are both sharp and forward looking allows within the bank or may be influenced by external elements
more time for management to take corrective or mitigating resulting from the environment within which the bank operates.
actions; it also helps to ensure that managers have a better For example, an idiosyncratic deposit run may result from either
the disclosure of poor performance or due to a systemic failure.
6 BCBS, "Principles of Sound Liquidity Management and Supervision," EWIs should be positioned to capture emerging internally-
Sept 2008. driven stress events before they become public knowledge, for

Chapter 3 Early W arning Indicators ■ 49

example, through monitoring of loan performance, planned sig­
nificant accounting adjustments, and operational losses. Alter­
natively, 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 institu­
tions that are exposed to those markets.
Environments, Both Normal and Stressed
EWIs are meant to provide signals or to act as a heads-up for an
upcoming potential disaster. Tracking appropriate EWI metrics dur­
ing a business as usual environment is essential as any deteriora­
tion 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.
In addition, institutions should include stressed measures and
limits into their EWI lists in order to gauge the adequacy of the
firm's liquidity buffer for a stressed environment. Additionally,
stress testing results may also expose previously unidentified or
emerging concentrations and risks that could threaten the viabil­
ity of the institution.
Spanning Various Time Horizons
EWI coverage cannot be static and needs to reflect various time
horizons in order to match the institution's unique balance sheet
needs as well as the market and economic conditions under
which it operates.
Typical cycle time horizons that match banking forecasts and
business operations tend to be daily, weekly, or monthly. An
indicator that is not updated for a period of more than a month
is unlikely to satisfy the "early" aspect of the EWI. Certain EWIs
may even be monitored on an intraday basis, as warranted by
business conditions or required by regulators.
Escalation
Although escalation criteria are bespoke to a bank, an effective
escalation policy should ensure that limit breaches are escalated
to the appropriate level of management with the authority to
undertake corrective actions. Modest responses such as increas­
ing the liquid asset buffer may usually be done within the del­
egation of the corporate treasurer; however, an EWI that signals
a potentially large cash outflow may require the asset-liability
committee (ALCO) to authorize a check on future asset growth.
The most extreme cases may require management to initiate the
bank's contingency funding plan (CFP).
EWIs will have a tangible and favorable impact on LRM governance
only when they are linked to a clearly defined escalation plan. The
governance overseeing the escalation of EWI triggered actions
must be formalized and documented as part of the liquidity risk
management framework and be included in the institution's CFP.
50 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Reporting
EWI reporting needs to be timely in order to provide manage­
ment with sufficient lead time to make adjustments in response to
potential crisis events. It is common practice to have the EWI dash­
board reported on a daily basis. While most institutions perform
some level of daily liquidity reporting, leading institutions are mov­
ing toward intraday reporting of certain measures. Firms with a sig­
nificant trading focus are more likely to use intraday reporting as a
result of their increased exposure to external market conditions.
Reporting also needs to strike a balance between being
(a) broad enough to provide wide coverage, and (b) specific
enough to communicate only key messages.
Integrated Systems
Metrics and reporting are feasible and meaningful only when
they are backed by the bank's ability to calculate the selected
metrics, and report them consistently.
Integrated data and systems within the bank are essential in
providing liquidity managers with the capability to ensure that
reported metrics are (a) accurate, and (b) in sync with each
other. For example, deposit volumes feeding into liquidity stress
tests, and their resulting measures, should be derived from the
same source system used to produce non-stressed measures,
such as week over week declines in deposit funding. This level
of automation and integration is particularly important as EWI
frameworks increasingly supplement traditional market-based
metrics with a larger array of internal indicators.
Thresholds
Firms generally use a stoplight system in representing and commu­
nicating their performance against the thresholds of their EWIs. A
green indicator means that the measure is within normal bounds. A
measure that is classified as amber according to the threshold frame­
work should be investigated further while a red indicator should
be a source for significant concern and may warrant an immediate
response. The threshold boundaries for which an EWI moves from
green to amber should not be so wide that movements go unde­
tected and the metric constantly indicates that the economic and
internal environments are healthy and unchanged. Institutions should
also be careful not to set boundaries that are so narrow as to force
constant investigation of its movements, desensitizing management
to its impact and creating a "boy who cried wolf" circumstance.
Historical data analysis is commonly used to estimate the volatil­
ity of an EWI and to calibrate its thresholds. The length of the
calibration time series needs to be sufficiently long in order to
be significant but should also capture recent events to ensure
that it represents the current operating environment. If possible,
the time series should include a period of stress, such as during
2007-08, to more accurately assess the performance of the metric
under stressed conditions. When available, a historical time series
OIS
of at least one year will be used for calibration. The threshold
LIBOR/OIS Spread
should be subjected to back-testing to determine if recalibra­
tion is needed and a management override, based on historical Euribor vs. Eonia (bp)
judgment, is warranted (e.g., historical analysis of the volatility of 10 yr Benchmark Treasury
the Fed Fund rate is informative; however, triggers may be more 2Y/10YU.S. Spread
appropriately set using the FOMC specified target range).
3M T-2yr T spread
Industry Practices 3M U.S. Tsy

Over the last few years, banking institutions have increased the 6 M U.S. Tsy
attention and resources devoted to developing and maintaining 12M U.S. Tsy
EWI dashboards and their overarching governance. The added FED Open
emphasis in recent years can be largely attributed to supervi­ FED EFF
sory demands in the form of matters requiring attention (MRAs),
Federal Reserve Rates (Discount Rate)
exams, etc. In certain instances, the credit should also duly be
given to self-initiatives from the bank leadership to launch projects Federal Reserve Rates (Fed Funds)
to enhance its liquidity management solidifying risk reporting. Global Treasuries

As an illustration, we have included lists of EWIs typically BankO/N Rate - Fed Effective > 1 0 bps
reported in the banking industry (Tables 3.3 to 3.9). Please note Overnight Positions
that the list is non-exhaustive. Net MM Fund Outflows
NAV <1 .x for MM Funds
Illustrative EWI List

Table 3.3 Market Indicators I

Table 3.5 Market Indicators 3
EWI Type Actual Indicator
EWI Type Actual Indicator
Credit Rating Moody's
Other Indicators USD/CAD foreign exchange rate
Standard & Poor's
USD/CAD FX Spot Rate
Fitch Ratings
BKX Index (Banking Sector Health)
Changes in ratings
Unemployment Rate
Equity Markets DJ STOXX 600 Banks
GDP Growth Rate-QoQ Change
DJIA
Crude
S&P 500
Economic indicators forecasting
S&P TSX recession
NASDAQ Political interference in bank regula-
FTSE 100 tion/supervision, leading to reduced
capacity at FHLB or discount
NIKKEI 225
window
VIX (Stock market volatility) Internal due diligence activity related
to a material acquisition
Table 3.4 Market Indicators 2 ABCP/LIBOR Spread
EWI Type Actual Indicator State ISMs
Rates/MM 1M LIBOR Case-Shiller HPIs
trends 3M LIBOR NCREIF CRE Transaction Price Index
6 M LIBOR BBB Option-Adjusted Spread
12M LIBOR Repo Spread

C hap ter 3 Early W arning Indicators ■ 51

 Bank Specific Indicators 1

EWI Type Actual Indicator

Credit Risk Bank 5yr CDS(bp)

Counterparty Concentration
S&P Sr. Credit Rating
Moody's Sr. Credit Rating
Fitch Sr. Credit Rating
S&P Bank ST Credit Rating
Moody's Bank ST Credit Rating
Fitch Bank ST Credit Rating
FHLB Credit Rating
CAMELS rating
DBRS Sr. Credit Rating
Bank CDS spread higher than Barclays Capital Aggregate Index
Total Outstanding 3rd Party Borrowings
Top 5 3rd Party Borrowings (% per institution)
% of OIS CDs with Top 10 counterparties
Total 3rd Party Borrowings (% per business sector)
% of Total Wholesale Borrowings (per counterparty)
% of Total Wholesale Borrowings (per business sector)
Total Outstanding 3rd Party Repo
Top 5 Total 3rd Party Repo (% per institution)
% of Repo CDs with Top 10 counterparties
Total 3rd Party Repo (% per business sector)
Breach of tactical liquidity limits
Largest Fund (Single) providers
Funding Sources as a percent of total average assets

Bank Specific Indicators 2

EWI Type Actual Indicator

Credit Performance Credit Card Net Losses

Credit Card Industry Avg Net Losses
Credit Card 30 + Day DQ
Card Excess Spread
Funding Need Total Deposits Variance to Plan (MM)
Total Loans Outstanding Variance to Plan (MM)

52 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Bank Specific Indicators 2 (Continued)

EWI Type Actual Indicator

Liquidity Metrics RWAs

Total Pic CD/CP
LOC - 1 Week /1 Month. 3 Months
CP (term) ($mm)
Next Days Maturities
WAM of Outstanding CP
Unsec Borrows from PLC - Term
Unsec Borrows from PLC - O/N
Total Unsec from PLC
O/N Non Traditional Repo (Ex Equities)
Total Available Liquidity
l/C Reverse Repo (Ex Equities)
Repo/Rev Repo Mismatch (per protuct type)
% cumulative RE financed
Limit - % Repo to Total Financed
% Reverses over repo
Limit - Reverses over Repos
Prelim TPAs (ex Deriv MTM)
Balance Sheet (U.S. GAAP)

Bank Specific Indicators 3

EWI Type Actual Indicator

Liquidity Metrics Disc Window Collateral

Due from % of 3rd Party Liabilities
Short term market cash
Total cash at FRB
Payments
Receipts
Closed Fed Balance
Collateral at Fed
Daylight OD Usage
Daily Highlight Comments
Other Immediate Potential Cash Outflows:
Anticipated Cash Inflows
More Liquid Assets
Total Gross Operational Risk Losses / 12 Month Revenue
Contingency Funding Plan Activation
Bank Unsecured Capacity reduced by 10% or more MoM
Bank Retail Loans greater than 30 days Delinquent
Criticized Credits > 7% of Total Commercial Loans
EPS Stress Test Ratio/EPS Branch Stress Test Ratio
Repo Haircut
Increased spread paid for uninsured debt issuance
Decline in earnings and or capital levels

Chapter 3 Early W arning Indicators ■ 53

Table 3.9 Bank Specific Indicators 4
EWI Type Actual Indicator

Market Sentiment Share Price

Bank vs BKX Index
Decline in stock price relative to the change in stock prices of peers
Trading loss risk
% of outstanding shares
UMich Index of Consumer Sentiment
Maturity Concentration % of Total Gross Repo in Overnight
Overnight Repo Average vs market
% Total Outstanding Unsecured Borrowing (single day)
% Total Outstanding Unsecured Borrowing (5 day)
% Total Outstanding Unsecured Borrowing (10 day)
% Total Outstanding Unsecured Borrowing (10 day)
National Market Funding Maturity Time Horizon
Stress Testing Results Liq Scenarios
Liq Stress Test + /—3M Cumulative
Parent Liquidity Scenario
U.S. LCR
NSFR
Other Indicators Quarterly Net Income Severely Adverse Parent Forecast
Disclosure Committee Trigger
Gross Impaired Loans & Loan Formations
Retail W/W Change in Deposits
Bank Credit Turndown of Significance
Bank classified ratio

CO N CLU SIO N
Over the years after the 2007-08 financial crisis, banking insti­
tutions have significantly increased their reliance on EWIs to
avert any potential liquidity crisis. Nonetheless, supervisors as
well as risk managers within the banks are constantly looking
to expand and refine their EWIs so that the list stays relevant
both to the internal changes that the bank may be under­
going and to the dynamic, ever-changing macro-economic
landscape.
Regulatory focus is expected to remain elevated, and super­
visors are likely to scrutinize idiosyncratic EWIs as these are
more tailored to the bank's specific vulnerabilities. Liquidity
risk managers at the bank must ensure that EWIs are gov­
erned as a part of the holistic risk management function within
the organization. It is critical to ensure that EWIs are updated
and aligned with other core aspects of the LRM framework,
such as:
• Risk inventory
• Liquidity stress testing assumptions
• Cash flow—actuals and projections
• Business plans—Short-term/tactical and long-term/strategic
• Contingency funding plan
• Stakeholders—business lines/treasury/risk (second line of
defense)
EWIs will likely aid in managing the risk and averting the crisis only if
the reporting mechanism is highly efficient. Thus, liquidity risk man­
agers should ensure the quality and timeliness of the data that feeds
into the EWIs. A relevant and reliable EWI list will not only alert the
leadership during or ahead of a crisis, but also will likely comple­
ment the overall risk management capabilities of the institution.

54 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The Investment
Function in
Financial-Services
Management
Learning Objectives
After completing this reading you should be able to:

Compare various money market and capital market Apply investment maturity strategies and maturity
instruments and discuss their advantages and management tools based on the yield curve
disadvantages. and duration.

Identify and discuss various factors that affect the choice

of investment securities by a bank.

Excerpt is Chapter 10 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

55
K E Y TOPICS IN THIS CH APTER
• Nature and Functions of Investments
• Investment Securities Available: Advantages and
Disadvantages
• Measuring Expected Returns
• Taxes, Credit, and Interest-Rate Risks
• Liquidity, Prepayment, and Other Risks
• Investment Maturity Strategies
• Maturity Management Tools
4.1 INTRODUCTION
An investments officer of a large money center bank was over­
heard to say: "There's no way I can win! I'm either buying bonds
when their prices are the highest or selling bonds when their
prices are the lowest. Who would want this job?" In this chapter
we will discover what that investments officer really meant.
To begin our journey, we need to keep in mind that the primary
function of most banks and other depository institutions is not
to buy and sell bonds, but rather to make loans to businesses
and individuals. After all, loans support business investment and
consumer spending in local communities. Such loans ultimately
provide jobs and income to thousands of community residents.
Yet buying and selling bonds has its place because not all of a
financial firm's funds can be allocated to loans. For one thing,
many loans are illiquid—they cannot easily be sold or securitized
prior to maturity if a lending institution needs cash in a hurry.
Another problem is that loans are among the riskiest assets,
generally carrying the highest customer default rates of any
from of credit. Moreover, for small and medium-size depository
institutions, at least, the majority of loans tend to come from the
local area. Therefore, a significant drop in local economic activ­
ity can weaken the quality can weaken the quality of the average
lender's loan portfolio, though the widespread use of securitiza­
tion, loan sales, and credit derivatives may help to insulate many
lenders serving local areas. Then, too, loan income is usually
taxable for banks and selected other financial institutions, neces­
sitating the search for tax shelters in years when earnings from
loans are high.
For all these reasons depository institutions, for example,
have learned to devote a significant portion of their asset
portfolios—usually somewhere between a fifth to a third
of all assets—to another major category of earning asset:
investments in securities that are under the manage­
ment of investments officers. Moreover, several nonbank
financial-service providers—insurance companies, pension
funds, and mutual funds, for example—often devote an
even bigger portion of their assets to investment securities.
These instruments typically include government bonds and
notes; corporate bonds, notes, and commercial paper; asset-
backed securities arising from lending activity; domestic and
Eurocurrency deposits; and certain kinds of common and
preferred stock where permitted by law.
As we will see as this chapter unfolds, investments perform
a number of vital functions in the asset portfolios of financial
firms, providing income, liquidity, diversification, and shelter
for at least a portion of earnings from taxation. Investments
also tend to stabilize earnings, providing supplemental income
when other sources of revenue are in decline. See Exhibit 4.1
and Table 4.1 for a summary of the principal roles investment
portfolios play on the balance sheets of many financial firms.

Assets Liabilities
Cash Deposits

Add to Sell When deposits are low Return investments pledged

investments investments use investments as as collateral to the investments
when cash is when cash is collateral for more portfolio when deposit growth
high low nondeposit borrowings is high
▼
Investments ► Nondeposit
◄--------------- — Borrowings
A
Sell Add to
investments investments
when loan when loan
demand is demand is
high low

Loans
Exhibit 4.1 Investments: The crossroads account on a depository institution's balance sheet.

56 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Table 4.1 Functions of the Investm ent Security Portfolio

Investment security portfolios help to

a. Stabilize income, so that revenues level out over the business cycle—when loan revenues fall, income from investment
securities may rise.
b. Offset credit risk exposure in the loan portfolio. High-quality securities can be purchased and held to balance out the risk
from loans.
c. Provide geographic diversification. Securities often come from different regions than the sources of loans, helping diversify
a financial firm's sources of income.
d. Provide a backup source of liquidity, because securities can be sold to raise needed cash or used as collateral for borrowing
additional funds.
e. Reduce tax exposure, especially in offsetting taxable loan revenues.
f. Serve as collateral (pledged assets) to secure federal, state, and local government deposits held by a depository institution.
g. Help hedge against losses due to changing interest rates.
h. Provide flexibility in a financial firm's asset portfolio because investment securities, unlike many loans, can be bought or sold
quickly to restructure assets.
i. Dress up the balance sheet and make a financial institution look financially stronger due to the high quality of many
marketable securities,
Federal regulations stress the need for every regulated institution to develop a written investment policy giving specific
guidelines on:
a. The quality or degree of default risk exposure the institution is willing to accept.
b. The desired maturity range and degree of marketability sought for all securities purchased.
c. The goals sought for its investment portfolio.
d. The degree of portfolio diversification to reduce risk the institution wishes to achieve.

4.2 IN VESTM EN T INSTRUMENTS
AVAILABLE TO FIN AN CIAL FIRMS
The number of financial instruments available for financial
institutions to add to their portfolios is both large and
growing. Moreover, each financial instrument has different
characteristics with regard to expected yields, risk, sensitivity
to inflation, and sensitivity to shifting government policies
and economic conditions. To examine the different investment
vehicles available, it is useful to divide them into two broad
groups: ( 1 ) money market instruments, which reach maturity
within one year and are noted for their low risk and ready
marketability and (2 ) capital market instruments, which have
remaining maturities beyond one year and are generally noted
for their higher expected rate of return and capital gains
potential. See Table 4.2 for a summary of the advantages and
disadvantages of the principal types of investment securities
available.
Some authorities refer to investments as the crossroads
account. Investments held by depository institutions literally
stand between cash, loans, and deposits. When cash is low,
some investments will be sold in order to raise more cash.
On the other hand, if cash is too high, some of the excess
cash will be placed in investment securities. If loan demand is
weak, investments will rise in order to provide more earning
assets and maintain profitability. But, if loan demand is strong,
some investments will be sold to accommodate the heavy loan
demand. Finally, when deposits are not growing fast enough,
some investment securities will be used as collateral to borrow
nondeposit funds. No other account on the balance sheet
occupies such a critical intersection as do investments.
4.3 POPULAR M O N EY M ARKET
IN VESTM EN T INSTRUMENTS
Treasury Bills
One of the most popular of all short-term investments is the
U.S. Treasury bill—a debt obligation of the United States
goverment that, by law, must mature within one year from date
of issue. T-bills are issued in weekly and monthly auctions and
are particularly attractive to financial firms because of their high
degree of safety. Bills are supported by the taxing power of the
federal government, their market prices are relatively stable,
and they are readily marketable. Moreover, T-bills can serve as
collateral for attracting funds from other institutions. Bills are
issued and traded at a discount from their par (face) value. Thus,
the investor's return consists purely of price appreciation as the
bill approaches maturity. The rate of return (yield) on T-bills is
figured by the bank discount method, which uses each bill's
par value at maturity as the basis for calculating its return (as
discussed in Chapter 18).

Chapter 4 The Investm ent Function in Financial-Services M anagem ent ■ 57

 tn
co

Table 4.2 Key Advantages and Disadvantages of Popular Investment Securities Often Purchased by Financial Firms
Money Market Instruments

Short-Term Federal International Short-Term

Treasury Notes Agency Certificates Eurocurrency Bankers' Municipal
Treasury Bills and Bonds Securities of Deposit Deposits Acceptances Paper Obligations

Key Safety and high Safety Good Safety Good Insured to at Low risk Low risk Low risk due Tax-exempt
advantages: liquidity resale market to average least $ 1 0 0 , 0 0 0 Higher yields due to mul­ to high quality interest
Good collateral Good collateral resale market Yields higher than on many tiple credit of borrowers income
for borrowing for borrowing Good collateral than on T-bills domestic CDs guarantees
Can pledge Offer yields for borrowing Large denomi­
behind govern­ usually higher Higher yields nations often
ment deposits than T-bill than on U.S. marketable
yields government through dealers
securities
Key Low yields rela­ More price risk Less market­ Limited resale Volatile inter­ Limited avail­ Volatile market Limited
disadvantages: tive to other than T-bills able than Trea­ market on est rates ability at spe­ Poor resale resale
financial instru­ Taxable gains sury securities lonqer-term Taxable cific maturities market market
ments and income Taxable gains CDs income Issued in odd Taxable Taxable
Taxable income and income Taxable income denominations income capital gains
Taxable income
Capital Money Market Instruments
Municipal (State and Local
Treasury Notes and Bonds Government) Bonds Corporate Notes and Bonds Asset-Backed Securities
Key Safety Tax-exempt interest income Higher pretax yields than on Higher pretax yields than on
advantages: Good resale market High credit quality government securities Treasury securities
Good collateral for borrowing Liquidity and marketability of Aid in locking in higher Collateral for borrowing addi­
May be pledged behind govern­ selected securities long-term rates of return tional funds
ment deposits
Key Low yields relative to long-term Volatile market Limited resale market Less marketable and more
disadvantages: private securities Some issues have limited resale Inflexible terms unstable in price than Treasury
Taxable gains and income potential Taxable gains and income securities
Limited supply of longest-term Taxable capital gains May carry substantial default
issues risk Taxable gains and income

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Short-Term Treasury Notes and Bonds
At the time they are issued, Treasury notes and Treasury bonds
have relatively long original maturities: 1 to 1 0 years for notes
and over 10 years for bonds. However, when these securities
come within one year of maturity, they are considered money
market instruments. While T-notes and bonds are more sensi­
tive to interest rate risk and less marketable than T-bills, their
expected returns are usually higher than for bills with greater
potential for capital gains. T-notes and bonds are coupon instru­
ments, which means they promise investors a fixed rate of return,
though the expected return may fall below or climb above the
promised coupon rate due to fluctuations in market price.
F a c to id
Which federal agency in the United States has more securi­
ties outstanding in the financial marketplace for investors to
buy than any other agency?
Answer: The Federal National Mortgage Association (Fannie
Mae), followed by the Federal Home Loan Banks (which are
lenders to banks and thrifts) and the Federal Home Loan
Mortgage Corporation (Freddie Mac).
All negotiable Treasury Department securities are issued by
electronic book entry. This system, known as Treasury Direct,
provides investment security owners of U.S. Treasury securi­
ties with a statement showing the bills, notes, and bonds they
hold. Any interest and principal payments earned are depos­
ited directly into the owners' checking or savings account.
This approach means not only greater convenience but also
increased protection against theft.
Federal Agency Securities
Marketable notes and bonds sold by agencies owned by or
sponsored by the federal government are known as federal
agency securities. Familiar examples 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). Most of these instruments are not formally guaranteed
by the federal government, though many believe Congress
would rescue an agency in trouble. This implied government
support keeps agency yields close to those on Treasury secu­
rities and contributes to the high liquidity of many agency
securities. Interest income on agency-issued notes is federally
taxable and, in most cases, subject to state and local taxa­
tion as well. Some agency debt (especially Fannie Mae and
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
Freddie Mac notes) appears now to be facing serious risk (with
Fannie and Freddie recently taken into receivership by the
U.S. government).
Certificates of Deposit
A certificate of deposit (CD) is simply an interest-bearing
receipt for the deposit of funds in a depository institution.
Thus, the primary role of CDs is to provide depository institu­
tions with an additional source of funds. Banks often buy CDs
issued by other depository institutions, believing them to be an
attractive, lower-risk investment. CDs carry a fixed term and a
penalty for early withdrawal. Depository institutions issue both
small consumer-oriented CDs, from $500 to $100,000, and
larger business-oriented or institution-oriented CDs (often called
jumbos or negotiable CDs) with denominations over $100,000
(though only the first $250,000 is federally insured). CDs have
negotiated interest rates that, while normally fixed, may fluctu­
ate with market conditions. Security dealers provide a secondary
market for $100,000-plus CDs maturing within six months.
International Eurocurrency Deposits
Eurocurrency deposits are time deposits of fixed maturity issued
in million-dollar units by the world's largest banks headquar­
tered in financial centers around the globe, though the heart
of the Eurocurrency market is in London. Most of these inter­
national deposits are of short maturity—30, 60, or 90 days—to
correspond with the funding requirements of international trade.
They are not insured, and due to their perceived higher credit
risk, they often carry slightly higher market yields than domes­
tic time deposits issued by comparable-size U.S. banks. (For
a detailed discussion of the role and creation of Eurocurrency
deposits, see Chapter 13.)
Bankers' Acceptances
Because they represent a bank's promise to pay the holder
a designated amount of money on a designated future date,
bankers' acceptances are considered to be among the safest of
all money market instruments. Most arise from a financial firm's
decision to guarantee the credit of one of its customers who is
exporting, importing, or storing goods or purchasing currency.
In legal language, the financial firm issuing the credit guarantee
agrees to be the primary obligor, committed to paying off a
customer's debt in return for a fee. The issuing institution sup­
plies its name and credit standing so its customer will be able to
obtain credit elsewhere at lower cost.
Because acceptances have a resale market, they may be
traded from one investor to another before reaching maturity.
■ 59
If the current holder sells the acceptances, this does not erase
the issuer's obligation to pay off its outstanding acceptances at
maturity. However, by selling an acceptance, the holder adds
to its reserves and transfers interest rate risk to another inves­
tor. The acceptance is a discount instrument and, therefore, is
sold at a price below par. The investor's expected return comes
from the prospect that the acceptance will rise in price as it gets
closer to maturity. Rates of return on acceptances generally lie
close to the yields on Eurocurrency deposits and Treasury bills.
Another important advantage of acceptances is that they may
qualify for discounting (borrowing) at the Federal Reserve Banks,
provided they are eligible acceptances, which means they must
be denominated in U.S. dollars, normally cannot exceed six
months to maturity, and must arise from the export or import of
goods or from the storage of marketable commodities.
Commercial Paper
Many smaller banks, money market funds, and other financial
firms find commercial paper—short-term, unsecured lOUs
offered by major corporations—an attractive investment safer
than many types of loans. Commercial paper sold in the United
States is of relatively short maturity—the bulk of it matures in
90 days or less—and generally is issued by borrowers with the
highest credit ratings. In Europe and Japan the paper market
has attracted participation by international banks, finance com­
panies, and other lending institutions. European paper gener­
ally carries longer maturities and higher interest rates than U.S.
paper due to its greater perceived credit risk; however, there is
a more active resale market for Europaper than for most U.S.
paper issues. Most commercial paper is issued at a discount
from par, though some bears a promised rate of return (coupon).
Short-Term Municipal Obligations
State and local governments—including counties, cities, and
special districts—issue a variety of short-term debt instruments
to cover temporary shortages. Two of the most common are
tax-anticipation notes (TANs), issued in lieu of future tax rev­
enues, and revenue-anticipation notes (RANs), issued to cover
expenses from special projects, such as the construction of a toll
bridge or highway until revenues flow in. All interest earned on
municipal notes is exempt from U.S. federal income taxation,
so they may be attractive to investors bearing relatively high
income tax rates. However, as we will see later, the tax savings
associated with municipals has been sharply limited for U.S.
banks in recent years, reducing their attractiveness relative to
federal and privately issued securities. At the same time, some
state and local governments have encountered serious financial
60 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
problems in the wake of the Great Recession of 2007-2009 that
weakened the credit quality of their notes, forcing investors to
take a closer look at the quality of the municipals they choose to
buy and their increasing volatility.
4.4 POPULAR CAPITAL MARKET
INVESTMENT INSTRUMENTS
Treasury Notes and Bonds
Among the safest assets investing institutions can buy are U.S.
Treasury notes and bonds. T-notes are available in a wide variety
of maturities (ranging from 1 year to 1 0 years when issued) and
in large volume. T-bonds (with original maturities of more than
1 0 years) are traded in a more limited market with wider price fluc­
tuations. Treasury bonds and notes carry higher expected returns
than T-bills, but present an investing institution with greater price
and liquidity risk. They are issued normally in denominations of
$1,000, $5,000, $10,000, $100,000, and $1 million. Paralleling the
U.S. Treasury bond market in recent years has been the Eurozone
government bond market, valued below the U.S. government
security market with serious European budget problems.
Municipal Notes and Bonds
Long-term debt obligations issued by states, cities, and other
local governmental units are known collectively as municipal
bonds. Interest on the majority of these bonds is exempt from
U.S. federal income tax provided they are issued to fund pub­
lic, not private, projects. Capital gains on municipals are fully
taxable, however, except for bonds sold at a discounted price,
where the gain from purchase price to par value is considered a
portion of tax-exempt interest earnings.
Investing institutions often submit competitive bids for, or pur­
chase after private negotiation, the debt issued by local cities,
counties, and school districts as a way of demonstrating support
for their communities and to attract other business. They also
purchase municipals from security dealers if their credit ratings
are high. Unfortunately, municipals are often not very liquid—
relatively few issues trade on any given day.
F a c to id
Which U.S. Treasury security is the most popular (measured
by volume outstanding)—Treasury bills, notes, or bonds?
Answer: T-notes (with an original maturity of 1 to 10 years),
followed by T-bills. (See, for example, www.treas.gov.)
Many different types of municipal bonds are issued today,
but the majority fall into one of two categories: ( 1 ) general
obligation (GO) bonds, backed by the full faith and credit
of the issuing government, which means they may be paid
from any available source of revenue (including the levying of
additional taxes); and (2 ) revenue bonds, which can be used
to fund long-term revenue-raising projects and are payable
only from certain stipulated sources of funds. U.S. banks have
long possessed the authority to deal in and underwrite gen­
eral obligation (GO) municipal bonds, but for many years they
faced restrictions on directly underwriting revenue bonds until
this power was extended by the Gramm-Leach-Bliley Act in
1999. Unfortunately many municipalities (e.g., Harrisburg, PA)
have recently been driven to the brink of failure in a troubled
economy, falling back on credit insurers (such as Assured Guar­
anty Municipal) to pay off investors and reduce the supply of
municipals available.
Corporate Notes and Bonds
Long-term debt securities issued by corporations are usu­
ally called corporate notes when they mature within five
years or corporate bonds when they carry longer maturi­
ties. There are many different varieties, depending on the
types of security pledged (e.g., mortgages on property
versus debentures), purpose and terms of issue. Corporate
notes and bonds generally are more attractive to insurance
companies and pension funds than to banks because of
their higher credit risk relative to government securities and
their more limited resale market. However, they usually offer
significantly higher yields than government securities and
their yield spread over governments widens when investors
become more concerned about credit quality and economic
downturns.
CONCEPT CHECK
4.1. Why do banks and other institutions choose to
devote a significant portion of their assets to invest­
ment securities?
4.2. What key roles do investments play in the manage­
ment a depository institution?
4.3. What are the principal money market and capital
market instruments available to institutions today?
What are their most important characteristics?
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
4.5 IN VESTM EN T INSTRUMENTS
D EV ELO P ED M ORE RECEN TLY
The range of investment opportunities for investing institutions
has expanded in recent years. Some new securities have been
developed; some of these are variations on traditional notes
and bonds, while others represent relatively young investment
vehicles. Examples include structured notes, securitized assets,
and stripped securities.
Structured Notes
In their search to protect themselves against shifting interest
rates, many investing institutions added structured notes to
their portfolios during the 1990s. Most of these notes arose
from security dealers who assembled pools of federal agency
securities and offered investments officers a packaged invest­
ment whose interest yield could be reset periodically based
on what happened to a reference interest rate, such as a U.S.
Treasury bond rate. A guaranteed floor rate and cap rate may
be added in which the investment return could not drop below
a stated (floor) level or rise above some maximum (cap) level.
Some structured notes carry multiple coupon (promised) rates
that periodically are given a boost ("step-up") to give inves­
tors a higher yield; others carry adjustable coupon (promised)
rates determined by formula. The complexity of these notes
has resulted in substantial losses for some investing institutions,
especially where interest rate risk is rising.
Securitized Assets
In recent years hybrid securities based upon pools of loans have
been prominent forms of investment vehicles. These securitized
assets are backed by selected loans of uniform type and quality,
such as FHA- and VA-insured home loans and credit card
loans. The most common securitized assets that depository
institutions have employed as investments are based upon
home mortgages.
There are at least three main types of mortgage-backed secu­
ritized assets: (1 ) pass-through securities, (2 ) collateralized
mortgage obligations (CMOs), and (3) mortgage-backed bonds.
Pass-through securities arise when a lender pools a group of sim­
ilar home mortgages appearing on its balance sheet, removes
them from that balance sheet into an account controlled by a
legal trustee, and issues securities using the mortgage loans as
collateral. As the mortgage loan pool generates principal and
interest payments, these payments are "passed through" to
investors holding the mortgage-backed securities. Repayment
■ 61
of principal and interest on the calendar dates promised may be
guaranteed by the Government National Mortgage Association
(Ginnie Mae), an agency of the U.S. government, in return for
a small fee (for example: perhaps as much as 6 basis points, or
0.06 percent of the total amount of loans placed in the pool).
The Federal National Mortgage Association (Fannie Mae), char­
tered by but legally separate from the U.S. government, also
helps create pass-throughs by purchasing packages of mortgage
loans from lending institutions. While GNMA aids in the creation
of mortgage-loan-backed securities for government-insured
home loans, FNMA securitizes both conventional (noninsured)
and government-insured home mortgages. Investors who acquire
pass-throughs issued against pools of government-insured home
mortgages which may be protected against default on those
securities if the Federal Housing and Veterans Administrations
ensure that the pooled loans will be repaid even if the home-
owner abandons his or her home. Moreover, GNMA and FNMA
may add their own guarantees of timely repayment of principal
and interest.
In 1983 another government-sponsored agency, the Federal
Home Loan Mortgage Corporation (Freddie Mac), now legally
separate from the U.S. government, developed the collateral­
ized mortgage obligation (CMO)—a pass-through security
divided into multiple classes (tranches), each with a different
promised (coupon) rate and level of risk exposure. CMOs arise
either from securitizing of mortgage loans themselves or from
securitizing pass-through securities.
Closely related to CMOs are REMICs—real estate mortgage
investment conduits—that also partition the cash flow from a
pool of mortgage loans or mortgage-backed securities into
multiple maturity classes in order to help reduce the cash-flow
uncertainty of investors. As we will see later in this chapter, the
principal risk to an investor buying these securities is prepay­
ment risk because some borrowers pay off their home mort­
gages early or default on their loans, meaning the holder may
receive diminished income.
A third type of mortgage-related security is the mortgage-
backed bond. Unlike pass-throughs and CMOs, where
mortgage loans are removed from the balance sheet, mortgage-
backed bonds (MBBs) and the mortgage loans backing them
stay on the issuer's balance sheet. The financial institution issu­
ing these bonds will separate the mortgage loans held on its
balance sheet from its other assets and pledge those loans as
collateral to support the MBBs. A trustee acting on behalf of the
mortgage bondholders keeps track of the dedicated loans and
checks periodically to be sure the market value of the loans is
greater than what is owed on the bonds.
62 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Pass-throughs, CMOs, and other securitized assets had been
among the largest segments of the financial marketplace when
purchases of new homes reached record levels. Several factors
accounted for the popularity of these asset-backed investment
securities, including:
1. Guarantees from government agencies (in the case of
home-mortgage-related securities) or from private institu­
tions (such as banks or insurance companies pledging to
back credit card loans).
2. The higher average yields generally available on securitized
assets than on most government securities.
3. The lack of good-quality assets of other kinds in some mar­
kets around the globe.
4. The superior liquidity and marketability of securities backed
by loans compared to the liquidity and marketability of
loans themselves.
However, despite the widespread popularity of asset-backed
instruments the credit crisis of 2007-2009 revealed substan­
tial weaknesses among these investments, including sharp
deterioration in their market values as the underlying assets
(loans) experienced a significant rise in default rates. Trad­
ing volume among securitized assets plummeted, though at
least some signs of recovery among stronger international
banks appeared following the depths of a global recession in
2007-2009.
Stripped Securities
In the 1980s, security dealers developed a hybrid instrument
known as the stripped security—a claim against either the prin­
cipal or interest payments associated with a debt security, such
as a Treasury bond. Dealers create stripped securities by sepa­
rating the principal and interest payments from an underlying
debt security and selling separate claims to these two promised
income streams. Claims against only the principal payments are
called PO (principal-only) securities, while claims against only
the promised interest payments are referred to as IO (interest-
only) securities.
Stripped securities often display markedly different behavior
from the underlying securities from which they come. In particu­
lar, stripped securities offer interest-rate hedging possibilities to
help protect an investment portfolio against loss from interest-
rate changes. The securities whose interest and principal pay­
ments are most likely to be stripped today include U.S. Treasury
notes and bonds and mortgage-backed securities. Both PO and
IO bond strips are really zero coupon bonds with no periodic
interest payments; they therefore carry zero reinvestment risk.
Each stripped security is sold at a discount from par, so the 4.6 IN VESTM EN T SECURITIES
investor's rate of return is based solely on price appreciation.
Because bonds normally pay interest twice a year, an investor
HELD BY BANKS
can lock in a fixed rate of return for a holding period as short as
We have examined the principal investment opportunities
six months or as long as several years up to the maturity of the
available to investing institutions, but which of these invest­
original bond. POs tend to be more price sensitive to interest-
ments are preferred? Table 4.3 provides an overview of
rate changes than regular bonds, whereas lOs tend to be less
investment securities held by U.S.-insured banks in 2010.
price sensitive.

Table 4.3 Investment Securities Held by FDIC-lnsured Commercial Banks, 2010*

All FDIC-lnsured Banks Percent of Investments Held by

Smallest Banks Medium-Size

Types of Investment Volume in Percent of All (less than Banks ($100 mill.— Largest Banks
Securities Millions of $ Investments $100 mill.] $1 bill.) (over $1 bill.)

Total Investments $2,337,748 1 0 0 0. % . %

1 0 0 0 . %
1 0 0 0 . %
1 0 0 0

U.S. government obligations** $1,269,255 53.4% 64.3% 66.4% 52.9%

(including U.S. Treasury and
federal agency securities)
State and local government 165,729 7.1 28.5 25.2 5.0
obligations

Asset-backed securities 135,195 5.8 0 .2 6.4

Other domestic debt securi­ 458,965 19.6 3.6 5.0 21.3

ties (including corporate
bonds and commercial paper)
Foreign debt securities 241,843 10.3 11.5

Equities (stock) 13,487 0 .6 0 .6 0.5 0 .6

Total Investment securities as 19.3% 21.9% 19.6% 19.2%

a percent of total assets

Memo items:

Pledged securities $1,119,692 47.9% 36.2% 45.8% 48.3%

Mortgage-backed securities 1,252,730 53.6 28.3 39.9 55.3

Securities held to maturity 129,078 5.5 13.5 9.4 0.5

Securities available for sale 2,208,670 94.5 86.5 90.6 95.0
Total debt securities 2,323,635 99.4 99.3 99.4 99.4

Structured notes 33,526 1.4 7.6 6.5 0 .8

Assets held in trading 764,426 32.7 ** 0 .1 36.5

account
* Figures for 9/30/2010.
** Includes federally guaranteed mortgage-backed securities.
*** Indicates figure is less than 0.05 percent.
Source: Federal Deposit Insurance Corporation, December 31, 2007.

Chapter 4 The Investm ent Function in Financial-Services M anagem ent ■ 63

Clearly just a few types of securities dominate bank invest­
ment portfolios:
1. U.S. government (especially Treasury) securities.
2. Obligations of various federal agencies such as the Federal
National Mortgage Association (FNMA), the Federal Home
Loan Mortgage Corporation (FHLMC), and the Government
National Mortgage Association (GNMA), especially in the
form of mortgage-backed securities.
3. State and local government obligations (municipals).
4. Nonmortgage-related asset-backed securities (such as obli­
gations backed by credit card and automobile loans).
5. Equities (common and preferred stock).
Federal-government-related lOUs account for just over half of
banks' investment total, counting various types of U.S. govern­
ment and federal agency-guaranteed debt instruments. In par­
ticular, mortgage-loan-backed securities also account for more
than half of all U.S. bank investment holdings (with the heaviest
concentrations of these mortgage-related instruments held by
the largest banks in the industry) due to their comparatively
high yields. Nongovernment-guaranteed asset-backed securities
(such as instruments backed by auto and credit card loans) fall
just behind state and local government (municipal) and foreign
debt securities.
As reflected in Table 4.3, we see that banks hold relatively fewer
private-sector securities, such as corporate bonds, notes, and
commercial paper or corporate stock. They would usually prefer
to make direct loans to customers rather than to buy their secu­
rities because the yield is often lower on investment securities
than on loans and because purchasing securities usually gener­
ates no new deposits for a bank.
Table 4.3 also tells us that management targets most bank-
held investments for eventual resale rather than planning
to hold them until they reach maturity. These investments
will generally be sold when a financial firm needs cash to
cover customer withdrawals of funds, to make loans, or to
take advantage of more lucrative investment opportunities.
More than half of banks' investment portfolios consists of
trading account securities, and the largest banks perform the
role of dealers, purchasing investments and reselling them
to customers.
F a c to id
After loans, what is the greatest source of revenue for most
banks around the world?
Answer: Interest and dividends on investment securities.
64 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
CO N CEPT CH ECK
4.4. What types of investment securities do banks seem
to prefer the most? Can you explain why?
4.5. What are securitized assets? Why have they grown
so rapidly in recent years?
4.6. What special risks do securitized assets present to
institutions investing in them?
4.7. What are structured notes and stripped securities?
What unusual features do they contain?
As might be expected, the smallest banks tend to invest more
heavily in government securities than do the largest. The smaller
institutions tend to be more heavily exposed to risk of loss from
economic problems in their local areas and, therefore, tend to use
the lowest-risk securities to offset the high risk often inherent in their
loans. In contrast, the largest banks tend to be more heavily invested
in foreign securities and private debt and equity obligations (espe­
cially corporate bonds and commercial paper), all of which tend to
carry greater risk exposure than government securities.
In total, investment securities represent only about a fifth
of total bank assets. But this proportion of bank assets var­
ies with size and location. Banks operating in areas with weak
loan demand usually hold significantly greater percentages of
investment securities relative to their total assets. Moreover, as
Table 4.3 suggests, size also plays a key role. The smallest size
group of banks holds just over 2 0 percent of its assets in the
form of investments, while the largest multi-billion-dollar banks
hold a lesser proportion of their assets in investment securities,
reflecting the relatively heavy loan demand most large banks
face. In contrast, loans often represent over half of all bank
assets and a majority of revenues usually come from loans; no
surprise, loans generally carry significantly higher average yields
than investments. But as we have already seen, the investment
portfolio is expected to do several jobs in addition to generat­
ing income, such as tax sheltering and reducing risk exposure.
4.7 FACTORS A FFEC TIN G CH O ICE
O F IN VESTM EN T SECU RITIES
The investments officer of a financial firm must consider several
factors in deciding which investment securities to buy, sell, or
hold. The principal factors bearing on which investments are
chosen include:
1. Expected rate of return
2. Tax exposure
 3. Interest rate risk
4. Credit or default risk
5. Business risk
6 . Liquidity risk
7. Call risk
8 . Prepayment risk
9. Inflation risk
10. Pledging requirements
We will briefly review each of these factors.
F ilm to id
What 1987 film busted Michael Douglas's and Charlie
Sheen's characters for insider trading when the expected
rates of return in the market were not enough to satisfy
their greed?
Answer: Wall S tre e t.
Expected Rate of Return
The investments officer must determine the total rate of
return that can reasonably be expected from each security,
including any interest payments promised and possible capi­
tal gains or losses. For most investments this requires the
portfolio manager to calculate the yield to maturity (YTM)
if a security is to be held to maturity or the planned holding
period yield (HPY) between point of purchase and point
of sale.
F ilm to id
What 2010 film follows the infamous Gordon Gekko's
exploits (played by Michael Douglas) after he is released
from prison for the crimes committed in Wall S tre e t ?
Answer: Wall S tre e t: M o n e y N e v e r S le e p s
As we will see in Chapter 18, th e y ie ld to m aturity form ula
d e te rm in e s th e rate o f d isc o u n t (or y ie ld ) on a loan o r se cu rity
that e q u a lize s th e m a rket p ric e o f th e loan o r se c u rity with its
e x p e c t e d strea m o f cash flo w s (in te re st a n d principal). To illus­
trate how the YTM formula can be useful to an investments
officer, suppose the officer is considering purchasing a $ 1 , 0 0 0
par-value Treasury note that promises an 8 percent coupon rate
(or 1 , 0 0 0 X 0.08 — $80) and is slated to mature in five years.
If the T-note's current price is $900, we have
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
$80 $80 $80
$900 = + + +
(1 + YTM ) 1 (1 + YTM) (1 + YTM ) 1
$ 1,000
+ (4.1)
(1 + YTM):
Solving using a financial calculator or software reveals that the
yield to maturity (YTM) is 10.74 percent. The calculated YTM
should be compared with the expected yields on other loans and
investments to determine where the best possible return lies.
However, many financial firms frequently do not hold all their
investments to maturity. Some must be sold off early to accom­
modate new loan demand or to cover deposit withdrawals.
To deal with this situation, the investments officer needs to calcu­
late the holding period yield (HPY). Th e H P Y is sim p ly th e rate o f
return (d isco u n t fa ctor) that e q u a te s a secu rity's p u rch a se p rice
with th e stream o f in co m e e x p e c te d until it is s o ld to a n o th er
in vestor. For example, suppose the 8 percent T-note described
above and currently priced at $900 was sold at the end of two
years for $950. Its holding period yield could be found from
$80 $80 $950
$900 = + + (4.2)
(1 + HPY) 1 (1 + HPY) 2 (1 + HPY)
1
In this case, the note's HPY would be 11.51 percent.
—
Tax Exposure
Interest and capital gains income from most investments are
taxed as ordin a ry in co m e for tax purposes, just as are wages and
salaries earned by U.S. citizens. Because of their relatively high
tax exposure, banks are more interested in the after-tax rate o f
return on loans and securities than in their before-tax return.
This situation contrasts with such institutions as credit unions
and mutual funds, which are generally tax-exempt.
The Tax Status of State and Local
Government Bonds
For banks in the upper tax brackets, tax-exempt state and local
government (municipal) bonds and notes have been attractive
from time to time, depending upon their status in tax law and
market conditions.
For example, suppose that Aaa-rated corporate bonds are car­
rying an average gross yield to maturity of 7 percent, the prime
rate on top-quality corporate loans is 6 percent, and Aaa-rated
municipal bonds have a 5.5 percent gross yield to maturity. The
investments officer for a financial firm subject to the corporate
1 Using a financial calculator such as the Tl BA II Plus™, N = 2, i = ?,
PV = -900, Pmt = 80, FV = 950. Solving for the interest rate (HPY)
gives i = 11.51%.
■ 65
 REAL BANKS, REAL DECISIONS
Crisis in the Investments Market: What the
9/11 Terrorist Attacks Did to the Delivery
of Securities to Investors
The market for investment securities is one of the larg­
est in the world. Trillions of dollars change hands daily and
both payments and delivery generally occur on time. Now
consider what happened following the terrorist attacks on
September 11, 2001. Within hours the system for delivering
U.S. Treasury securities—the most popular financial invest­
ment in the world—began to unravel, Many sellers were
unable to meet their promises to deliver and some buyers
couldn't execute payments on the scheduled date. These
settlement fails soared from an average of less than $ 2 bil­
lion a day before the attacks to as much as $190 billion a day
immediately following the attacks.
The settlement fails occurred initially because some com­
munications systems linking dealers and their customers
were destroyed or damaged when the World Trade Center
collapsed. Moreover, several key institutions experienced
destruction of their records. A severe shortage of certain
Treasury securities developed, and the usual remedy for such
shortages—borrowing securities through special collateral
income tax could compare each of these potential yields using
this formula:
Before-tax
X (1 — Firm's marginal income tax rate)
gross yield
= After-tax gross yield (4.3)
This comparison yields the following expected after-tax gross
returns for a taxed financial firm in the top 35 percent federal
income tax bracket:
Aaa-rated corporate bonds: 7.00 percent X (1 — 0.35)
= 4.55 percent
Prime-rated loans: 6 percent X (1 — 0.35) = 3.90 percent
Aaa-rated municipal bonds: 5.50 percent X ( 1 - 0 )
= 5.50 percent before and after taxes
Under the assumptions given, the municipal bond is the most
attractive investment in gross yield. However, other consider­
ations enter into this decision, such as the need to attract other
customer accounts, management's desire to keep good loan
customers, recent changes in tax laws, and changes in state and
local government credit quality.
Note that Equation (4.3) permits an investments officer to
calculate what is called the tax-equivalent yield (TEY) from a
66 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
repurchase agreements—became as costly as the failure to
deliver what was promised.
Fortunately, two critical government agencies reacted
quickly. The Federal Reserve poured liquid funds into the
banking system so that emergency money was available. The
U.S. Treasury, even though it didn't need to borrow addi­
tional funds at the time, announced the reopening of a key
security issue—the 10-year T-note that was currently "on the
run." The Treasury's same day ("snap") auction expanded the
supply of these particular notes by 50 percent, which helped
to make borrowing these securities a superior alternative to
failing to settle.
An excellent article prepared by two staff officers at the Fed­
eral Reserve Bank of New York (Fleming and Garbade [6 ])
offers some proposals for the future should a tragedy of com­
parable magnitude happen again, These proposals include
setting up an expanded government facility that would be
able to lend securities experiencing excess demand. Indeed,
in the wake of 9/11 the Federal Reserve expanded its pro­
gram, set up originally in 1969, to lend Treasury securities
from its huge open market account to dealers facing settle­
ment problems. A more recent analysis of this problem in
Treasury securities appears in Garbade et al. [11].
municipal bond or other tax-exempt security. The TEY indicates
what before-tax rate of return on a taxable investment pro­
vides an investor with the same after-tax return as a tax-exempt
investment would. The TEY can usually be found using the fol­
lowing relationship:
After-tax return on a tax-exempt investment
TEY (4.4)
(1 - Investing firm's marginal tax rate)
In the numerical example above the Aaa-rated corporate bond
and the prime-rated loans would have to have a before-tax yield
of 8.46 percent to match the Aaa-municipal bond's after-tax
yield of 5.50 percent.
The Impact of Changes in Tax Laws
Tax reform in the United States has had a major impact on
the relative attractiveness of state and local government
bonds as investments for banks. Prior to federal tax reform
legislation during the 1980s, banks held close to a quarter
of all state and local government debt outstanding. But their
share of the municipal market has fallen substantially since
that time, due to ( 1 ) declining tax advantages, (2 ) lower
corporate tax rates, and (3) fewer qualified tax-exempt
securities.
Bank Qualified Bonds
Before 1986 the federal tax code allowed significant tax deduc­
tions for interest expenses incurred when banks borrowed funds
to buy municipal securities. However, after 1986, banks could no
longer deduct all of the interest paid on borrowed funds used to
purchase tax-exempt bonds. Today banks buying bank-qualified
bonds—those issued by smaller local governments (govern­
ments issuing no more than $ 1 0 million of public securities per
year)—are allowed to deduct 80 percent of any interest paid
to fund these purchases. This tax advantage is not available for
nonbank-qualified bonds.
Prior to the 1986 Tax Reform Act the highest corporate tax
bracket was 46 percent. Today the top bracket is 35 percent for
corporations earning more than $ 1 0 million in annual taxable
income or 34 percent otherwise. Lower tax brackets reduce the
tax savings associated with the tax-exemption feature. 2
Fewer state and local bonds qualify for tax exemption today.
If 10 percent or more of the proceeds of a municipal bond
issue is used to benefit a private individual or business, it is
considered a private activity issue and fully taxable. In addi­
tion, Congress placed ceilings on the amount of industrial
development bonds (IDBs) local governments could issue to
provide new facilities or tax breaks in order to attract new
industry. These laws reduced the supply of tax-exempt securi­
ties for investors to purchase and contributed to the lower
proportion of municipals found in the securities portfolios of
many taxed financial institutions.
To evaluate the attractiveness of municipals, financial firms
calculate the net after tax returns and/or the tax-equivalent
yields to enable comparisons with other investment alterna­
tives. The net after-tax return of bank-qualified municipals is
calculated as follows:
Net after-tax Nominal return Interest expense incurred
return on on municipals in acquring the
municipals after taxes municipals
(in percent) (in percent) (in percent)
Tax advantage
+ of a (4.5)
qualifield bond
2 Under current federal law, U.S. banks must calculate their income
taxes in two different ways—using a normal tax rate schedule (maximum
35 percent tax rate) and using an alternative minimum tax rate of
20 percent, and then must pay the greater of the two different amounts.
Interest income from municipals has to be added in to determine each
bank's alternative minimum tax (AMT), making municipal income subject
to at least some taxation.
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
where the tax advantage of a qualified bond is determined like this:
Tax advantage
of
qualified
bond
The bank's Percentage of Interest
marginal interest expense expense of
income X that is still X acquiring the
tax rate tax deductible municipals
(in percent) (if any) (in percent)
Suppose a bank purchases a bank-qualified bond from a small
city, county, or school district and the bond carries a nominal
(published) gross rate of return of 7 percent. Assume also that
the bank had to borrow the funds needed to make this purchase
at an interest rate of 6.5 percent and is in the top (35 percent)
income tax bracket. Because this bond comes from a small local
government that qualifies for special tax treatment under the
1986 Tax Reform Act, the bond's net annual after-tax return
(after all funding costs and taxes) must be:
Net after-tax return
on a qualified = (7.0 — 6.50) + (0.35 X 0.80 X 6.50)
municipal security
= 0.50 percent + 1.82 percent
= 2.32 percent (4.7)
The investments officer would want to compare this calculated
net after-tax return to the net returns after taxes available from
other securities and loans, both taxable and tax-exempt. If the
municipal bond described previously had come from a larger
state or local government not eligible for special treatment
under the Tax Reform Act, none of the interest expense would
have been tax deductible and the net tax advantage to the bank
purchasing the nonqualified bonds would be nil.
The Tax Swapping Tool
The size of a lender's revenue from loans plays a key role in how its
investments are handled. In years when loan revenues are high, it
may be beneficial to engage in tax swapping. In a tax swap, the
lending institution sells lower-yielding securities at a loss in order
to reduce its current taxable income, while simultaneously purchas­
ing new higher-yielding securities in order to boost future returns.
Tax considerations in choosing securities to buy or sell tend to
be more important for larger lending institutions than for smaller
ones. Usually 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 manager tries to esti­
mate the institution's projected net taxable income under alter­
native portfolio choices.
■ 67
 INSIGHTS AND ISSUES
Complex Investments on the Rise: Range
Notes, Bank Officer Life Insurance (Boli),
Equity-Linked CDs, Auction-Rate Securities,
and Trust-Preferred Securities
in recent years—especially prior to the Great Recession of
2007-2009—many financial firms have had the tendency to
accept greater risk and complexity in their investment port­
folios. New instruments have appeared intended to do more
than just provide liquidity and income.
For example, range notes are callable securities that promise
relatively high coupon interest rates contingent on which way
the market moves. These notes pay out interest provided an
agreed-upon market index stays within a specified range.
If the market index moves outside the designated range,
there is no payoff. For example, a range note might call for
paying its holder interest only if the interest rate on Eurocur­
rency deposits stays between 2 and 4 percent
Some financial firms have purchased life insurance on their
officers and directors (BOLI), with the purchasing firm des­
ignated beneficiary. As long as the purchaser continues to
pay annual premiums, the BOLI is recorded as an asset on
its books. If the officer or director dies during the policy's
term, the purchasing institution has several options, includ­
ing donating the proceeds to charity and securing a tax
deduction.
This involves, among other things, estimating how much tax-
exempt income the taxed lending institution can use. No
financial firm can use unlimited amounts of tax-exempt income.
For depository institutions, at least, some taxable income will be
necessary to offset the allowable annual deduction for possible
loan losses (ALL). However, once these conditions are met, the
basic decision between purchasing tax-exempt securities or pur­
chasing taxable securities and loans comes down to the relative
after-tax returns of the two.
The Portfolio Shifting Tool
Lending institutions also do a great deal of portfolio shift­
ing in their holdings of investment securities, with both taxes
and higher returns in mind. Financial firms, for example, often
sell off selected securities at a loss in order to offset large
amounts of loan income, thereby reducing their tax liability.
They may also shift their portfolios simply to substitute new,
higher-yielding securities for old security holdings whose yields
may be below current market levels. The result may be to take
substantial short-run losses in return for the prospect of higher
long-run profits.
68 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Equity-linked CDs contain features of both debt and stock.
They promise guaranteed interest income and provide an
embedded option, offering an additional bonus based on a
market index (most often Standard & Poor's 500 stock index).
For example, a bull CD with an embedded call option scores
additional returns if the market index rises above a designated
strike price, Alternatively, a bear CD contains a put option
only paying off if the market index falls below the strike price.
Auction-rate securities consist of bonds bearing short-term
interest rates reset every few days. While many investors have
regarded auction-rate securities as relatively safe, recent experi­
ence during the credit crisis of 2007-2009 suggests these instru­
ments can carry significant liquidity risk should their auctions fail.
Finally, trust-preferred securities are created with the help of
an investment banker who sets up a special-purpose entity
(SPE) that issues preferred shares. In return, the participating
institution issues long-term debentures to support the new
stock. Multiple possible payoffs include that the debentures
are considered to be new capital, the interest paid out is tax
deductible, and the risk of shareholder dilution is reduced.
Regulatory agencies have expressed concern in recent years
that many such investments carry considerable credit and
liquidity risk. Regulators insist that purchasing institutions
do a careful prepurchase analysis of these investments and
employ stress testing to determine what their risk exposure
would be under different market conditions.
For example, the investments officer of First National Bank may
be considering the following shift in its municipal bond portfolio:
Find a buyer for $10 million Current market
in 10-year New York City price = $9.5 million
bonds bearing a 7 percent
Value recorded on the
coupon rate that the bank
bank's balance
currently holds.
sheet = $ 1 0 million
Annual interest
income = $0.7 million
Then acquire $10 million in Current market
10-year Los Angeles County price = $ 1 0 million
bonds bearing a 9 percent
Annual interest
coupon rate to add to the
income = $ 0.9 million
bank's investment portfolio.
Clearly, this bank takes an immediate $500,000 loss before
taxes ($10 million — $9.5 million) on selling the 7 percent
New York City bonds. But if First National is in the 35 per­
cent tax bracket, its immediate loss after taxes becomes only
$500,000 X (1 — 0.35), or $325,000. Moreover, it has swapped
this loss for an additional $2 0 0 , 0 0 0 annually in tax-exempt
income for 10 years. This portfolio shift is probably worth the
immediate loss the bank must absorb from its current earnings.
Moreover, if the bank has high taxable income from loans, that
near-term loss can be used to lower current taxable income and
perhaps increase this year's after-tax profits.
Interest Rate Risk
Changing interest rates create real risk for investments officers
and their institutions. Rising interest rates lower the market value
of previously issued bonds and notes, with the longest-term
issues suffering the greatest losses. Moreover, periods of rising
interest rates are often marked by surging loan demand. Because
a lender's first priority is usually to make loans, many investments
must be sold off to generate cash for lending at the very time
their prices are headed downward. Such sales frequently result in
substantial capital losses, which the lender hopes to counteract
by a combination of tax benefits and the relatively higher yields
available on loans. On the other hand, investments officers often
find themselves purchasing investment securities when interest
rates and loan demand are declining and, therefore, the prices
investments officers must pay for desired investments are headed
upward. A growing number of tools to hedge (counteract) inter­
est rate risk have appeared in recent years, including financial
futures, options, interest-rate swaps, gap management, and dura­
tion, as we will see in Chapter 18.
Credit or Default Risk
The investments made by banks and their closest competitors
are closely regulated due to the credit risk displayed by many
securities, especially those issued by private corporations and
some governments. The risk that the security issuer may default
on the principal or interest owed has led to regulatory controls
that prohibit the acquisition of speculative securities—those
rated below' Baa by Moody's or BBB on Standard & Poor's
bond-rating schedule and below BBB on Fitch's Rating Service.
(See Table 4.4 for definitions of the various credit rating

Table 4.4 D efault Risk Ratings on M arketable Investm ent Securities (Including Long-Term Corporate Obligations)

Investment securities sold by corporations and state and local governments must be assigned credit ratings that assess their
probability of default before they can be successfully marketed. Among the most popular private security rating companies are
Moody's Investor Service, Standard & Poor's Corporation, and Fitch Inc. Their rating symbols have served as general guides for
assessing credit quality for decades:

Rating Symbols

Moody's Rating Standard & Poor's Fitch Inc. Ratings

Credit Quality of Securities Category Rating Category Category

Best quality/smallest investment risk Aaa AAA AAA Investment quality

or investment grade/
High grade or high quality Aa AA AA
considered acceptable
Upper medium grade A A A for most banks and
other closely regulated
Medium grade Baa BBB BBB
financial firms.
Medium grade with some Ba BB BB
speculative elements
Lower medium grade B B B Speculative quality
and junk bonds/not
Poor standing/may be in default Caa CCC CCC
considered suitable for
Speculative/often in default Ca CC CC banks and other closely
regulated financial firms.
Lowest-grade speculative securities/ C C C
poor prospects
Defaulted securities and securities Not rated DDD RD Includes security issuers
issued by bankrupt firms DD D in default or bankrupt.
D
Most depository institutions are limited to investment-grade securities—that is, they must purchase securities rated AAA to
BBB (by recognized rating agencies), Unrated securities may also be acquired, but the regulated institution must be able to
demonstrate they are of investment-grade quality.

C hap ter 4 The Investm ent Function in Financial-Services M anagem ent ■ 69

symbols used.) U.S. banks generally are allowed to buy only
investment-grade securities, rated at least Baa or BBB, in order
to protect depositors against excessive risk. Moreover, banks
through their securities affiliates or through the formation of a
financial holding company are permitted to underwrite govern­
ment and privately issued securities (including corporate bonds,
notes, and stock).
In 1997 Moody's Investors Service announced significant modi­
fication of its credit rating system for bonds issued by state and
local (municipal) governments. Specifically, securities in selected
categories (such as Aa, A, and Baa) were given 2 or 3 numerical
modifiers added to their rating to differentiate securities slightly
different in quality that carry similar letter grades. In 1981
Moody's added the number 1 to the letter grades attached
to some A- and B-rated municipals. Now, with the numbers 2
and 3 also added to some letter grades, an investments officer
is alerted that a 1 means the security in question ranks at the
upper end of its letter rating category, while a 2 implies the
issue lies in the middle range and a 3 suggests the security in
question lies at the low end of the letter grade category. These
1, 2, and 3 numerical modifiers were also added to corporate
bond ratings from Aa to B. The table below provides a picture
of these more refined credit ratings:
M o o d y's In vesto r S e rv ice 's C re d it Rating S y m b o ls
fo r S ta te and Local G o v e rn m e n t S e c u ritie s
Aaa Baal Caa
Aa1 Baa2 Ca
Aa2 Baa3 C attached to U.S. Treasury obligations by Standard & Poor's
Aa3 Ba1
A1 Ba2
A2 Ba3
A3 B1
B2
B3
These rating modifiers reflect concern about recent trends in the
municipal market, especially increased credit risk and volatility.
There has been a fluctuating but general uptrend in munici­
pal defaults over the past several years. For example, in 1991
a record 258 municipal bond defaults occurred, involving
about $5 billion in defaulted lOUs. Today many state and
local governments seem to face, potentially at least, even
greater risk of loss because of factors like high unemployment,
depressed government revenues, declining support from the
federal government for welfare programs, health services, and
70 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
infrastructure needs (roads, bridges, etc.), higher energy costs,
and strong taxpayer resistance to higher taxes. Moreover, with
many local areas opposing new taxes and spending programs,
a sizable portion of state and local governments have turned
to more risky revenue bonds in an effort to supplement their
financing options.
Unfortunately the credit rating process has become far more
stressful as investors increasingly question the reliability of
the credit reports they are receiving. Financial reform in the
wake of the Great Recession of 2007-2009 appears to have
exposed credit rating companies to greater risk of legal
action when investors lose money. In some cases credit raters
have refused to let bond issuers publish the ratings they are
assigned.
As we saw in the preceding chapter, many lending institutions
have developed new methods for dealing with credit risk in
their investments and loans in recent years. Credit options and
swaps can be used to protect the expected yield on invest­
ment securities. For example, investments officers may be able
to find another financial institution willing to swap an uncertain
return on securities held for a lower but more certain return
based upon a standard reference rate, such as the market yield
on Treasury bonds. Credit options are also available in today's
markets that 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 par­
tially offsets the loss. Investments officers can also use credit
options to protect the market value of a bond in case its credit
rating is lowered as happened to the declining credit rating
Corporation in 2011.
Business Risk
Financial institutions of all sizes face significant risk that the
economy of the market area they serve may turn down, with
falling sales and rising unemployment. These adverse devel­
opments, often called business risk, can be reflected quickly
in the loan portfolio, where delinquent loans may rise as
borrowers struggle to generate enough cash flow to pay the
lender. Because business risk is always present, many financial
institutions rely heavily on their security portfolios to offset
the impact of this form of risk on their loan portfolios. This
usually means that many investment securities purchased will
come from borrowers located outside the principal market for
loans. For example, a bank located in Dallas or Kansas City
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). Bank examiners
often encourage out-of-market security purchases to balance
risk exposure in the loan portfolio.
Liquidity Risk
Financial institutions must be ever mindful of the possibility they
will be required to sell investment securities in advance of their
maturity due to liquidity needs and be subjected to liquidity
risk. Thus, a key issue that a portfolio manager must face in
selecting a security for investment portfolios is th e b re a d th a n d
d e p th o f its resa le m arket. Liquid securities are, by definition,
those investments that have a ready market, relatively stable
price over time, and high probability of recovering the original
amount invested (i.e., the risk to the principal value is low).
Treasury securities are generally the most liquid and have the
most active resale markets, followed by federal agency securi­
ties, municipals, and mortgage-backed securities. Unfortunately,
the purchase of a large volume of liquid, readily marketable
securities tends to lower the average yield from a financial
institution's earning assets and reduce its profitability. Thus,
management faces a trade-off between profitability and liquid­
ity that must be reevaluated daily as market interest rates and
exposure to liquidity risk change.
Call Risk
Many corporations and some governments that issue securities
reserve the right to call in those instruments in advance of matu­
rity and pay them off. Because such calls usually take place when
market interest rates have declined (and the borrower can get
lower interest costs), the financial firm investing in callable secu­
rities runs the risk of an earnings loss because it must reinvest its
recovered funds at lower interest rates. Investments officers
generally try to minimize this call risk by purchasing callable
instruments bearing longer call deferments (so that a call cannot
occur for several years) or simply by avoiding the purchase of
callable securities. Fortunately for investments officers, call privi­
leges attached to bonds have been declining in recent years
due to the availability of other tools to manage interest-rate risk
(thouqh call privileges are quite common today in the trillion-
dollar market for municipal bonds) 3
3 Investments officers dealing with callable bonds generally calculate
their yield to call (YTC) as well as their yield to maturity (YTM). If a call­
able bond happens to be trading at a premium above its parvalue,
indicating its nominal interest rate exceeds current market rates, it is
generally priced as though it will be retired on its call date. The reason
is that callable bonds with bigger nominal rates are the most likely to
be called in. On the other hand, a bond typically is priced to its yield to
maturity if it is trading at a discount. Its yield is relatively low compared
to current interest rates and, therefore, is less likely to be called.
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
Prepayment Risk
A form of risk specific to asset-backed securities is prepayment
risk. This form of risk arises because the realized interest and
principal payments (cash flow) from a pool of securitized loans,
such as GNMA or FNMA pass-throughs, collateralized mortgage
obligations (CMOs), or securitized packages of auto or credit
card loans, may be quite different from the cash flows expected
originally. Indeed, having to price the prepayment option asso­
ciated with asset-backed securities distinguishes these invest­
ments from any other investments.
For example, consider what can happen to the planned interest
and principal payments from a pool of home mortgage loans
that serve as collateral for the issuance of mortgage-backed
securities. Variations in cash flow to holders of the securities
backed by these loans can arise from
1. Loan refin a n cin g s, which tend to accelerate when market
interest rates fall (in this case, borrowers may realize they
will save on loan payments if they replace their existing
loans with new lower-rate loans).
2. T u rn o ver o f th e a sse ts b e h in d th e loans (in this case borrow­
ers may sell out and move away or some borrowers may not
be able to meet their required loan payments and default
on their loans).
In either or both of these cases some loans will be terminated
or paid off ahead of schedule, generating smaller long-term
cash flows than expected, which can lower the expected rate of
return from loan-backed securities.
The pace at which loans that underlie asset-backed securities
are terminated or paid off depends heavily upon the interest
rate spread between current interest rates on similar type loans
and the interest rates attached to loans in the securitized pool.
When market interest rates drop below the rates attached
to loans in the pool far enough to cover refinancing costs,
more borrowers will call in their loans and pay them off early.
This means that the market value of a loan-backed security
depends not only upon the promised cash flows it will gener­
ate, but also on the projected prepayments and loan defaults
that occur—that is,
Expected cash flows Expected cash flows
adjusted for any adjusted for any
prepayments or prepayments or
defaults of defaults of
Market value existing loans in existing loans in
(price) of a = the pool in Period 1 + • • ■+ the pool in Period n X m
loan-backed (1 + y/m)1 (1 + y/rn)nXm
security
(4.8)
■ 71
where n is the number of years required for the last of the loans
in the pool to be paid off or retired, m represents the number
of times during the year interest and principal must be paid to
holders of the loan-backed securities, and y is the expected
yield to maturity from these securities.
In order to properly value an asset-backed security, the invest­
ments officer needs to make some reasonable assumptions
about what volume of loans might be prepaid or terminated
while his or her institution is holding the security. In making esti­
mates of loan prepayment behavior, the officer must consider
such factors as expected market interest rates, future changes in
the shape of the yield curve, the impact of seasonal factors
(e.g., most homes are bought and sold in the spring of each
year), the condition of the economy, and how old the loans in
the pool are (because new loans are less likely to be repaid).
One commonly employed way of making loan prepayment
estimates is to use the prepayment model developed by
the Public Securities Association (PSA), which calculates an
average loan prepayment rate based upon past experience.
The PSA model typically assumes, for example, that insured
home mortgages will prepay at an annual rate of 0 . 2 percent
the first month and the prepayment rate will grow by 0 . 2 per­
cent each month for the first 30 months. Loan prepayments
are then assumed to level off at a 6 percent annual rate for
the remainder of the loan pool's life. When an investments
officer adopts the PSA model without any modifications, he or
she is said to be assuming a 100 percent PSA repayment rate.
However, the investments officer may decide to alter the PSA
model to 75 percent PSA or some other percentage multiplier
based upon his or her knowledge of the nature of loans in the
pool, such as their geographic location, distribution of maturi­
ties, or the average age of borrowers.
It must be noted that while prepayment of securitized loans
tends to accelerate in periods of falling interest rates, this is not
always an adverse development for investors in asset-backed
securities. For example, as prepayments accelerate, an investing
institution recovers its invested cash at a faster rate, which can
be a favorable development if it has other profitable uses for
those funds. Moreover, lower interest rates increase the present
value of all projected cash flows from a loan-backed security so
that its market value could rise. The investments officer must
compare these potential benefits to the potential losses from
falling interest payments in the form of lower reinvestment rates
and lost future income from loans that are prepaid. In general,
asset-backed securities will fall in value when interest rates
decline if the expected loss of interest income from prepaid
loans and reduced reinvestment earnings exceeds the expected
benefits that arise from recovering cash more quickly from pre­
paid loans.
72 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Inflation Risk
Investing institutions must be alert to the possibility that the
purchasing power of interest income and repaid principal from
a security or loan will be eroded by rising prices for goods and
services. Inflation can also erode the value of the stockholders'
investment in a financial firm—its net worth. Some protection
against inflation risk is provided by short-term securities and
those with variable interest rates, which usually grant the invest­
ments officer greater flexibility in responding to any flare-up in
inflationary pressures.
One recently developed inflation risk hedge that may aid some
financial firms is the United States Treasury Department's TIPS—
Treasury Inflation-Protected Securities. Beginning in 1997 the
Treasury began issuing 5-, 10-, and 30-year inflation-adjusted
marketable notes and later announced the offering of inflation-
protected savings bonds for the small investor. Both the coupon
rate and the principal (face) value of a TIPS are adjusted annu­
ally to match changes in the consumer price index (CPI). Thus,
the spread between the market yield on noninflation-adjusted
Treasury notes or bonds and the yield on TIPS of the same matu­
rity provides an index of expected inflation as viewed by the
average investor in the marketplace. If expected inflation rises,
TIPS tend to become more valuable to investors.
Many financial institutions have not been particularly enthusi­
astic about TIPS recently for a variety of reasons. With inflation
proceeding at a relatively moderate pace in the United States,
the market yield on TIPS has been modest as well. Then, too,
other inflation hedges are available, such as real estate and
selected stocks, with the potential for favorable returns. More­
over, TIPS do not protect investors from all the effects of infla­
tion, such as moving into higher tax brackets, and they carry
market risk like regular bonds, but tend to be less liquid.
Pledging Requirements
Depository institutions in the United States cannot accept
deposits from federal, state, and local governments unless
they post collateral acceptable to these governmental units in
order to safeguard public funds. At least the first $100,000 of
these public deposits is covered by federal deposit insurance;
the rest must be backed up by holdings of Treasury and federal
agency securities valued at par. Some municipal bonds (pro­
vided they are at least A-rated) can also be used to secure the
federal government's deposits in depository institutions, but
these securities must be valued at a discount from par (often 80
to 90 percent of their face value) in order to give governmental
depositors an added cushion of safety. State and local govern­
ment deposit pledging requirements differ widely from state to
 CONCEPT CHECK
4.8. How is the expected yield on most bonds determined?
4.9. If a government bond is expected to mature in two
years and has a current price of $950, what is the
bond's YTM if it has a par value of $1,000 and a
promised coupon rate of 10 percent? Suppose this
bond is sold one year after purchase for a price of $970.
What would this investor's holding period yield be?
4.10. What forms of risk affect investments?
4.11. How has the tax exposure of various U.S. bank security
investments changed in recent years?
4.12. Suppose a corporate bond an investments officer
would like to purchase for her bank has a before-tax
yield of 8.98 percent and the bank is in the 35 percent
federal income tax bracket. What is the bond's after­
tax gross yield? What after-tax rate of return must a
prospective loan generate to be competitive with the
corporate bond? Does a loan have some advantages
for a lending institution that a corporate bond would
not have?
state, though most allow a combination of federal and municipal
securities to meet government pledging requirements. Some­
times the government owning the deposit requires that the
pledged securities be placed with a trustee not affiliated with
the institution receiving the deposit. We note from looking at
Table 4.3 that just over half of bank-held investment securities
are pledged to back up government-owned deposits.
Pledging requirements also exist for selected other liabilities.
For example, when a bank borrows from the discount window
of the Federal Reserve bank in its district, it must pledge either
federal securities or other collateral acceptable to the Fed. If a
financial institution uses repurchase agreements (RPs) to raise
money, it must pledge some of its securities (usually Treasury
and federal agency issues) as collateral in order to receive funds
at the lowest RP rate.
4.8 IN VESTM EN T MATURITY
STRATEGIES
Once the investments officer chooses the type of securities he
or she believes a financial firm should hold, there remains the
question of how to distribute those security holdings over time.
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
4.13. What is the net after-tax return on a qualified municipal
security whose nominal gross return is 6 percent, the
cost of borrowed funds is 5 percent, and the financial
firm holding the bond is in the 35 percent tax bracket?
What is the tax-equivalent yield (TEY) on this tax-
exempt security?
4.14. Spiro Savings Bank currently holds a government bond
valued on the day of its purchase at $5 million, with
a promised interest yield of 6 percent, whose current
market value is $3.9 million. Comparable quality bonds
are available today for a promised yield of 8 percent.
What are the advantages to Spiro Savings from selling
the government bond bearing a 6 percent promised
yield and buying some 8 percent bonds?
4.15. What is tax swapping? What is portfolio shifting? Give
an example of each.
4.16. Why do depository institutions face pledging require­
ments when they accept government deposits?
4.17. What types of securities are used to meet collateraliza­
tion requirements?
That is, what maturities of securities should the investing institu­
tion hold? Should it purchase mainly short-term bills and notes,
or only long-term bonds, or perhaps some combination of the
two? Several maturity distribution strategies have been devel­
oped over the years, each with its own unique set of advantages
and disadvantages. (See Exhibit 4.2 and Exhibit 4.3.)
The Ladder, or Spaced-Maturity, Policy
One popular approach to the maturity problem, particularly
among smaller institutions, is to choose some maximum accept­
able maturity and then invest in an equal proportion of securities
in each of several maturity intervals until the maximum accept­
able maturity is reached.
For example, suppose management decided that it did not want
to purchase any bonds or notes with maturities longer than five
years. It might then decide to invest 20 percent of the firm's
investment portfolio in securities one year or less from maturity,
another 2 0 percent in securities maturing within two years but
no less than one year, another 2 0 percent in the interval of two
to three years, and so forth, until the five-year point is reached.
This strategy certainly does not maximize investment income,
but it has the advantage of reducing income fluctuations and
requires little expertise to carry out. Moreover, this ladder
■ 73
 The Ladder or Spaced-Maturity Policy

STRATEGY: Divide 30-

investment portfolio (U3
equally among ail

ercent of the
Fall securitie
to the investing institution.
ADVANTAGES: Reduces
investment income 20% of 20% of 20% of 20% of 20% of
10“
fluctuations/requires portfolio portfolio portfolio portfolio portfolio
little management PU o
expertise.
n
1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
Maturity in years and months

The Front-End Load Maturity Policy

STRATEGY: All
security investments
are short-term.
ADVANTAGES:
u 2
Strengthens the
financial firm’s 1 s
£ S3
liquidity position a s
and avoids large <4-1 §
O o
capital losses if S 8
market interest
rates rise. &U <o4^
P

1 yr. 2 yr. 3 yr. 4 yr.

Maturity in years and months

The Back-End Load Maturity Policy

STRATEGY: All
security investments
are long-term.
ADVANTAGES:
Maximizes
income potential
from security
investments if
market interest
rates fall.

Maturity in years and months

Exhibit 4.2 Alternative maturity strategies for managing investm ent portfolios.

approach tends to build in investment flexibility. Because some

securities are always rolling over into cash, the firm can take F a c to id
advantage of any promising opportunities that may appear. Which type of financial institution holds more Treasury
securities than any other financial institution?

The Front-End Load Maturity Policy Answer: The Federal Reserve System with several hundred
billion in Treasuries in its portfolio; among private financial
Another popular strategy is to purchase only short-term securi­
institutions pension funds, mutual funds, insurance companies,
ties and place all investments within a brief interval of time.
and depository institutions, hold large quantities of Treasuries.
For example, the investments officer may decide to invest

74 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 The Barbell Investment Portfolio Strategy

STRATEGY:
Security holdings
are divided between o -a Half or a substantial Half or a substantial
short-term and percentage of portfolio percentage of portfolio
long-term. _________________A_________________
J .j
ADVANTAGES: ■5 £
Helps to meet -

liquidity needs with § 8

short term securities 8 ^ 30% 30%

and to achieve earnings On O
goals due to higher
potential earnings from
the long term portion 1 yr. 2 yr, 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10 yr.
of the portfolio.

The Rate-Expectations Approach

STRATEGY: 50 H
Change the mix of Shift toward long-term securities
investment maturities if interest rates are expected to fall
as the interest-rate p 4tH
outlook changes.
ADVANTAGES: l | 3<H
W H Shift toward short-term securities
Maximizes the oh S if interest rates are expected to rise
potential for earnings g s 20 H
(and also for losses). E^
Cu o
10^

0
1 yr. 2 yr. 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10 yr.

Exhibit 4.3 Additional m aturity strategies for managing investm ent portfolios.

1 0 0 percent of his or her institution's funds not needed for loans
or cash reserves in securities three years or less from maturity.
This approach stresses using the investment portfolio primarily
as a source of liq u id ity rather than as a source of income.
The Back-End Load Maturity Policy
An opposite approach would stress the investment portfolio as
a source of in co m e. An investing institution following the b a c k ­
e n d lo a d approach might decide to invest only in bonds in the
5- to 10-year maturity range. This institution would probably
rely heavily on borrowing in the money market to help meet its
liquidity requirements.
The Barbell Strategy
A combination of the front-end and back-end load approaches,
frequently employed by smaller financial firms, is the b a rb e ll
stra te g y , in which an 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. The short-term portfolio provides liquidity, while the
long-term portfolio is designed to generate income.
The Rate Expectations Approach
The most aggressive of all maturity strategies, often used by the
largest financial firms, is one that continually shifts maturities of
securities in line with current forecasts of interest rates and the
economy. This total p e rfo rm a n ce , or rate e x p e cta tio n , approach
calls for shifting investments toward the short end of the maturity
spectrum when interest rates are expected to rise and toward
the long end when falling interest rates are expected. Such an
approach offers the potential for large capital gains, but also
raises the specter of substantial losses. It requires in-depth knowl­
edge of market forces, presents greater risk if expectations turn
out to be wrong, and carries greater transactions costs because it
may require frequent security trading and switching.
Banks, for example, often trade some of their unpledged
security holdings whenever there is the prospect of significant
gains in expected returns or the opportunity to reduce asset
risk without significant loss in expected yield. They are particu­
larly aggressive when loan revenues are down and the sale of
securities whose market value has risen will boost net income
and shareholder returns. However, because losses on security
trades reduce before-tax income, portfolio managers do not like
to take such losses unless they can demonstrate to the board

C hap ter 4 The Investm ent Function in Financial-Services M anagem ent ■ 75

of directors that the loss will be more than made up by higher
expected returns on new assets acquired from the proceeds of
the security sale. In general, investing institutions are inclined
to trade securities if (a) their expected after-tax returns can be
raised through effective tax management strategies; (b) higher
yields can be locked in at the long-term end of the yield curve
when the forecast is for falling interest rates; (c) the trade would
contribute to an overall improvement in asset quality that would
enable the institution to better weather an economic downturn;
or (c/) the investment portfolio can be moved toward higher-
grade securities without an appreciable loss in expected return
(especially if problems are developing in the loan portfolio).
4.9 MATURITY M AN AGEM EN T TO O LS
In choosing among various maturities of investments to acquire,
investments officers need to consider carefully the use of two
key maturity management tools—the yield curve and duration.
These tools help the investments officer understand more fully
the consequences and potential impact upon earnings and risk
from any particular maturity mix of securities.
The Yield Curve
As we will see in Chapter 18, the yield curve is simply a picture
of how market interest rates differ across loans and securities
of varying term (time) to maturity. Each yield curve, such as
the one drawn in Exhibit 4.2, assumes that all interest rates (or
yields) included along the curve are measured at the same time
and that all other rate-determining forces are held fixed. While
the curve in Exhibit 4.2 slopes upward as we move to the right,
yield curves may also slope downward or be horizontal, indicat­
ing that short- and long-term interest rates at that particular
moment are about the same.
76 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Forecasting Interest Rates and the Economy
Yield curve shapes have critical implications for the decisions an
investments officer must make. For example, the yield curve con­
tains an implicit forecast of future interest rate changes, Positively
sloped yield curves reflect the average expectation in the market
that future short-term interest rates will be higher than they are
today. In this case, investors expect to see an upward interest-rate
movement, and they often translate this expectation into action by
shifting their investment holdings away from longer-term securities
(which will incur greater capital losses when market interest rates
do rise). Conversely, a downward-sloping yield curve points to
investor expectations of declining short-term interest rates in the
period ahead. The investments officer will consider lengthening
portfolio maturity because falling interest rates offer the prospect
of substantial capital gains income from longer-term investments.
Yield curves also provide the investments officer with a clue
about overpriced and underpriced securities, Because the pre­
vailing yield curve indicates what the yield to maturity should
be for each maturity, a security whose yield lies above the curve
represents a tempting buy situation; its yield is temporarily too
high (and, therefore, its price is too low). On the other hand, a
security whose yield lies below the curve represents a possible
sell or "don't buy" situation because its yield is too low for its
maturity (and, thus, its price is too high).
In the long run, yield curves send signals about what stage of
the business cycle the economy presently occupies, They gener­
ally rise in economic expansions and fall in recessions.
Risk-Return Trade-Offs
The yield curve is also useful because it tells the investments
officer something important about the current trade-offs
between greater returns and greater risks. The yield curve's
shape determines how much additional yield the investments
officer can earn by replacing shorter-term
securities with longer-term issues, or vice
versa. For example, a steeply sloped
positive yield curve that rises 1 0 0 basis
points between 2 -year and 1 0 -year matu­
rity bonds indicates that the investments
officer can pick up a full percentage point
in extra yield (less broker or dealer com­
missions and any tax liability incurred) by
switching from 2 -year to 1 0 -year bonds.
However, 10-year bonds are generally
more volatile in price than 2 -year bonds,
so the investments officer must be will­
ing to accept greater risk of a capital loss
on the 1 0 -year bonds if interest rates
rise. Longer-term bonds often have a thinner market in case
cash must be raised quickly. The investments officer can mea­
sure along the curve what gain in yield will result from maturity
extension and compare that gain against the likelihood a finan­
cial firm will face a liquidity crisis ("cash out") or suffer capital
losses if interest rates go in an unexpected direction.
Pursuing the Carry Trade
Likewise, yield curves provide the investments officer with a
measure of how much might be earned at the moment by pur­
suing the carry trade, The officer can borrow funds at the short­
est end of the curve (such as borrowing short-term money using
the safest and most liquid investment securities in the financial
firm's portfolio as collateral) and then invest the borrowed funds
in income-generating assets farther out along the curve. For
example, the officer may borrow funds for 30 days at 4 percent
and use that money to invest in five-year government bonds
yielding 6 percent. The difference between these two rates of
return is called carry income and tends to be greatest when the
yield curve has a steep upward slope.
Riding the Yield Curve
If the yield curve does have a sufficiently strong positive slope,
an investing institution may also be able to score significant
gains with a maneuver known as riding the yield curve, The
investments officer looks for a situation in which some securi­
ties are soon to approach maturity and their prices have risen
significantly while their yields to maturity have fallen. If the yield
curve's slope is steep enough to more than cover transactions
costs, the investing institution can sell those securities, scoring
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 the riding maneuver works (i.e., the
slope of the yield curve does not fall), the investing institution
will reap both higher current income and greater future returns.
Duration
While the yield curve presents the investments officer with valu­
able information and occasionally the opportunity for substantial
gains, it has several limitations, such as uncertainty over exactly
how and why the curve appears the way it does at any particular
moment and the possibility of a change in the curve's shape at
any time. Moreover, the yield curve counts only clock time, not
the timing of cash flows expected from a security. The most
critical information for the investments officer is usually not how
long any particular security will be around but, rather, when it
will generate cash and how much cash will be generated each
month, quarter, or year the security is held.
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
The need for this kind of information gave rise to the concept
of duration—a present-value-weighted measure of maturity of
an individual security or portfolio of securities. As we will discuss
in Chapter 18, duration measures the average amount of time
needed for all of the cash flows from a security to reach the
investor who holds it.
We will see in Chapter 18 (especially from Equation [18.18]) that
there is a critical relationship between duration, market interest
rates, and investment security prices. Specifically, the percent­
age change in the price of an investment security is equal to the
negative of its duration times the change in interest rates
divided by one plus the initial interest rate or yield. 4 Using this
relationship we can see how sensitive an investment security's
market price will be to changes in market interest rates and we
can decide whether the security we are interested in is too price
sensitive, or perhaps not price sensitive enough, to meet our
financial firm's investment needs.
For example, suppose a Treasury note has a duration of
4.26 years and market interest rates rise from 10.73 percent
to 12 percent, or 1.27 percent. The duration relationship we
described above tells us that should interest rates rise just over
one percentage point, the security in question will experience
almost a 5 percent decline in price. The investments officer must
decide how much chance there is that market interest rates will
rise, whether this degree of price sensitivity is acceptable, and
whether other investments would better suit the institution's
current investment needs.
Immunization
Duration also suggests a way to minimize damage to an invest­
ing institution's earnings that changes in market interest rates
may cause. That is, duration gives the investments officer a tool
to reduce his or her institution's exposure to interest rate risk. It
suggests a formula for minimizing interest rate risk:
Duration of Length of the investor's
an individual planned holding period
security or a for a security or a
(4.9)
security portfolio security portfolio*1
4 The formula described in this sentence (and presented in Chapter 18)
applies if a security pays interest once each year, if interest is paid more
than once each year the appropriate formula is this:
Percentage change Change in interest rate
— —Duration X
in price 1 + (1/m)(lnitial rate)
where m is the number of times during a year that the security pays interest.
For example, most bonds pay interest semiannually, in which case m = 2.
■ 77
 CONCEPT CHECK
4.18. What factors affect a financial-service institution's deci­
sion regarding the different maturities of securities it
should hold?
4.19. What maturity strategies do financial firms employ in
managing their portfolios?
4.20. Bacone National Bank has structured its investment
portfolio, which extends out to four-year maturities,
so that it holds about $ 1 1 million each in one-year,
two-year, three-year, and four-year securities.
In contrast, Dunham National Bank and Trust holds
$36 million in one- and two-year securities and
about $30 million in 8 - to 10-year maturities. What
maturity strategy is each bank following? Why do
For example, suppose a bank is interested in buying Treasury
notes because loan demand currently is weak. However, the
investments officer is concerned that he or she may be
required to sell those securities at this time next year in order
to make profitable loans. Faced with this prospect and deter­
mined to minimize interest rate risk, the officer could choose
those notes with a duration of one year. The effect of this step
is to engage in portfolio immunization—that is, protecting
securities purchased from loss of return, no matter which way
interest rates go . 5 *•
Duration works to immunize a security or portfolio of securi­
ties against interest rate changes because two key forms of
risk—interest rate risk and reinvestment risk—offset each
other when duration is set equal to the investing institution's
planned holding period. If interest rates rise after the securi­
ties are purchased, their market price will decline, but the
investments officer can reinvest the cash flow those securities
are generating at higher market rates. Similarly, if interest
rates fall, the institution will be forced to reinvest at lower
interest rates but, correspondingly, the prices of those securi­
ties will have risen. The net result is to approximately freeze
the total return from investment security holdings. Capital
gains or losses are counterbalanced by falling or rising rein­
vestment yields when duration matches the investing institu­
tion's planned holding period.
5 See Chapter 18 for additional discussion of portfolio immunization.
78 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
you believe that each of these banks has adopted
the particular strategy it has as reflected in the
maturity structure of its portfolio?
4.21. How can the yield curve and duration help an invest­
ments officer choose which securities to acquire or sell?
4.22. A bond currently sells for $950 based on a par value
of $ 1 , 0 0 0 and promises $ 1 0 0 in interest for three
years before being retired. Yields to maturity on
comparable-quality securities are currently at
12 percent. What is the bond's duration? Suppose
interest rates in the market fall to 10 percent. What
will be the approximate percent change in the
bond's price?
SUM MARY
This chapter has focused on investments in the banking and
financial-services field. What is involved in making investments
and why are they important?
• For most financial-service firms, investments refer to the buy­
ing and selling of marketable securities, such as government
bonds and notes.
• Investments fulfill multiple roles in the management of a
financial firm. These roles include (a) supplementing income
from loans; (b) supplying extra liquidity when cash is low;
(c) serving as collateral for borrowings; (d) reducing tax expo­
sure; (e) offsetting risks inherent in other parts of the balance
sheet, such as in the loan portfolio; (f) dressing up the bal­
ance sheet; (g) helping to hedge against interest rate risk;
and (h) providing greater flexibility in management of assets
and liabilities.
• The investments officer must choose what kinds of invest­
ments best contribute to the goals established for each insti­
tution's investment portfolio. In lending-type institutions, the
investment portfolio normally plays "second fiddle" and the
investments officer is often charged with the responsibility
for backstopping loans—providing more income when loan
demand is weak and more cash when loan demand is high.
• In choosing which investments to hold, investments officers
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.
• An additional factor that investments officers must consider
is the maturity or duration of different investment securities,
represented by the yield curve. Yield curves convey informa­
tion about the market's outlook for interest rates and graphi­
cally illustrate the trade-off between risk and return that
confronts the investments officer. Duration provides a picture
of the time distribution of expected cash flows from invest­
ments and can be used to help reduce interest rate risk.
• Most financial firms appear to have a preferred range of
maturities and durations for the investments they make, with
depository institutions tending to focus upon comparatively
short and midrange maturities or durations, and many of
their competitors, such as insurance companies and pension
funds, tending to reach heavily into the longest maturities or
durations.

K E Y TERM S
money market instruments, 57 corporate notes, 61 credit risk, 69
capital market instruments, 57 corporate bonds, 61 business risk, 70
U.S. Treasury bill, 57 securitized assets, 61 liquidity risk, 71
Treasury notes, 59 mortgage-backed bond, 62 call risk, 71
Treasury bonds, 59 stripped security, 62 prepayment risk, 71
federal agency securities, 59 yield to maturity (YTM), 65 inflation risk, 72
certificate of deposit (CD), 59 holding period yield (HPY), 65 pledging, 72
bankers' acceptances, 59 tax swap, 67 yield curve, 76
commercial paper, 60 portfolio shifting, 6 8 duration, 77
municipal bonds, 60 interest rate risk, 69 portfolio immunization, 78

Chapter 4 The Investm ent Function in Financial-Services M anagem ent

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
PROBLEM S AND PRO JECTS
1. A 20-year U.S. Treasury bond with a par value of $1,000 is
currently selling for $1,025 from various securities dealers.
The bond carries a 6 percent coupon rate with payments
made annually. If purchased today and held to maturity,
what is its expected yield to maturity?
2. A municipal bond has a $1,000 face (par) value. Its yield to
maturity is 5 percent, and the bond promises its holders
$60 per year in interest (paid annually) for the next 1 0 years
before it matures. What is the bond's duration?
3. Calculate the yield to maturity of a 20-year U.S. government
bond that is selling for $975 in today's market and carries a
5 percent coupon rate with interest paid semi-annually.
4. A corporate bond being seriously considered for purchase
by Old Dominion Financial will mature 20 years from today
and promises a 7 percent interest payment once a year.
Recent inflation in the economy has driven the yield to
maturity on this bond to 1 0 percent, and it carries a face
value of $1,000. Calculate this bond's duration.
5. Forever Savings Bank regularly purchases municipal bonds
issued by small rural school districts in its region of the state.
At the moment, the bank is considering purchasing an
$ 8 million general obligation issue from the York school district,
the only bond issue that district plans this year. The bonds,
which mature in 15 years, carry a nominal annual rate of return
of 6.75 percent. Forever Savings, which is in the top corporate
tax bracket of 35 percent, must pay an average interest rate
of 4.25 percent to borrow the funds needed to I purchase the
municipals. Would you recommend purchasing these bonds?
Calculate the net after-tax return on this bank-qualified
municipal security. What is the tax advantage for being a
qualified bond?
6 . Forever Savings Bank also purchases municipal bonds issued
by the city of Richmond. Currently the bank is considering a
nonqualified general obligation municipal issue. The bonds,
which mature in 15 years, provide a nominal annual rate of
return of 9.75 percent. Forever Savings Bank has the same
cost of funds and tax rate as stated in the previous problem.
a. Calculate the net after-tax return on this nonqualified
municipal security.
b. What is the difference in the net after-tax return for
this qualified security (Problem 5) versus the nonquali­
fied municipal security?
80 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
c. Discuss the pros and cons of purchasing the nonquali­
fied rather than the bank-qualified municipal described
in the previous problem.
7. Lakeway Thrift Savings and Trust is interested in doing
some investment portfolio shifting. This institution has had
a good year thus far, with strong loan demand; its loan
revenue has increased by 16 percent over last year's level.
Lakeway is subject to the 35 percent corporate income
tax rate. The investments officer has several options in the
form of bonds that have been held for some time in its
portfolio:
a. Selling $4 million in 12-year City of Dallas bonds
with a coupon rate of 7.5 percent and purchasing
$4 million in bonds from Bexar County (also with
1 2 -year maturities) with a coupon of 8 percent and
issued at par. The Dallas bonds have a current market
value of $3,750,000 but are listed at par on the institu­
tion's books.
b. Selling $4 million in 12-year U.S. Treasury bonds that
carry a coupon rate of 1 2 percent and are recorded
at par, which was the price when the institution pur­
chased them. The market value of these bonds has
risen to $4,330,000.
Which of these two portfolio shifts would you recommend?
Is there a good reason for not selling these Treasury bonds?
What other information is needed to make the best deci­
sion? Please explain.
8. Current market yields on U.S. government securities are
distributed by maturity as follows:
3-month Treasury bills 1.90 percent
6 - month Treasury bills percent
2 .1 0
1-year Treasury notes 2.25 percent
2- year Treasury notes 2.51 percent
3- year Treasury notes 2.82 percent
5-year Treasury notes 3.28 percent
7- year Treasury notes 3.56 percent
10-year Treasury bonds 3.98 percent
20-year Treasury bonds 4.69 percent
30-year Treasury bonds 5.25 percent
Draw a yield curve for these securities. What shape does
the curve have? What significance might this yield curve
have for an investing institution with 75 percent of its
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

investment portfolio in 7-year to 30-year U.S. Treasury would you recommend as good additions to the portfolio
bonds and 25 percent in U.S. government bills and notes during the period covered by the recession forecast and
with maturities under one year? What would you recom­ why? What other kinds of information would you like to
mend to management? have about the bank's current balance sheet and earnings
9. A bond possesses a duration of 8.89 years. Suppose that report in order to help you make the best quality decisions
market interest rates on comparable bonds were 7.5 per­ regarding the investment portfolio?
cent this morning, but have now shifted downward to 13. Arrington Hills Savings Bank, a $3.5 billion asset institution,
7.25 percent. What percentage change in the bond's value holds the investment portfolio outlined in the following
occurred when interest rates decreased by 25 basis points? table. This savings bank serves a rapidly growing money
10. The investments officer for Sillistine Savings is concerned center into which substantial numbers of businesses are
about interest rate risk lowering the value of the institu­ relocating their corporate headquarters. Suburban areas
tion's bonds. A check of the bond portfolio reveals an aver­ around the city are also growing rapidly as large numbers
age duration of 4.5 years. How could this bond portfolio of business owners and managers along with retired profes­
be altered in order to minimize interest rate risk within the sionals are purchasing new homes. Would you recommend
next year? any changes in the makeup of this investment portfolio?
Please explain why.
11. A bank's economics department has just forecast acceler­
ated growth in the economy, with GDP expected to grow
at a 4.5 percent annual growth rate for at least the next two Percent Types of Percent
years. What are the implications of this economic forecast Types of of Total Securities of Total
for an investments officer? What types of securities should Securities Held Portfolio Held Portfolio
the officer think most seriously about adding to the invest­
U.S. Treasury 38.7% Securities 45.6%
ment portfolio? Why? Suppose the bank holds a security securities available for
portfolio similar to that described in Table 4.3 for all insured sale
Federal agency 35.2
U.S. banks. Which types of securities might the investments
securities
officer want to think seriously about selling if the projected
economic expansion takes place? What losses might occur State and local 15.5 Securities 11.3
government with
and how could these losses be minimized?
obligations maturities:
12. Contrary to the exuberant economic forecast described Under one
in Problem 11, suppose a bank's economics department year
is forecasting a significant recession in economic activity. Domestic debt 5.1 One to five 37.9
Output and employment are projected to decline signifi­ securities years
cantly over the next 18 months. What are the implications Foreign debt 4.9 Over five 50.8
of this forecast for an investment portfolio manager? What securities years
is the outlook for interest rates and inflation under the fore­
Equities 0 .6
going assumptions? What types of investment securities

C hap ter 4 The Investm ent Function in Financial-Services M anagem ent 81

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
Internet Exercises
1. As the investments officer for Bank of America, you have
been informed by a member of that bank's board of direc­
tors that the investment policies you have followed over
the past year have been substandard relative to your com­
petitors, including Citigroup, Wells Fargo, and JP Morgan
Chase. You protest and observe that all financial institutions
have faced a tough market and, in your opinion, your bank
has done exceptionally well. Challenged, your CEO asks
you to prepare a brief memo with comparative investment
facts, defending your bank's relative investment perfor­
mance against the other BHCs mentioned. Use the FDIC's
Statistics on Depository Institutions at www2.fdic.gov/sdi to
develop a reply. What conclusion did you reach after exam­
ining your bank's relative investment performance over the
last complete calendar year?
CA SE ASSIGN M EN T FO R CH APTER 4
YOUR BANK'S INVESTMENT FUNCTION: AN
EXAMINATION OF THE SECURITIES PORTFOLIO
Chapter 4 explores how the investments officer manages a
financial firm's securities portfolio and describes the portfolio's
purpose and composition. A significant portion of the chapter
outlines and describes the different types of money market and
capital market instruments found in the securities portfolio.
Part One of this assignment examines the types of securities
in your bank's portfolio and asks you to make some inferences
about factors that played a role in the selection of securities for
that portfolio. The possible factors are discussed midchapter.
Part Two of this assignment examines the maturity structure of
your bank's securities portfolio. This topic is covered in the later
part of the chapter. Chapter 4's assignment is designed to focus
on the issues of importance to investments officers in large com­
mercial banks or similar competing institutions.
Part One: The Composition of Your Bank's
Securities Portfolio—Trend and Comparative
Analysis
A. Data Collection: For this part, you will access data at the
FDIC's website located at www2.fdic.gov/sdi for your
BHC. Use SDI to create a four-column report of your bank's
information and the peer group information across years. In
this part of the assignment for Report Selection use the pull­
down menu to select Securities and view this in Percent of
Assets. For the size of the securities portfolio relative to total
82 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
2. A number of websites are available to help in evaluating
the merits and demerits of different types of securities
that banks are allowed to hold in their investment portfo­
lios. See www.sifma.org and www.investinginbonds.com.
Find one additional website on your own and compare and
contrast the usefulness of these three websites.
3. If you want a summary of regulations applying to bank and
thrift security portfolios, you would turn to the regulators'
websites. The Federal Reserve's Trading and Capital-
Markets Activity Manual found at www.federalreserve
.gov/boarddocs/supmanual/trading.pdf has a section on
"Capital Market Activities." Read and briefly outline the
first two pages on "Limitations and Restrictions on Securi­
ties Holdings" that is found in section 3000.1—Investment
Securities and End-User Activities.
assets, see Item 1—the components of the securities portfo­
lio are listed as Items 4-7 and 13-14. Enter the percentage
information for these items as an addition to the spread­
sheet for comparisons with the peer group as illustrated
using BB&T's 2010 and 2009 year-end data.
B. Compare columns of row 77. How has the relative size of
your bank's securities portfolio-to-total assets ratio changed
across periods? Does your BHC have more or less liquidity
than the group of comparable institutions?
C. Use the Chart function in Excel and the data by columns in
rows 78 through 83 to create four pie charts illustrating the
profile of securities held by your BHC and its peer group.
With these pie charts provide titles, labels, and percent­
ages. If you save these as separate sheets, they do not clut­
ter the spreadsheets that you use most frequently, yet they
are available to insert in Word documents. To give you an
example, the charts for BB&T and its peer group for 2010
would appear as on the following page.
D. Utilizing the above information, write one or two paragraphs
about your BHC's securities portfolio and how it compares
to its peers. Use your pie charts as graphics and incorporate
them in the discussion. Provide inferences concerning the fac­
tors (e.g., expected rate of return, tax exposure, interest rate
risk) affecting the choice of investment securities.
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

0 Real Numbers for Real Banks Chapter 10 - Microsoft Excel

File Home 1:7 Page Layout Formulas Data Review View Acrobat Q Tell me what you want to do...

PivotTable Recommended Table

[3 0 ® •. •-
Pictures Online Shapes SmartArt Screenshot ^ My Add-ins -•
DB
Bing People
if J:5:J: *
Recommended PivotChart
m
3D Line Column Win/ Slicer Timeline Hyperlink
md ^ & a n a
Text Header WordArt Signature Object Equation Symbol
PivotTables Pictures » * Maps Graph Charts " Lj ’ ^ Map * Loss Box & Footer * Lin e1'
Tables Illustrations Add-ins Charts r; Tours Sparklines Filters Links Text Symbols

A75 fx Composition of Securities Portfolio

A A C D
E F G H 1 > K
L M N O P I Q l R l S T
75 C o m p o s itio n o f S e c u r it ie s P o rtfo lio BB&T P e e r G ro u p BB& T P e e r G ro u p
76 Date 31-12-2010 31-12-2010 31-12-2009 31-12-2009
77 Securities 14.98% 19.25% 20.40% 18.54%
78 U.S. Treasury securities 0.00% 1.74% 1.16% 0.94%
79 U.S. Government obligations 11.97% 10.00% 15.54% 9.52%
80 Securities issued by states & political subdivsions 1.40% 0.78% 1.40% 0.73%
81 Other domestic debt securities 1.63% 4.18% 1.19% 4.76%
82 Foreign debt securities 0.00% 2.43% 0.00% 1.42%
83 Equity securities 0.08% 0.12% 0.10% 0.16%
84
85
B a sic In fo rm a tio n Year-to-Year Comparisons Comparisons with Peer Group 1 © : <1...........................................................................................................................................................
Ready

Composition of Securities Portfolio for Composition of Securities Portfolio for

BB&T (12/31/2010) Peer Group (12/31/2010)

Other domestic Equity securities U.S. Treasury

debt securities 1% Equity securities
10% securities 9%
Securities issued by 1%
states & political
Foreign debt
subdivisions
securities
9%
12%

U.S Government
obligations
80% Other domestic
debt securities
22%
U.S. Government
obligations
Securities issued by 52%
states & political
subdivisions
4%

Part Two: Investment Maturity Strategies lien 1-4 residential mortgages, (2) CMOs, REMICs, and
stripped MBs, and (3) other debt securities. Groups 1 and 3
A. Data Collection: The chapter concludes with a discussion
are partitioned into six maturity periods, whereas Group 2,
of investment maturity strategies. The SDI at www2.fdic
given the prepayment risk, has its expected average life
.gov/sdi contains maturity data for debt securities for banks
partitioned into two more general categories. Our objective
and BHCs. You will follow the process used to collect data
is to aggregate the data for all the debt securities based on
for Part One; however, this time you will focus on the dollar
maturities and enter our dollar sums in the spreadsheet for
year-end information for your BHC only. You will collect
year-to-year comparisons as illustrated for BB&T using 2010
information in the two-column format. For Report Selec­
and 2009 data. For simplification we will include CMOs,
tion, use the pull-down menu to select Total Debt Securities
REMICs, and stripped MBs with expected average lives of
and view this in dollars. For maturity and repricing data for
three years or less in the aggregation for row 82 and CMOs,
debt securities (all securities but equities), you are inter­
REMICs, and stripped MBs with expected average lives
ested in items 3-16. This includes a breakdown by maturity
of more than three years in row 84. Enter the aggregated
of (1 ) mortgage pass-throughs backed by closed-end first

C hap ter 4 The Investm ent Function in Financial-Services M anagem ent ■ 83

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

0 ; Real Numbers for Real Banks Chapter 10 - Microsoft Excel

ami?
File Home Page Layout Formulas Data Review View Acrobat Q Tell me what you want to do...

13
PivotTable Recommended Table
a 3 R?
Pictures Online Shapes SmartArt Screenshot
«a+ •*-
& My Add-ins - Bm9 PeoPle Recommended
r
P.votChart
hi
3D
]ih7 f v
Line Column Win/ Slicer Timeline Hyperlink
El Q 4 B 9
Text Header WordArt Signature Object
tz a
Equation Symbol
PivotTables Pictures Maps Graph Charts - Map - Loss Box & Footer ,r Line''
Tables Illustrations Add-ins Charts n Tours Sparklines Filters Links Text Symbols

A77 w x >/ fx Maturity and repricing data for debt securities

A A B C D E F G H 1 J K L M N O P Q R s T U
76
77 M a tu rity a n d re p ric in g d ata fo r d e b t s e c u r it ie s BB&T BB&T
78 Date 31-12-2010 31-12-2009
79 Total debt securities 22,060.508 32,080.426
80 Three months or less $1,055,338 $206,650
81 Over 3 months through 12 months $225,421 $249,176
82 Over 1 year through 3 years $1,313,000 $4,628,334
83 Over 3 years through 5 years $15,146 $127,916
84 Over 5 years through 15 years $10,935,069 $20,341,685
85 Over 15 years $1,142,116 $7,182,920
86
87
Basic Information Year-to-Year Comparisons Comparisons with Peer Group j © <[
Ready

data using dollar information for Debt Securities as an addi­ portfolio. With these column charts provide titles and labels
tion to Spreadsheet One as follows: For example, cell B80 and save for insertion in Word documents. To give you an
would be the sum of mortgage pass-throughs and other example, one chart for BB&T appears as follows:
debt securities with maturity and repricing of three months
C. Interpreting the information illustrated in the column charts,
or less.
write one paragraph about your bank's maturity strategy
B. Use the Chart function in Excel and the data by columns and how it has changed between the two year-ends. Use
in rows 80 through 85 of spreadsheet labeled year-to-year your column charts as graphics and incorporate them in the
comparison to create two column charts that graphically discussion. Tie your discussion to the types of strategies dis­
portray the maturity characteristics of your bank's securities cussed in the latter part of Chapter 4.

M aturity and Repricing Data for BB&T Debt Securities 12/31/2010

25 . 000 . 000

20 .000 . 000

15. 000 . 000

. .
10 000 000

5 , 000,000

0 T
Total debt Three Over Over Over
securities months 3 months 3 years 5 years
or less through through through
12 months 5 years 15 years

84 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
Selected References
See below for a discussion of securitization, security stripping,
and other investment instruments:
1. Dupont, Dominique, and Brian Sack. "The Treasury Securi­
ties Market: Overview and Recent Developments." Federal
Reserve Bulletin 85, no. 12 (1999), pp. 785-806.
2. Smith, Stephen D. "Analyzing Risk and Return for Mortgage-
Backed Securities," Economic Review, Federal Reserve Bank
of Richmond, January/February 1991, pp. 2-10.
The following articles review yield to maturity, yield curves, and
other yield measures:
3. Gurkaynak, Refet S., Brian Sack, and Jonathan H. Wright.
"The TIPs Yield Curve and Inflation Compensation."
Finance and Economics Discussion Series 2008-05, Federal
Reserve Board, Washington, D.C., 2008.
4. Poole, William. "Understanding the Term Structure of Inter­
est Rates." Review, Federal Reserve Bank of St. Louis, Sep-
tember/October 2005, pp. 589-595.
5. Rose, Peter S.; and Milton H. Marquis. Money and Capi­
tal Markets: Financial Institutions and Markets, 11th ed.
New York: McGraw-Hill/Irwin, 2010. (See especially Chapter 6 ,
"Measuring and Calculating Interest Rates and Financial Asset
Prices.")
For a discussion of investment strategies involving securities
purchased by depository institutions and other investment-
oriented institutions, see:
6 . Fleming, Michael J.; and Kenneth Garbade. "When the
Back Office Moved to the Front Burner: Settlement Fails in
the Treasury Market after 9/11." Economic Policy Review,
C hap ter 4 The Investm ent Function in Financial-Services M anagem ent
Federal Reserve Bank of New York, November 2002,
pp. 35-58.
7. Sundaresan, Suresh M. Fixed Income Markets and Their
Derivatives. Cincinnati, OH: Southwestern Publishing, 1997.
To explore the recent emergence of inflation-indexed invest­
ment securities, see especially:
8 . Sack, Brian, and Robert Elsasser. "Treasury Inflation-
Indexed Debt: A Review of the U.S. Experience." Economic
Policy Review, Federal Reserve Bank of New York, May
2004, pp. 47-63.
9. D'Amico, Stefania, Don H. Kim, and Min Wei. "Tips from
TIPS: The Informational Content of Treasury Inflation-
Protected Security Prices," Finance and Economics Discus­
sion Series, Federal Reserve Board, Washington, D.C., no.
2010-19, 2 0 1 0 .
For an in-depth analysis of the impact of default risk in interna­
tional securities markets see especially:
10. Hatchondo, Juan Carlos, and Leonardo Martinez. "The Poli­
tics of Sovereign Defaults," Economic Quarterly, Federal
Reserve Bank of Richmond, vol. 96, no. 3 (Third Quarter
2010), pp. 291-317.
To find a more recent discussion of settlement fails in the Trea­
sury security market consult, for example:
11. Garbade, Kenneth D, Frank M. Keane, Lorie Logan, Amanda
Stokes, and Jennifer Wolgemuth. "The Introduction of the
TMPG Fails Charge for U.S. Treasury Securities," Economic
Policy Review, Federal Reserve Bank of New York, vol. 16,
no. 2 (October 2010), pp. 45-71.
■ 85
 Learning Objectives
After completing this reading you should be able to:

Calculate a bank's net liquidity position and explain factors Summarize the process taken by a US bank to calculate its
that affect the supply and demand of liquidity at a bank. legal reserves.

Compare strategies that a bank can use to meet demands Differentiate between factors that affect the choice among
for additional liquidity. alternate sources of reserves.

Estimate a bank's liquidity needs through three methods

(sources and uses of funds, structure of funds, and liquidity
indicators).

Excerpt is Chapter 11 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

87
K E Y TOPICS IN THIS CH APTER
• Sources of Demand for and Supply of Liquidity
• Why Financial Firms Have Liquidity Problems
• Liquidity Management Strategies
• Estimating Liquidity Needs
• The Impact of Market Discipline
• Legal Reserves and Money Management
5.1 INTRODUCTION
Not long ago, as noted in a recent article from the Federal
Reserve Bank of St. Louis [5], a savings bank headquartered
in the northeastern United States experienced a real liquidity
crisis. Acting on rumors of a possible embezzlement of funds,
some worried depositors launched an old-fashioned "run" on
the bank. Flooding into the institution's Philadelphia and New
York City branches, some frightened customers yanked out
close to 13 percent of the savings bank's deposits in less than
a week, sending management scrambling to find enough cash
to meet the demands of concerned depositors. While the bank
appeared to weather the storm in time, the event reminds us of
at least two things: ( 1 ) how much financial institutions depend
upon public confidence to survive and prosper and (2 ) how
quickly the essential item called "liquidity" can be eroded when
the public, even temporarily, loses its confidence in one or
more institutions.
One of the most important tasks the management of any finan­
cial institution faces is ensuring adequate liquidity at all times,
no matter what emergencies may appear. A financial firm is
considered to be "liquid" if it has ready access to immediately
spendable funds at reasonable cost at precisely the time those
funds are needed. This suggests that a liquid financial firm either
has the right amount of immediately spendable funds on hand
when they are required or can raise liquid funds in timely fashion
by borrowing or selling assets.
Indeed, lack of adequate liquidity can be one of the first signs
that a financial institution is in trouble. For example, a troubled
bank losing deposits will likely be forced to dispose of some
of its safer, more liquid assets. Other lending institutions may
become increasingly reluctant to lend the troubled firm any new
funds without additional security or the promise of a higher rate
of interest, which may reduce the earnings of the beleaguered
financial firm and threaten it with failure.
88 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The cash shortages that some financial-service providers
experience make clear that liquidity needs cannot be ignored.
A financial firm can be closed if it cannot raise sufficient liquidity
even though, technically, it may still be solvent. For example,
during the 1990s, the Federal Reserve forced the closure of the
$10 billion Southeast Bank of Miami because it couldn't come
up with enough liquidity to repay the loans it had received from
the Fed. Moreover, the competence of liquidity managers is an
important barometer of management's overall effectiveness in
achieving any institution's goals. So, let's begin our journey and
see how important quality liquidity management is to the suc­
cess of virtually any financial firm.
5.2 THE DEM AND FO R AN D SUPPLY
O F LIQUIDITY *1
A financial institution's need for liquidity—immediately spend­
able funds—can be viewed within a demand-supply framework.
What activities give rise to the demand for liquidity? And what
sources can be relied upon to supply liquidity?
For most financial institutions, the most pressing demands
for spendable funds generally come from two sources:
( 1 ) customers withdrawing money from their accounts, and
(2 ) credit requests from customers the institution wishes to
keep, either in the form of new loan requests or drawings
upon existing credit lines. Other sources of liquidity demand
include paying off previous borrowings, such as loans the
institution may have received from other financial firms or
from the central bank (e.g., the Federal Reserve System).
Similarly, payment of income taxes or cash dividends to
stockholders periodically gives rise to a demand for immedi­
ately spendable cash.
To meet the foregoing demands for liquidity, financial firms can
draw upon several potential sources of supply. The most impor­
tant source for a depository institution normally is receipt of
new customer deposits. These deposit inflows tend to be heavy
the first of each month as business payrolls are dispensed, and
they may reach a secondary peak toward the middle of each
month as bills are paid. Another important element in the sup­
ply of liquidity comes from customers repaying their loans and
from sales of assets, especially marketable securities, from the
investment portfolio. Liquidity also flows in from revenues (fee
income) generated by selling nondeposit services and from bor­
rowings in the money market.
These various sources of liquidity demand and supply come Timing is critical to liquidity management: Financial managers
together to determine each financial firm's net liquidity position must plan carefully how, when, and where liquid funds can be
at any moment in time. That net liquidity position (L) at time t is: raised.

Supplies of Liquidity Flowing into the Financial Firm

A financial firm's Revenues from Borrowings
net liquidity ncoming the sale of Customer Sales of from the
position deposits + nondeposit + loan + assets + money
(inflows) services repayments market
(Lt)

— Demands on the Financial Firm for Liquidity

Deposit Volume of Repayments Other Dividend
- withdrawals — acceptable — of - operating - payments
(5.1)
(outflows) loan requests borrowings expenses to
stockholders

When the demand for liquidity exceeds its supply (i.e., Lt < 0),
management must prepare for a liquidity deficit, deciding
when and where to raise additional funds. On the other hand,
if at any point in time the supply of liquidity exceeds all liquid­
ity demands (i.e., Lt > 0), management must prepare for a
liquidity surplus, deciding when and where to profitably invest
surplus liquid funds until they are needed to cover future cash
needs.
Liquidity has a critical time dimension. Some liquidity needs
are immediate or nearly so. For example, in the case of a
depository institution several large CDs may be due to mature
tomorrow, and the customers may have indicated they plan
to withdraw these deposits rather than simply rolling them
over into new deposits. Sources of funds that can be accessed
immediately must be used to meet these near-term liquidity
pressures.
Longer-term liquidity demands arise from seasonal, cyclical, and
trend factors. For example, liquid funds are generally in greater
demand during the fall and summer coincident with school,
holidays, and travel plans. Anticipating these longer-term
liquidity needs managers can draw upon a wider array of funds
sources than is true for immediate liquidity needs, such as sell­
ing off accumulated liquid assets, aggressively advertising the
institution's current menu of services, or negotiating long-term
borrowings of reserves from other financial firms. Of course,
not all demands for liquidity need to be met by selling assets or
borrowing new money. For example, just the right amount of
new deposits may flow in or loan repayments from borrowing
customers may occur close to the date new funds are needed.
Most liquidity problems arise from outside the financial firm as a
result of the activities of customers. In effect, customers' liquid­
ity problems gravitate toward their liquidity suppliers. If a busi­
ness is short liquid reserves, for example, it will ask for a loan
or draw down its account balances, either of which may require
the firm's financial institution to come up with additional funds.
A dramatic example of this phenomenon occurred in the wake
of the worldwide stock market crash in October 1987. Investors
who had borrowed heavily to buy stock on margin were forced
to come up with additional funds to secure their stock loans.
Factoid
Did you know that a serious liquidity crisis inside the United
States in 1907, which followed several other liquidity crises in
the 19th century, led to the creation of the U.S. central bank,
the Federal Reserve System, to prevent liquidity problems
in the future?
They went to their lending institutions in huge numbers, turn­
ing a liquidity crisis in the capital market into a liquidity crisis for
lenders.
The essence of liquidity management problems for financial
institutions may be described in two succinct statements:
1. Rarely are demands for liquidity equal to the supply of
liquidity at any particular moment in time. The financial
firm must continually deal with either a liquidity deficit or a
liquidity surplus.

C h ap ter 5 Liquidity and Reserves M anagem ent: Strateg ies and Policies ■ 89
 2. There is a trade-off between liquidity and profitability. The
more resources are tied up in readiness to meet demands
for liquidity, the lower is that financial firm's expected prof­
itability (other factors held constant).
Thus, ensuring adequate liquidity is a never-ending problem for
management that will always have significant implications for
the financial firm's performance.
Moreover, resolving liquidity problems subjects a financial
institution to costs, including the interest cost on borrowed
funds, the transactions cost of time and money in finding
adequate liquid funds, and an opportunity cost in the form of
future earnings that must be forgone when earning assets are
sold in order to meet liquidity needs. Clearly, management
must weigh these costs against the immediacy of the institu­
tion's liquidity needs. If a financial firm winds up with excess
liquidity, its management must be prepared to invest those
excess funds immediately to avoid incurring an opportunity
cost from idle funds not generating earnings.
From a slightly different vantage point, we could say that the
management of liquidity is subject to the risks that interest
rates will change (interest rate risk) and that liquid funds will
not be available in the volume needed (availability risk). If
market interest rates rise, assets that the financial firm plans
to sell to raise liquid funds will decline in value, and some
must be sold at a loss. Not only will fewer liquid funds be
raised from the sale of those assets, but the losses incurred
will reduce earnings as well. Then, too, raising liquid funds
by borrowing will cost more as interest rates rise, and some
forms of borrowed liquidity may no longer be available. If
lenders perceive a financial institution to be more risky than
before, it will be forced to pay higher interest rates to borrow
liquidity, and some lenders will simply refuse to make liquid
funds available at all.
5.3 W HY FIN AN CIAL FIRMS O FTEN
FA CE SIGN IFICAN T LIQUIDITY
PROBLEM S
It should be clear from the foregoing discussion that most finan­
cial institutions face major liquidity problems. This significant
exposure to liquidity pressures arises from several sources.
For example, depository institutions borrow large amounts of
short-term cash from individuals and businesses and from other
lending institutions and then turn around and make long-term
credit available to their borrowing customers. Thus, depository
90 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
institutions typically face an imbalance between the maturity
dates attached to their assets and the maturity dates of their
liabilities. Rarely will incoming cash flows from assets exactly
match the cash flowing out to cover liabilities.
Filmtoid
What Christmastime favorite finds George Bailey, played by
Jimmy Stewart, suicidal when facing a liquidity crisis at his
small-town financial institution?
Answer: It's a Wonderful Life.
A problem related to the maturity mismatch situation is that
most depository institutions hold an unusually high propor­
tion of liabilities subject to immediate payment, especially
demand (checkable) deposits and money market borrowings.
They must stand ready to meet immediate cash demands that
can be substantial at times, especially near the end of a week,
near the first of each month, and during certain seasons of
the year.
Another source of liquidity problems is sensitivity to changes
in market interest rates. When interest rates rise, for example,
some customers will withdraw their funds in search of higher
returns elsewhere. Many loan customers may postpone new
loan requests or speed up their drawings on those credit lines
that carry lower interest rates. Thus, changing market interest
rates affect both customer demand for deposits and customer
demand for loans, each of which has a potent impact on a
depository institution's liquidity position. Moreover, movements
in market interest rates affect the market values of assets the
financial firm may need to sell in order to raise additional funds,
and they directly affect the cost of borrowing in the money
market.
Beyond these factors, financial firms must give high priority to
meeting demands for liquidity. To fail in this area may severely
damage public confidence in the institution. We can imagine
the reaction of a bank's customers, for example, if the teller
windows and ATMs had to be closed one morning because the
bank was temporarily out of cash and could not cash checks or
meet deposit withdrawals (as happened to a bank in Montana
several years ago, prompting a federal investigation). One of the
most important tasks of a liquidity manager is to keep close con­
tact with the largest funds-supplying customers and the holders
of large unused credit lines to determine if and when withdraw­
als will be made and to make sure adequate funds will be avail­
able when demand for funds occurs.
 CONCEPT CHECK
5.1. What are the principal sources of liquidity demand for a
financial firm?
5.2. What are the principal sources from which the supply of
liquidity comes?
5.3. Suppose that a bank faces the following cash inflows and
outflows during the coming week: (a) deposit withdrawals
are expected to total $33 million, (b) customer loan
repayments are expected to amount to $108 million,
(c) operating expenses demanding cash payment will
probably approach $51 million, (d) acceptable new loan
requests should reach $294 million, (e) sales of bank assets
5.4 STRATEGIES FO R LIQUIDITY
M AN AGERS
Over the years, experienced liquidity managers have developed
several strategies for dealing with liquidity problems: (1 ) provid­
ing liquidity from assets (asset liquidity management), (2 ) relying
on borrowed liquidity to meet cash demands (liability manage­
ment), and (3) balanced (asset and liability) liquidity management.
Asset Liquidity Management (or Asset
Conversion) Strategies
The oldest approach to meeting liquidity needs is known as
asset conversion. In its purest form, this strategy calls for stor­
ing liquidity in assets, predominantly in cash and marketable
securities. When liquidity is needed, selected assets are con­
verted into cash until all demands for cash are met.
What is a liquid asset? It must have three characteristics:
1. A liquid asset has a ready market so it can be converted
into cash without delay.
2. It has a reasonably stable price so that, no matter how
quickly the asset must be sold or how large the sale is, the
market is deep enough to absorb the sale without a signifi­
cant decline in price.
3. It is reversible, meaning the seller can recover his or her
original investment (principal) with little risk of loss.
Among the most popular liquid assets are Treasury bills, federal
funds loans, certificates of deposit, municipal bonds, federal
agency securities, and Eurocurrency loans. (See the box entitled
C h ap ter 5 Liquidity and Reserves M anagem ent: Strateg ies and Policies
are projected to be $18 million, (f) new deposits should
total $670 million, (g) borrowings from the money market
are expected to be about $43 million, (h) nondeposit
service fees should amount to $27 million, (i) previous
bank borrowings totaling $23 million are scheduled to be
repaid, and (j) a dividend payment to back stockholders of
$140 million is schduled. What is this bank's projected net
liquidity position for the coming week?
5.4. When is a financial institution adequately liquid?
5.5. Why do financial firms face significant liquidity manage­
ment problems?
"Storing Liquidity in Assets—The Principal Options" for brief
descriptions of these liquid assets.) Although a financial firm can
strengthen its liquidity position by holding more liquid assets, it will
not necessarily be a liquid institution if it does so, because each
institution's liquidity position is also influenced by the demands for
liquidity made against it. Remember: A financial firm is liquid only
if it has access, at reasonable cost, to liquid funds in exactly the
amounts required at precisely the time they are needed.
Filmtoid
What 1980s thriller, starring Kris Kristofferson and Jane
Fonda, aligned murder with the liquidity problems of
Borough National Bank created by Arab withdrawals of
Eurodeposits?
Answer: Rollover.
Asset conversion strategy is used mainly by smaller financial
institutions that find it a less risky approach to liquidity man­
agement than relying on borrowings. But it is not a costless
approach. First, selling assets means loss of future earnings
those assets would have generated had they not been sold off.
Thus, there is an opportunity cost to storing liquidity in assets
when those assets must be sold. Most asset sales also involve
transactions costs (commissions) paid to security brokers. More­
over, the assets in question may need to be sold in a market
experiencing declining prices and increasing risk. Management
must take care that assets with the least profit potential are sold
first in order to minimize the opportunity cost of future earnings
forgone. Selling assets to raise liquidity also tends to weaken
■ 91
 STORING LIQUIDITY IN ASSETS—THE PRINCIPAL OPTIONS
The principal options open to liquidity managers for holdings of
liquid assets that can be sold when additional cash is needed are
1. Treasury bills—direct obligations of the United States gov­
ernment or of foreign governments issued at a discount
and redeemed at par (face value) when they reach matu­
rity; T-bills have original maturities of 3, 6 , and 12 months,
with an active resale market through security dealers.
2. Federal funds loans to other institutions—loans of
reserves held by depository institutions with short (often
overnight) maturities.
3. Purchase of liquid securities under a repurchase agree­
ment (RP)—using high-quality securities as collateral to
raise new funds.
4. Placing correspondent deposits with various depository
institutions—these interbank deposits can be borrowed
or loaned in minutes by telephone or by wire.
the appearance of the balance sheet because the assets sold
are often low-risk securities that give the impression the finan­
cial firm is financially strong. 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.
Borrowed Liquidity (Liability)
Management Strategies
For several decades now the largest financial institutions
around the world have chosen to raise more of their liquid
BORROWING LIQUIDITY—THE PRINCIPAL OPTIONS
When a liquidity deficit arises, the financial firm can borrow
funds from:
1. Federal funds borrowings—reserves from other lenders
that can be accessed immediately.
2. Selling liquid, low-risk securities under a repurchase
agreement (RP) to financial institutions having temporary
surpluses of funds. RPs generally carry a fixed rate of
interest and maturity, though continuing-contract RPs
remain in force until either the borrower or the lender
terminates the loan.
3. Issuing jumbo ($100,000+) negotiable CDs to major cor­
porations, governmental units, and wealthy individuals
for periods ranging from a few days to several months.
92 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
5. Municipal bonds and notes—debt securities issued by
state and local governments that range in maturity from
a few days to several years.
6 . Federal agency securities—short- and long-term debt
instruments sold by federally sponsored agencies such as
FNMA (Fannie Mae) or FHLMC (Freddie Mac).
7. Negotiable certificates of deposit—investing in short­
term CDs until they mature and can be converted into
cash without penalty.
8 . Eurocurrency loans—the lending of deposits accepted
by bank offices located outside a particular currency's
home country for periods stretching from a few days to a
few months.
funds through borrowings in the money market. This bor­
rowed liquidity strategy—called purchased liquidity or
liability management—in its purest form calls for borrowing
immediately spendable funds to cover all anticipated demands
for liquidity. Today many different types of financial institutions
use this liquidity management strategy.
Borrowing liquid funds has a number of advantages. A financial
firm can choose to borrow only when it actually needs funds,
unlike storing liquidity in assets where a storehouse of liquid
assets must be held at all times, lowering potential returns.
Then, too, using borrowed funds permits a financial institu­
tion to leave the volume and composition of its asset portfolio
4. Issuing Eurocurrency deposits to multinational banks and
other corporations at interest rates determined by the
demand and supply for these short-term international
deposits.
5. Securing advances from the Federal Home Loan Bank
(FHLB) system, which provides loans to institutions lend­
ing in the real-estate-backed loan market.
6 . Borrowing reserves from the discount window of the
central bank (such as the Federal Reserve or the Bank
of Japan)—usually available within a matter of minutes
provided the borrowing institution has collateral on hand
and a signed borrowing authorization.
unchanged if it is satisfied with the assets it currently holds. In
contrast, selling assets to provide liquidity for liability-derived
demands, such as deposit withdrawals, shrinks the size of a
financial firm as its asset holdings decline. Finally, as we will see
in Chapter 18, liability management comes with its own control
lever—the interest rate offered to borrow funds. If the borrow­
ing institution needs more funds, it merely raises its offer rate
until the requisite amount of funds flow in. If fewer funds are
required, the financial firm's offer rate may be lowered.
The principal sources of borrowed liquidity for a depository
institution include jumbo ($100,000+) negotiable CDs, federal
funds borrowings, repurchase agreements, Eurocurrency bor­
rowings, advances from the Federal Home Loan Banks, and
borrowings at the discount window of the central bank in each
nation. (See the box above, "Borrowing Liquidity—The Princi­
pal Options" for a description of these instruments.) Liability
management techniques are used most extensively by the
largest banks, which often borrow close to 1 0 0 percent of their
liquidity needs.
Borrowing liquidity is the most risky approach to solving
liquidity problems (but also carries the highest expected
return) because of the volatility of interest rates and the rapid­
ity with which the availability of credit can change. Often
financial-service providers must purchase liquidity when it is
most difficult to do so, both in cost and availability. Borrow­
ing cost is always uncertain, which adds greater uncertainty
to earnings. Moreover, a financial firm that gets into trouble
is usually most in need of borrowed liquidity, particularly
because knowledge of its difficulties spreads and customers
begin to withdraw their funds. At the same time, other finan­
cial firms become less willing to lend to the troubled institu­
tion due to the risk involved.
Balanced Liquidity Management
Strategies
Due to the risks inherent in relying on borrowed liquidity and
the costs of storing liquidity in assets, most financial firms
compromise by using both asset and liability management.
Under a balanced liquidity management strategy, some
of the expected demands for liquidity are stored in assets
(principally holdings of marketable securities), while other
anticipated liquidity needs are backstopped by advance
arrangements for lines of credit from potential suppliers of
funds. Unexpected cash needs are typically met from near-
term borrowings. Longer-term liquidity needs can be planned
for and the funds to meet these needs can be parked in short­
term and medium-term assets that will provide cash as those
liquidity needs arise.
C h ap ter 5 Liquidity and Reserves M anagem ent: Strateg ies and Policies
CONCEPT CHECK
5.6. What are the principal differences among asset
liquidity management, liability management, and
balanced liquidity management?
5.7. What guidelines should management keep in
mind when it manages a financial firm's liquidity
position?
Guidelines for Liquidity Managers
Over the years, liquidity managers have developed several rules
that often guide their activities. First, the liquidity manager must
keep track of the activities of all departments using and/or supply­
ing funds. Whenever the loan department grants a new credit line
to a customer, for example, the liquidity manager must prepare
for possible drawings against that line. If the savings account divi­
sion expects to receive several large deposits in the next few days,
this information should be passed on to the liquidity manager.
Second, those responsible for liquidity management should
know in advance when the biggest credit or funds-supplying
customers plan to withdraw their funds or add funds to their
accounts. This allows management to plan ahead to deal more
effectively with emerging liquidity surpluses and deficits.
Third, the liquidity manager must make sure the financial firm's
priorities for liquidity management are clear. For example, in
the past, a depository institution's liquidity position was often
assigned top priority when it came to allocating funds. A typi­
cal assumption was that a depository institution had little or no
control over its sources of funds—those were determined by
the public—but the institution could control its uses of funds.
In addition, because the law may require depository institutions
to set aside liquid funds at the central bank to cover reserve
requirements and because the depository must be ready at all
times to handle deposit withdrawals, liquidity management and
the diverting of sufficient funds into liquid assets were given
the highest priority. Today, liquidity management has generally
been relegated to a supporting role compared to most financial
firms' number one priority—making loans and supplying fee­
generating services to all qualified customers in order to maxi­
mize returns.
Fourth, liquidity needs must be analyzed on a continuing basis
to avoid both excess and deficit liquidity positions. Excess
liquidity not reinvested the day it occurs results in lost income,
while liquidity deficits must be dealt with quickly to avoid dire
emergencies where the hurried borrowing of funds or sale of
assets results in excessive losses.
■ 93
5.5 ESTIMATING LIQUIDITY N EED S
Several methods have been developed in recent years for esti­
mating a financial institution's liquidity requirements. These
methods include the sources and uses of funds approach, the
structure of funds approach, the liquidity indicator approach,
and the market signals (or discipline) approach. Each method
rests on specific assumptions and yields only an approximation
of actual liquidity requirements. This is why a liquidity manager
must always be ready to fine-tune estimates of liquidity require­
ments as new information becomes available. In fact, most
financial firms make sure their liquidity reserves include both a
planned component, consisting of the reserves called for by the
latest forecast, and a protective component, consisting of an
extra margin of liquid reserves over those dictated by the most
recent forecast. The protective liquidity component may be
large or small, depending on management's philosophy and atti­
tude toward risk—that is, how much chance of running a "cash­
out" management wishes to accept.
F a c to id
Among the most rapidly growing sources of borrowed liquid­
ity among U.S. financial institutions are advances of funds by
the Federal Home Loan Banks, which are relatively low in cost
and more stable with longer maturities than most deposits.
By the 21 st century close to half of all U.S. banks had FHLB
advances outstanding, but some of these federal banks faced
serious financial problems.
Let us turn now to a few of the most popular methods for estimat­
ing a financial institution's liquidity needs. For illustrative purposes,
we will focus on the problem of estimating a bank's liquidity needs
because banks typically face the greatest liquidity management
challenges of any financial firm. However, the principles we will
explore apply to other financial-service providers as well.
/ projected growth in the
Estimated
change in total is a
loans for the function
coming period of
L\
current rate of
growth in the
money
supply
94 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The Sources and Uses of Funds Approach
The sources and uses of funds method for estimating liquidity
needs begins with two simple facts:
1. In the case of a bank, for example, liquidity rises as deposits
increase and loans decrease.
2. Alternatively, liquidity declines when deposits decrease and
loans increase.
Whenever sources and uses of liquidity do not match, there is a
liquidity gap, measured by the size of the difference between
sources and uses of funds. When sources of liquidity (e.g.,
increasing deposits or decreasing loans) exceed uses of liquidity
(e.g., decreasing deposits or increasing loans), the financial firm
will have a positive liquidity gap (surplus). Its surplus liquid funds
must be quickly invested in earning assets until they are needed
to cover future cash needs. On the other hand, when uses
exceed sources, a financial institution faces a negative liquid­
ity gap (deficit). It now must raise funds from the cheapest and
most timely sources available.
The key steps in the sources and uses of funds approach, using a
bank as an example, are:
1. Loans and deposits must be forecast for a given planning
period.
2. The estimated change in loans and deposits must be calcu­
lated for that same period.
3. The liquidity manager must estimate 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).
Banks, for example, use a wide variety of statistical techniques,
supplemented by management's judgment and experience, to
prepare forecasts of deposits and loans. For example, a bank's
economics department or its liquidity managers might develop
the following forecasting models:
economy / projected \
(for example, the quarterly
growth of gross domestic corporate
product [GDP] or \ earnings /
business sales)
/ projected prime
loan rate
/ estimated
minus the
, and rate of (5.2)
commercia
\ inflation
paper rate
\ or CD rate
 Estimated
change in total is a
deposits for function
the coming of
period
/ current rate of\
I growth of the
money
( projected yield on
money market
deposits
supply /
Factoid
Did you know that robberies of cash from banks have been
on the rise again in recent years due, in part, to banking
offices that stress customer convenience and easy access
rather than security? Does this seem to make sense as a busi­
ness decision? Why?
Using the forecasts of loans and deposits generated by the
foregoing relationships, management could then estimate the
bank's need for liquidity by calculating
Estimated liquidity Estimated
deficit (-) or surplus (+) = Estimated change in - change in (5.4)
for the coming period deposits loans
A somewhat simpler approach for estimating future deposits (or
other funds sources) and loans (or other funds uses) is to divide the
forecast of future deposit and loan growth into three components:
1. A trend component, estimated by constructing a trend
(constant-growth) line using as reference points year-end,
quarterly, or monthly deposit and loan totals established
over at least the last 1 0 years (or some other base period
sufficiently long to define a trend growth rate).
2. A seasonal component, measuring how deposits (or other
funds sources) and loans (or other funds uses) are expected
to behave in any given week or month due to seasonal fac­
tors, as compared to the most recent year-end deposit or
loan level.
3. A cyclical component, representing positive or negative
deviations from a bank's total expected deposits and loans
(measured by the sum of trend and seasonal components),
depending upon the strength or weakness of the economy
in the current year.
For example, suppose we are managing liquidity for a bank
whose trend growth rate in deposits over the past decade has
averaged 10 percent a year. Loan growth has been slightly less
rapid, averaging 8 percent a year for the past 10 years. Our
C h ap ter 5 Liquidity and Reserves M anagem ent: Strateg ies and Policies
/ projected growth / estimated
in personal income increase in /
\ in the economy \ retail sales
/ estimated rate
\ of inflation
(5.3)
bank's total deposits stood at $ 1 , 2 0 0 million and total loans
outstanding reached $800 million at the most recent year-end.
Table 5.1 presents a forecast of weekly deposit and loan totals
for the first six weeks of the new year. Each weekly loan and
deposit trend figure shown in column 1 accounts for a one-week
portion of the projected 1 0 percent annual increase in deposits
and the expected 8 percent annual increase in loans. To derive
the appropriate seasonal element shown in column 2 , we com­
pare the ratio for the average (trend) deposit and loan figure
for each week of the year to the average deposit and loan level
during the final week of the year for each of the past 1 0 years.
We assume the seasonal ratio of the current week's level to the
preceding year-end level applies in the current year in the same
way as it did for all past years, so we simply add or subtract the
calculated seasonal element to the trend element.
The cyclical element, given in column 3, compares the sum of
the estimated trend and seasonal elements with the actual level
of deposits and loans the previous year. The dollar gap between
these two numbers is presumed to result from cyclical forces,
and we assume that roughly the same cyclical pressures that
prevailed last year apply to the current year. Finally, column 4
reports estimated total deposits and loans, consisting of the
sum of trend (column 1 ), seasonal (column 2 ), and cyclical com­
ponents (column 3).
Table 5.2 shows how we can take estimated deposit and loan fig­
ures, such as those given in column 4 of Table 5.1, and use them
to estimate expected liquidity deficits and surpluses in the period
ahead. In this instance, the liquidity manager has estimated liquid­
ity needs for the next six weeks. Columns 1 and 2 in Table 5.2
merely repeat the estimated total deposit and total loan figures
from column 4 in Table 5.1. Columns 3 and 4 in Table 5.2 calculate
the change in total deposits and total loans from one week to the
next. Column 5 shows differences between change in loans and
change in deposits each week. When deposits fall and loans rise,
a liquidity deficit is more likely to occur. When deposits grow and
loans decline, a liquidity surplus is more likely.
As Table 5.2 reveals, our bank has a projected liquidity deficit over
the next three weeks—$150 million next week, $ 2 0 0 million the
■ 95
Table 5.1 Forecasting Deposits and Loans with the Sources and Uses of Funds Approach (figures in millions
of dollars)

Trend Estimate Seasonal Cyclical Estimated

Deposit Forecast for for Deposits Element* Element** Total Deposits
January, Week 1 $1 , 2 1 0 -4 - 6 $1 , 2 0 0
January, Week 2 1 ,2 1 2 -5 4 -58 1 ,1 0 0

January, Week 3 1,214 - 1 2 1 -93 1 ,0 0 0

January, Week 4 1,216 -165 - 1 0 1 950

February, Week 1 1,218 +70 -38 1,250
February, Week 2 1 ,2 2 0 +32 -52 1 ,2 0 0

Trend Estimate Seasonal Cyclical Estimated

Loan Forecast for for Loans Element* Element** Total Loans
January, Week 1 $799 + 6 -5 $800
January, Week 2 800 + 59 -9 850
January, Week 3 801 + 174 -25 950
January, Week 4 802 + 166 +32 1 ,0 0 0

February, Week 1 803 +27 -8 0 750

February, Week 2 804 +98 - 2 900
*The seasonal element 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.
**The cyclical element reflects the difference between expected deposit and loan levels in 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.

Table 5.2 Forecasting Liquidity Deficits and Surpluses with the Sources and Uses of Funds Approach (figures in
millions of dollars)

Estimated Estimated Estimated Estimated Estimated Liquidity

Time Period Total Deposits Total Loans Deposit Change Loan Change Deficit ( - ) or Surplus ( + )

January, Week 1 $1 , 2 0 0 $ 800 $ $ $

January, Week 2 1 ,1 0 0 850 - 1 0 0 +50 -150
January, Week 3 1 ,0 0 0 950 - 1 0 0 +1 0 0 - 2 0 0

January, Week 4 950 1 ,0 0 0 -5 0 +50 - 1 0 0

February, Week 1 1,250 750 +300 -250 +550

February, Week 2 1 ,2 0 0 900 -5 0 + 150 - 2 0 0

third week, and $ 1 0 0 million in the fourth week—because its loans
are growing while its deposit levels are declining. Due to a fore­
cast of rising deposits and falling loans in the fifth week, a liquidity
surplus of $550 million is expected, followed by a $200 million
liquidity deficit in week 6 . What liquidity management decisions
must be made over the six-week period shown in Table 5.2? The
liquidity manager must prepare to raise new funds in weeks 2, 3,
4, and 6 from the cheapest and most reliable funds sources and to
profitably invest the expected funds surplus in week 5.
Management can now begin planning which sources of liq­
uid funds to draw upon, first evaluating the bank's stock of
liquid assets to see which assets are likely to be available
and then determining if adequate sources of borrowed funds
are likely to be available. For example, the bank probably
has already set up lines of credit for borrowing from its prin­
cipal correspondent institution and wants to be sure these
credit lines are adequate to meet the projected amount of
borrowing needed.

96 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The Structure of Funds Approach
Another approach to estimating a financial firm's liquidity require­
ments is the structure of funds method. Once again we will
illustrate this liquidity estimation procedure using some figures pro­
vided by a bank that frequently faces substantial liquidity demands.
In the first step in the structure of funds approach, deposits and
other funds sources are divided into categories based upon their
estimated probability of being withdrawn and, therefore, lost
to the financial firm. As an illustration, we might divide a bank's
deposit and nondeposit liabilities into three categories:
1. " H o t m o n e y " liabilities (often called volatile liabilities)—
deposits and other borrowed funds (such as federal funds
borrowings) that are very interest sensitive or that manage­
ment is sure will be withdrawn during the current period.
2. V ulnerable fu n d s —customer deposits of which a substantial
portion, perhaps 25 to 30 percent, will probably be with­
drawn sometime during the current time period.
3. S ta b le fu n d s (often called co re d e p o s its or co re liabilities )—
funds that management considers unlikely to be removed
(except for a minor percentage of the total).
Second, the liquidity manager must set aside liquid funds
according to some desired o p e ra tin g rule for each of these
funds sources. For example, the manager may decide to set up
a 95 percent liquid reserve behind all hot money funds (less any
required legal reserves held behind hot money deposits). This
liquidity reserve might consist of holdings of immediately spend­
able deposits in correspondent institutions plus investments in
Treasury bills and repurchase agreements where the committed
funds can be recovered in a matter of minutes or hours.
A common rule of thumb for vulnerable deposit and non­
deposit liabilities is to hold a fixed percentage of their total
amount—say, 30 percent—in liquid reserves. For stable (core)
funds sources, a liquidity manager may decide to place a small
proportion—perhaps 15 percent or less—of their total in liquid
reserves. Thus, the liquidity reserve behind deposit and nonde­
posit liabilities would be:
Liability = 0.95 X (Hot money deposits and nondeposit
liquidity reserve funds-Legal reserves held) + 0.30
X (Vulnerable deposit and nondeposit funds
— Legal reserves held) + 0.15
X (Stable deposits and nondeposit funds
- Legal reserves held) (5.5)
In the case of loans, a lending institution must be ready at all
times to make good loans—that is, to meet the legitimate credit
needs of those customers who satisfy the lender's loan quality
standards. The financial firm in this example must have sufficient
C h ap ter 5 Liquidity and Reserves M anagem ent: Strateg ies and Policies
liquid reserves on hand because, once a loan is made, the bor­
rowing customer will spend the proceeds immediately and those
funds will flow out to other institutions. However, this lending
institution does not want to turn down any good loan, because
loan customers bring in new deposits and normally are the prin­
cipal source of earnings from interest and fees.
Indeed, a substantial body of current thinking suggests that any
lending institution should make all good loans, counting on its
ability to borrow liquid funds, if necessary, to cover any pressing
cash needs. Under today's concept of rela tio n sh ip ban kin g, once
the customer is sold a loan, the lender can then proceed to sell
that customer other services, establishing a multidimensional
relationship that will bring in additional fee income and increase
the customer's dependence on (and, therefore, loyalty to) the
lending institution. This reasoning suggests that management
must try to estimate the maximum possible figure for total loans
and hold in liquid reserves or borrowing capacity the full amount
( 1 0 0 percent) of the difference between the actual amount of
loans outstanding and the maximum potential for total loans.
Combining both loan and deposit liquidity requirements, this
institution's to ta l liq u id ity re q u ire m e n t would be:
Total liquidity 0.95 X (Hot money funds
requirement = -Required legal reserves held
Deposit and behind hot money deposits)
nondeposit +0.30 X (Vulnerable deposits and
liability liquidity nondeposit funds - Required legal (5.6)
requirement reserves) + 0.15 X (Stable deposits
and loan and nondeposit funds - Required legal
liquidity reserves) + 1.00 X (Potential loans
requirement outstanding - Actual loans outstanding)
Admittedly, the deposit and loan liquidity requirements that
make up the above equation are s u b je c tiv e estimates that
rely heavily on management's judgment, experience, and
attitude toward risk.
A numerical example of this liquidity management method
is shown in Table 5.3. First National Bank has broken down
its deposit and nondeposit liabilities into hot money, vulner­
able funds, and stable (core) funds, amounting to $25 million,
$24 million, and $100 million, respectively. The bank's loans
total $135 million currently, but recently have been as high as
$140 million, and loans are projected to grow at a 1 0 percent
annual rate. Thus, within the coming year, total loans might reach
as high as $154 million, or $140 million + (0.10 X $140 million),
which would be $19 million higher than they are now. Applying
the percentages of deposits that management wishes to hold
in liquid reserves, we find this financial firm needs more than
$60 million in total liquidity, consisting of both liquid assets and
borrowing capacity.
■ 97
Table 5.3 Estim ating Liquidity Needs with the Structure of Funds Method

A. First National Bank finds that its current deposits and nondeposit liabilities break down as follows:
Hot money $ 25 million
Vulnerable funds (including the largest
deposit and nondeposit liability accounts) $ 24 million
Stable (core) funds $100 million
First National's management wants to keep a 95% reserve behind its hot money deposits (less the 3% legal reserve require­
ment imposed by the central bank behind many of these deposits) and nondeposit liabilities, a 30% liquidity reserve in back of
its vulnerable deposits and other borrowings (less required reserves), and a 15% liquidity reserve behind its core deposit and
nondeposit funds (less required reserves).
B. First National Bank's loans total $135 million but recently have been as high as $140 million, with a trend growth rate of about
10 percent a year. This financial firm wishes to be ready at all times to honor customer demands for all loans that meet its
quality standards.
C. The bank's total liquidity requirement is:

D e p o sit/N o n d e p o sit F u n d s plus Lo an s

0.95 ($25 million - 0.03 X $25 million)
+0.30 ($24 million - 0.03 X $24 million)
+0.15 ($100 million - 0.03 X $100 million)
+ $140 million X 0.10 + ($140 - $135 million)
= $23.04 million + $6.98 million + $14.55 million + $19 million
= $63.57 million (held in liquid assets and additional borrowing capacity)

REAL BANKS, REAL DECISIONS

Liquidity Shortages in the Wake of the
September 11, 2001, Terrorist Attacks
The terrorist attacks of 9/11 in New York City assaulted the
financial system as well as the twin towers of the World Trade
Center. Financial firms with facilities for making payments
located in or near the World Trade Center experienced tem­
porary, intense shortages of funds due to their inability to
collect and record payments they were owed and to dispense
payments they were obligated to make. The problems finan­
cial institutions near Ground Zero in Lower Manhattan faced
soon spread to outlying firms in domino fashion. Firms whose
electronic communications systems were destroyed or dam­
aged couldn't make timely payment of their obligations to
other institutions that, in turn, could not make good on their
own promises to pay. Within hours many financial institutions
faced a fullblown liquidity crisis.
One of the first signs of trouble was a sharp reduction in the
movement of funds through Fed Wire—the Federal Reserve's
electronic funds transfer network—as firms hit hardest by
the attacks stopped transferring reserves to other institu­
tions because they could not be sure they themselves would
receive the incoming funds they expected. Several banks that
borrowed reserves from other institutions on September 10
were unable to return the borrowed funds on the 11th. More­
over, many financial firms near Ground Zero were unable
to communicate with their customers to explain what was
happening. Nor could they update their records or make
deliveries of securities they had promised to their clients.
Within hours, however, the system began to recover and
was approaching near-normal operating levels by Septem­
ber 14. Why did recovery from such a serious liquidity crisis
come about so quickly? The Federal Reserve—the proverbial
"lender of last resort"—stepped in aggressively. At 10:00 a . m .
on September 11, the Fed announced that loans from its
discount window would be available. At the same time, the
Fed temporarily suspended penalties against banks running
overdrafts and cranked up its open market operations to
pour new funds into the money market. Discount window
loans jumped from a daily average of about $ 1 0 0 million to
more than $45 billion on September 12, while the Fed's open-
market trading desk accelerated its trading activity from a
relatively normal $3.5 billion a day to about $38 billion that
same day. The Fed's quick reaction along with the determina­
tion of many financial managers to restore communications
links to their customers soon quelled this liquidity crisis.

98 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Many financial firms like to use probabilities in deciding how situation next week as likely to fall into one of three possible
much liquidity to hold. Under this refinement of the structure of situations:
funds approach, the liquidity manager will
want to define the best and the worst pos­
Estimated Estimated Estimated Probability
sible liquidity positions his or her financial
Average Average Liquidity Assigned by
institution might find itself in and assign
Possible Volume of Volume Surplus or Management
probabilities to each. For example,
Liquidity Deposits of Loans Deficit Position to Each
1. The worst possible liquidity position. Outcomes for Next Week Next Week Next Week Possible
Suppose deposit growth at the finan­ Next Week (millions) (millions) (millions) Outcome
cial firm we have been following falls
Best possible $170 $ 1 1 0 + $60 15%
below management's expectations, so
liquidity
that actual deposit totals sometimes go position
below the lowest points on the firm's (maximum
historical minimum deposit growth deposits,
track. Further, suppose loan demand minimum loans)
rises significantly above management's Liquidity $150 $140 +$ 1 0 60%
expectations, so that loan demand position
sometimes goes beyond the high points bearing
the highest
of the firm's loan growth track. In this
probability
instance, the financial firm would face
maximum pressure on its available liq­ Worst possible $130 $150 - $ 2 0 25%
liquidity
uid reserves because deposit growth
position
would not likely be able to fund all the (minimum
loans customers were demanding. In deposits,
this worst situation the liquidity man­ maximum loans)
ager would have to prepare for a sizable
liquidity deficit and develop a plan for raising substantial Thus, management sees the worst possible situation next week
amounts of new funds. as one characterized by a $ 2 0 million liquidity deficit, but this
2. The best possible liquidity position. Suppose deposit growth least desirable outcome is assigned a probability of only 25 per­
turns out to be above management's expectations, so that cent. Similarly, the best possible outcome would be a $60 mil­
it touches the highest points in the financial institution's lion liquidity surplus. However, this is judged to have only a
deposit growth record. Moreover, suppose loan demand 15 percent probability of occurring. More likely is the middle
turns out to be below management's expectations, so that ground—a $ 1 0 million liquidity surplus—with a management-
loan demand grows along a minimum path that touches low estimated probability of 60 percent.
points in the financial firm's loan growth track. In this case What, then, is the institution's expected liquidity requirement?
the firm would face minimum pressure on its liquid reserves We can find the answer from:
because deposit growth probably could fund nearly all the
quality loans that walk in the door. In this "best" situation, / Estimated
it is likely that a liquidity surplus will develop. The liquidity Expected iquidity
Probability of
manager must have a plan for investing these surplus funds liquidity Outcome A X surplus or
in order to maximize the institution's return. requirement deficit in
\Outcome A
Of course, neither the worst nor the best possible outcome is (5.7)
likely for both deposit and loan growth. The most likely out­ / Estimated \
come lies somewhere between these extremes. Many financial liquidity
firms like to calculate their expected liquidity requirement, + Probability of X surplus or
based on the probabilities they assign to different possible Outcome B deficit in
outcomes. For example, suppose the liquidity manager of the \Outcome B /
institution we have been following considers the firm's liquidity + • • •
+ • • •

Chapter 5 Liquidity and Reserves M anagem ent: Strateg ies and Policies ■ 99
for all possible outcomes, subject to the restriction that the sum
of all probabilities assigned by management must be 1 .
Using this formula, this financial firm's expected liquidity require­
ment must be:
Expected
liquidity = 0.15 X (+$60 million) + 0.60 X (+$10 million)
requirement +0.25 X (-$ 2 0 million)
= + $ 1 0 million
On average, management should plan for a $10 million liquid­
ity surplus next week and begin now to review the options for
investing this expected surplus. Of course, management would
do well to have a contingency plan in case the worst possible
outcome occurs.
Liquidity Indicator Approach
Many financial-service institutions estimate their liquidity needs
based upon experience and industry averages. This often means
using certain liquidity indicators. For example, for depository
institutions the following liquidity indicator ratios are often useful:
1. Cash position indicator: Cash and deposits due from depos­
itory institutions + total assets, where a greater proportion
of cash implies the institution is in a stronger position to
handle immediate cash needs.
2. Liquid securities indicator: U.S. government securities +
total assets, which compares the most marketable securities
an institution can hold with the overall size of its asset port­
folio; the greater the proportion of government securities,
the more liquid the depository institution's position tends
to be.
3. Net federal funds and repurchase agreements position:
(Federal funds sold and reverse repurchase agreements -
Federal funds purchased and repurchase agreements)
+ total assets, which measures the comparative impor­
tance of overnight loans relative to overnight borrowings of
reserves; liquidity tends to increase when this ratio rises.
4. Capacity ratio: Net loans and leases + total assets, which is
really a negative liquidity indicator because loans and leases
are often the most illiquid of assets.
5. Pledged securities ratio: Pledged securities + total security
holdings, also a negative liquidity indicator because the
greater the proportion of securities pledged to back gov­
ernment deposits, the fewer securities are available to sell
when liquidity needs arise. 1
1 See Chapter 4 for a discussion of the nature and use of pledged
securities.
100 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
6 . Hot money ratio: Money market (short-term) assets +
volatile liabilities = (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
+ Federal funds borrowings + repurchase agreements), a
ratio that reflects whether the institution has roughly bal­
anced the volatile liabilities it has issued with the money
market assets it holds that could be sold quickly to cover
those liabilities.
7. Deposit brokerage index: Brokered deposits + total
deposits, where brokered deposits consist of packages of
funds (usually $ 1 0 0 , 0 0 0 or less to gain the advantage of
deposit insurance) placed by securities brokers for their cus­
tomers with institutions paying the highest yields. Brokered
deposits are interest sensitive and may be quickly with­
drawn; the more a depository institution holds, the greater
the chance of a liquidity crisis.
8 . Core deposit ratio: Core deposits + total assets, where
core deposits include total deposits less all deposits over
$100,000. Core deposits are primarily small-denomination
checking and savings accounts that are considered unlikely
to be withdrawn on short notice and so carry lower liquidity
requirements.
9. Deposit composition ratio: Demand deposits + time
deposits, where demand deposits are subject to immedi­
ate withdrawal via check writing, while time deposits have
fixed maturities with penalties for early withdrawal. This
ratio measures how stable a funding base each institution
possesses; a decline suggests greater deposit stability and
a lesser need for liquidity.
10. Loan commitments ratio: Unused loan commitments +
total assets, which measures the volume of promises a
lender has made to its customers to provide credit up to a
prespecified amount over a given time period. These com­
mitments will not appear on the lender's balance sheet until
a loan is actually "taken down" (i.e., drawn upon) by the
borrower. Thus, with loan commitments there is risk as to
the exact amount and timing when some portion of loan
commitments become actual loans. The lender must be
prepared with sufficient liquidity to accommodate a variety
of "takedown" scenarios that borrowers may demand. A
rise in this ratio implies greater future liquidity needs.
Table 5.4 indicates several recent trends among liquidity indicators
for U.S.-insured banks. Many of these indicators displayed a decline
during the first decade of the 2 1 st century as depository institutions
first loaned out money at a torrid pace, eroding their liquid ("near­
money") assets. Then the great business recession of 2007-2009
Table 5.4 Recent Trends in Liquidity Indicators for FDIC-lnsured U .S. Banks

Selected Liquidity Indicators 1985 1989 1993 1996 2001 2003 2007 2010*

Cash Position Indicator: Cash and 12.5% . %

1 0 6 6.3% 7.3% . %
6 0 4.6% 4.3% 7.7%
deposits due from depository
institutions -5- total assets
Net Federal Funds Position: -3 .3 -3 .9 -3 .4 -3 .4 - 2 .8 - 1 .2 - 1 .1 - 1 .2

(Federal funds sold - Federal funds

purchased) -s- total assets
Credit Capacity Ratio: Net loans and 58.9 60.7 56.6 60.2 58.2 58.6 58.5 54.0
leases total assets
Deposit Composition Ratio: 68.4 44.8 52.4 58.2 44.4 42.2 24.4 32.2
Demand deposits -s- time deposits
Loan Commitments Ratio: NA NA NA 33.1 49.9 70.9 65.0 45.2
Unused loan commitments total assets
Notes: NA indicates the missing figures are not available.
*Figures shown appear in the third quarter of 2010.
Source: Federal Deposit Insurance Corporation (www.fdic.gov).

struck and cash began piling up because lenders perceived tittle the remaining half of the indicators tend to focus on liabilities or
demand for quality loans and there appeared to be fewer success­ upon future commitments to lend money and are designed prin­
ful new businesses. Moreover, unused loan commitments extended cipally to focus on forms of purchased liquidity. These indicators
to customers simply evaporated in a struggling economy. tend to be highly sensitive to the season of the year and stage
of the business cycle. For example, liquidity indicators based on
There were other factors at work in shaping the liquidity position of
assets or stored liquidity often decline during boom periods of
financial institutions aside from the serious recession in economic
rising loan demand, only to rise again during periods of sluggish
activity. One of these has been consolidation—smaller financial
business activity. In contrast, liquidity indicators based on liabili­
firms being absorbed by larger institutions, making the survivors
ties or purchased liquidity often increase quickly when credit
bigger so that money withdrawn from one customer's account was
demands are heavy, only to begin falling in an unresponsive
more likely to wind up in the account of another customer of the
economy. Liquidity managers must stay abreast of what's hap­
same financial firm. Thus, from the vantage point of the whole insti­
pening in the financial marketplace all the time.
tution daily transactions more frequently were "netted out" with
little overall change in a particular financial firm's cash position. Finally, we must note that using industrywide averages for each
liquidity indicator can be misleading. Each financial institution's
Another factor centered around trends in the composition of
liquidity position must be judged relative to peer institutions
sources of funds (especially deposits). When longer-maturity
of similar size operating in similar markets. Moreover, liquidity
funds flowed in (such as long-term CDs), funds sources tended
managers usually focus on changes in their institution's liquidity
to be more stable with diminished customer withdrawals and,
indicators rather than on the level of each indicator. They want
therefore, fewer liquidity needs. Conversely, shorter-term funds
to know whether liquidity is rising or falling and why.
flowing in increased the probability funds sources would be
more unstable, calling for a strengthening of liquidity posi­
tions. Moreover, central banks, such as the Federal Reserve,
occasionally lower legal reserve requirements during a reces­
The Ultimate Standard for Assessing
sion so that less cash is demanded by law. On the other hand, if Liquidity Needs: Signals from the
reserve requirements are raised, usually out of fear of inflation, Marketplace
more cash usually is needed. Then, too, clever financial manag­
Many analysts believe there is one ultimately sound method
ers have occasionally discovered new and improved ways to
for assessing a financial institution's liquidity needs and how
forecast liquidity demands and to meet those demands.
well it is fulfilling them. This method centers on the discipline of
About half the liquidity indicators discussed in this section focus the financial marketplace. No financial-service provider can tell for
on liquid assets or what is often called stored liquidity. Roughly sure if it has sufficient liquidity until it has passed the market's test.

Chapter 5 Liquidity and Reserves M anagem ent: Strategies and Policies ■ 101
 CONCEPT CHECK
5.8. How does the sources and uses of funds approach help
a manager estimate a financial institution's need for
liquidity?
5.9. Suppose that a bank estimates its total deposits for the
next six months in millions of dollars to be, respectively,
$112, $132, $121, $147, $151, and $139, while its loans
(also in millions of dollars) will total an estimated $87,
$95, $102, $113, $101, and $124, respectively, over the
same six months. Under the sources and uses of funds
approach, when does this bank face liquidity deficits,
if any?
5.10. What steps are needed to carry out the structure of
funds approach to liquidity management?
5.11. Suppose that a thrift institution's liquidity division esti­
mates that it holds $19 million in hot money deposits
and other lOUs against which it will hold an 80 percent
liquidity reserve, $54 million in vulnerable funds against
which it plans to hold a 25 percent liquidity reserve,
and $ 1 1 2 million in stable or core funds against which it
REAL BANKS, REAL DECISIONS
Experiencing the Ultimate Liquidity Crisis
Few events in the management of a financial firm are as scary
as a "bank run" in which flocks of customers either come in
to withdraw their money or transfer large amounts of funds
by wire to other, presumably "safer" institutions. And it's not
just depositors who may take their money and run; borrow­
ers too may switch to other lenders when they are scared
their current lender may be losing its creditworthiness. Dur­
ing the Great Depression of the 1930s thousands of failures
occurred, sometimes doing in not only those depository insti­
tutions that were in real trouble, but also sound institutions
which had the misfortune of being in the wrong place at the
wrong time. The "run" is the ultimate liquidity crisis for man­
agement and stockholders of a financial firm.
Bank runs recorded in history go all the way back to the Roman
Empire. In modern times the failure of Continental Illinois
National Bank of Chicago in 1984 was one of the biggest, los­
ing $10 billion in deposits over a 60-day period. Ultimately the
Federal Deposit Insurance Corporation (FDIC) put together a
rescue program that, for all intents and purposes, "national­
ized" this huge money-center bank. Continental's chief errors
were allowing excessively rapid growth in its business loans,
many of which turned out to be bad, and growing so fast it
102 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
will hold a 5 percent liquidity reserve. The thrift expects
its loans to grow 8 percent annually; its loans currently
total $117 million but have recently reached $132
million. If reserve requirements on liabilities currently
stand at 3 percent, what is this depository institution's
total liquidity requirement?
5.12. What is the liquidity indicator approach to liquidity
management?
5.13. First National Bank posts the following balance sheet
entries on today's date: Net loans and leases, $3,502
million; cash and deposits held at other banks, $633
million; Federal funds sold, $48 million; U.S. govern­
ment securities, $185 million; Federal funds pur­
chased, $62 million; demand deposits, $988 million;
time deposits, $2,627 million; and total assets, $4,446
million. How many liquidity indicators can you calculate
from these figures?
5.14. How can the discipline of the marketplace be used as a
guide for making liquidity management decisions?
had to rely on "hot money" (i.e., negotiable CDs and nonde­
posit borrowings in the money market) rather than more stable
deposits for its funding. When money market investors heard
that Continental was experiencing trouble in its loan portfolio
the "hot money" suddenly left and the bank was forced to bor­
row from government agencies in order to survive.
A similar combination of events greeted the British bank
Northern Rock PLC in 2007. Rumors the bank was on the
verge of serious trouble (in part stemming from its large
mortgage loan portfolio) led to depositors lining up at the
bank's branches, demanding their money, while others
sought recovery of their funds through the bank's website.
Within hours losses approached $2 billion. As explained by
Milne and Wood [5], the Bank of England quickly stepped in
as a "lender of last resort" and several large banks expressed
interest in a possible takeover.
In short, liquidity crises—especially lack of available funds, ris­
ing funding costs, and bad loans that reduce cash flow—can
be lethal in sinking even the largest of financial institutions.
Liquidity managers need to pay special attention to the
changing cost and composition of their institution's funding
and also to what is happening to quality and composition in
the asset portfolio.
For example, liquidity managers should closely monitor the fol­
lowing market signals:
1. Public confidence. Is there evidence the institution is losing
money because individuals and institutions believe there
is some danger it will be unable to meet its obligations on
time?
2. Stock price behavior. Is the corporation's stock price falling
because investors perceive the institution has an actual or
pending liquidity crisis?
3. Risk premiums on CDs and other borrowings. Is there evi­
dence the institution is paying higher interest rates on its
offerings of time and savings deposits (especially on large
negotiable CDs) and money market borrowings than other
institutions of similar size and location? In other words, is
the market imposing a risk premium in the form of higher
borrowing costs because it believes the institution is
headed for a liquidity crisis?
4. Loss sales of assets. Has the institution recently been forced
to sell assets in a hurry, with significant losses, in order to
meet demands for liquidity? Is this a rare event or has it
become a frequent occurrence?
5. Meeting commitments to credit customers. Has the institu­
tion been able to honor all potentially profitable requests
for loans from its valued customers? Or have liquidity pres­
sures compelled management to turn down some otherwise
acceptable credit applications?
6 . Borrowings from the central bank. Has the institution been
forced to borrow in larger volume and more frequently from
the central bank in its home territory (such as the Federal
Reserve or Bank of Japan) lately? Have central bank officials
begun to question the institution's borrowings?
If the answer to any of the foregoing questions is yes,
management needs to take a close look at its liquidity
management policies and practices to determine whether
changes are needed.
5.6 LEG A L R ESER V ES AND M O N EY
POSITION M A N A G EM EN T
The Money Position Manager
Management of a financial institution's liquidity position can be
a harrowing job, requiring quick decisions that may have long-
run consequences for profitability. Nowhere is this more evident
than in the job of money position manager.
Chapter 5 Liquidity and Reserves M anagem ent: Strategies and Policies
Most large depository institutions have designated an officer of
the firm as money position manager. Smaller banks and thrifts
often hand this job over to larger depositories with whom they
have a correspondent relationship (that is, that hold deposits to
help clear checks and meet other liquidity needs).
Legal Reserves
The manager of the money position is responsible for ensur­
ing that his or her institution maintains an adequate level of
legal reserves—that is, those assets that law and central bank
regulation say must be held during a particular time period.
For example, in the United States a qualified depository institu­
tion must hold the required level of legal reserves in the form
of vault cash and, if this is not sufficient, in the form of deposits
held in a reserve account at the Federal Reserve bank in the
region. Smaller depository institutions and banks, who are not
members of the Federal Reserve system, may be granted per­
mission to hold their legal reserve deposits with a Fed-approved
institution. Among the financial firms subject to U.S. legal
reserve requirements are commercial and savings banks, savings
and loan associations, credit unions, agencies and branches of
foreign banks offering qualified deposits and other liabilities in
the United States.
The very smallest U.S. depository institutions (holding about
$10.7 million of reservable deposits in 2010) are exempt from
any legal reserve requirements at all. This zero exemption is
adjusted each year to help reduce the impact of inflation on
deposit growth and lighten the regulatory burden on the small­
est depository institutions.
Regulations on Calculating Legal Reserve
Requirements
Reserve Computation
Exhibit 5.1 illustrates the timing associated with calculating
reserve requirements and maintaining reserves that the Fed­
eral Reserve has set up for institutions holding deposits and
other liabilities subject to legal reserve requirements. As the
exhibit shows, under the current system of accounting for
legal reserves—called lagged reserve accounting (LRA)—
the daily average amount of deposits and other reservable lia­
bilities are computed using information gathered over a two-
week period stretching from a Tuesday through a Monday two
weeks later. This interval of time is known as the reserve com­
putation period. The daily average amount of vault cash each
depository institution holds is also figured over the same
■ 103
 Federal Reserve rules for calculating and maintaining required legal reserves Exhibit 5.1 that this period begins
(Regulation D):
30 days after the beginning of the
reserve computation period for depos­
Week 1 Week 2 Week 3 its and other reservable liabilities. Using
LRA, the money position manager has
(t ) W Th F S Su M T W Th F S Su ® T W Th F S SuM
a 16-day lag following the computation
period and preceding the maintenance
Reserve computation period for period. This period provides time for
deposits and other reservable liabilities
and for vault cash holdings, money position managers to plan.
Tuesday through Monday
(a two-week period)
Reserve Requirements
How much money must be held in legal
Week 4 Week5 Week 6
A A reserves? The answer depends on the
T W Th F S Su \ ? T W @ F S S u M T W T h F S S u M T ® volume and mix of each institution's
deposits and also on the particular time
Reserve maintenance period for
period, because the amount of deposits
meeting each depository institution's subject to legal reserve requirements
average level of required legal reserves, changes each year. For example, in the
Thursday through Wednesday
(a two-week period) case of transaction deposits—checking
accounts, NOWs, and other deposits that
Exhibit 5.1 Federal Reserve Rules for Calculating a Weekly Reporting can be used to execute payments—the
Depository Institution's Required Legal Reserves. reserve requirement in 2 0 1 0 was
3 percent of the end-of-the-day daily
two-week computation period. Exhibit 5.1 illustrates one average amount held over a two-week period, from $10.7 mil­
computation cycle. For large institutions another cycle begins lion to $58.8 million. Transaction deposits over $58.8 million
immediately . 2 held by the same depository institution carried a 1 0 percent
legal reserve requirement.
Reserve Maintenance The $58.8 million figure, known as the reserve tranche, is
After the money position manager calculates daily average changed once each year based upon the annual rate of
deposits and the institution's required legal reserves, he or deposit growth. Under the dictates of the Depository Institu­
she must maintain that required legal reserve on deposit tions Deregulation and Monetary Control Act of 1980, the
with the Federal Reserve bank in the region (less the amount Federal Reserve Board must calculate the June-to-June annual
of daily average vault cash held), on average, over a 14-day growth rate of all deposits subject to legal reserve require­
period stretching from a Thursday through a Wednesday. This ments. The dollar cutoff point above which reserve require­
is known as the reserve maintenance period. Notice from ments on transaction deposits become 1 0 percent instead
of 3 percent is then adjusted by 80 percent of the calculated
annual deposit growth rate. This annual legal reserve adjust­
ment is designed to offset the impact of inflation, which over
2 The process used for calculating legal reserve requirements described
here applies to the largest U.S. depository institutions, known as weekly time would tend to push depository institutions into higher
reporters, which must report their cash positions to the Federal Reserve reserve requirement categories.
banks on a weekly basis. The more numerous, but smaller U.S. banks
and qualifying thrift institutions are known as quarterly reporters. This
latter group of institutions have their daily average deposit balances Calculating Required Reserves
figured over a seven-day computation period beginning on the third
The largest depository institutions must hold the largest per­
Tuesday in the months of March, June, September, and December,
each representing one quarter of the calendar year. These smaller U.S. centage of legal reserves, reflecting their great importance as
depository institutions, then, must settle their reserve position at the funds managers for themselves and for hundreds of smaller
required level weekly based on a legal reserve requirement determined
financial institutions. However, whether large or small, the total
once each quarter of the year. In contrast, the largest U.S. depositories
must meet (settle) their legal reserve requirement over successive two- required legal reserves of each depository institution are figured
week periods (biweekly). by the same method. Each reservable liability item is multiplied

104 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Table 5.5 Sam ple Calculation of Legal Reserve Requirem ents in the United States

The first $10.7 million of net transaction deposits are subject to a 0 percent legal reserve requirement (known as the "exemption
amount"). The volume of net transaction deposits over $10.7 million up to $58.8 million carries a 3 percent reserve requirement
(known as the "low reserve tranche"), while the amount over $58.8 million is subject to a 10 percent reserve requirement (the
"high reserve tranche"). Nontransaction reservable liabilities (including nonpersonal time deposits and Eurocurrency liabilities)
are subject to a 0 percent reserve requirement.*
First National's net transaction deposits averaged $100 million over the 14-day reserve computation period, while its nontransac­
tion reservable liabilities had a daily average of $200 million over the same period. Then First National's daily average required
legal reserve level = 0.0 X $10.7 million + 0.03 X ($58.8 million - $10.7 million) + 0.10 ($100 million - $58.8 million)
= $5,563 million.**
First National held a daily average of $5 million in vault cash over the required two-week reserve computation period. Therefore,
it must hold an additional amount of legal reserves over its two-week reserve maintenance period as follows:
Daily average level of additional = Total required - Daily average vault = $5,563 million - $5,000 million = $0,563 million
legal reserves First National legal reserves cash holdings
Bank must raise
Federal Reserve officials today differentiate between so-called bound and nonbound depository institutions. Bound institutions'
required reserves are larger than their vault cash holdings, meaning that they must hold additional reserves beyond the amount
of their vault cash at the Federal Reserve Bank in their district. Nonbound institutions hold more vault cash than their required
reserves and therefore are not required to hold legal reserves at the Fed. As reserve requirements have been lowered in recent
years, the number of nonbound depositories has increased.
* As of 2010.
** Net transaction deposits are gross demand deposits less cash items in process of collection and deposits due from other banks. The percentage
reserve requirement on nonpersonal time deposits with an original maturity of less than 18 months and on Eurocurrency liabilities was reduced to zero
in 1991. Nonpersonal time deposits 18 months or longer to maturity were assigned a zero reserve requirement in 1983.
Source: Board of Governors of the Federal Reserve System.

by the stipulated reserve requirement percentage to derive each
depository's total legal reserve requirement. Thus:
Total required Reserve requirement on transaction deposits
legal reserves X Daily average amount of net transaction
deposits over the computation period
+ Reserve requirement on nontransaction
reservable liabilities X Daily average
amount of nontransaction reservable liabilities
over the computation period. 3 ^ g^
3 Net transaction deposits include the sum total of all deposits on which a
depositor is permitted to make withdrawals by check, telephone, or other
transferable instrument minus any cash items in the process of collection and
deposits held with other depository institutions. Nonpersonal (business) time
deposits and Eurocurrency liabilities also may, from time to time, be subject
to legal reserve requirements. Nonpersonal time deposits include savings
deposits, CDs, and other time accounts held by a customer who is not a
natural person (i.e., not an individual, family, or sole proprietorship). Eurocur­
rency liabilities are mainly the sum of net borrowings from foreign offices.
Note that only transaction deposits currently carry legal reserve require­
ments that act as a "tax" on financial institutions offering this type of
deposit. Financial institutions subject to this requirement try to minimize
the "tax burden" by selling customers nonreservable time deposits and
Eurocurrency deposits whose reserve requirement is zero. However,
transaction accounts usually pay little or no interest, which helps offset a
portion of the tax burden imposed by reserve requirements.
A sample calculation of a U.S. bank's total required legal
reserves is shown in Table 5.5.
Once a depository institution determines its required reserve
amount it compares that figure to its actual daily average hold­
ings of legal reserves—vault cash and any deposits held directly
or indirectly at the central bank. If total legal reserves held are
greater than required reserves, the depository institution has
excess reserves. Normally management of the financial firm will
move quickly to invest any excess reserves to earn additional
income. However, during the global credit crisis of 2007-2009
excess reserves held by U.S. depository institutions repeatedly
approached a trillion dollars, reflecting record extensions of
credit to private banks by the U.S. central bank. Initially these
credit extensions by the Federal Reserve appeared to have little
impact on lending to rescue the economy. Eventually, however,
with the Fed pushing toward lower interest rates economic con­
ditions have struggled to improve, even if only slowly.
On the other hand, if the calculated required reserve figure
exceeds the amount of legal reserves actually held on a daily
average basis, the depository institution has a reserve deficit.
Law and regulation normally require the institution to cover this
deficit by acquiring additional legal reserves. And there may be
a penalty of up to 2 percent a year above the Fed's Discount

C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies ■ 105
Rate depending upon the circumstances that led to the reserve Assuming a 360-day year for ease of computation, this bank could
deficit. Actually, regulations may allow a depository institution apply up to $2,138.89 to offset any fees charged the bank for its use
to run a small deficit in its required daily average reserve posi­ of Federal Reserve services. In October 2008, the Fed began paying
tion, provided this shortfall is balanced out by a corresponding interest on legal reserve balances held by depository institutions.
excess during the next reserve maintenance period . 4
Factors Influencing the Money Position
Clearing Balances
A depository institution's money position is influenced by a long
In addition to holding a legal reserve account at the central bank, list of factors, some of which are included in the following table.
many depository institutions also hold a clearing balance with Among the most important are the volume of checks and other
the Fed to cover any checks or other debit items drawn against drafts cleared each day, the amount of currency and coin ship­
them. In the United States any depository institution using ments back and forth between each depository and the central
the Federal Reserve's check-clearing facilities must maintain a bank's vault, purchases and sales of government securities, and
minimum-sized clearing balance—an amount set by agreement borrowing and lending in the Federal funds (interbank) market.
between each institution and its district Federal Reserve bank. Some of these factors are largely controllable by management,
Clearing balance rules work much like legal reserve require­ while others are essentially noncontrollable, and management
ments, with depository institutions required to maintain a needs to anticipate and react quickly to them.
minimum daily average amount in their clearing account over C o n tro lla b le F a c to rs C o n tro lla b le F a c to rs
the same two-week maintenance period as applies to legal In creasin g Leg a l R e se rv e s D e cre a sin g Leg al R e se rv e s
reserves. When they fall below the minimum balance required,
• Selling securities. • Purchasing securities.
they must provide additional funds to bring the balance up to
• Receiving interest pay­ • Making interest payments
the promised level. If a clearing balance has an excess amount
ments on securities. to investors holding the
in it, this can act as an extra cushion of reserves to help a
bank's securities.
depository institution avoid a deficit in its legal reserve account.
• Borrowing reserves from • Repaying a loan from the
A depository institution earns credit from holding a clearing the Federal Reserve bank. Federal Reserve bank.
balance that it can apply to help cover the cost of using Fed • Purchasing Federal funds • Selling Federal funds to
services (such as the collection of checks or making: use of Fed from other banks. other institutions in need
Wire, the Federal Reserve's electronic wire transfer service). The of reserves.
amount of credit earned from holding a Fed clearing balance • Selling securities under a • Security purchases under a
depends on the size of the average account balance and the repurchase agreement (RP). repurchase agreement (RP).
level of the Federal funds interest rate over the relevant period, • Selling new CDs, Eurocur­ • Receiving currency and
For example, suppose a bank had a clearing balance averaging rency deposits, or other coin shipments from the
$ 1 million during a particular two-week maintenance period and deposits to customers. Federal Reserve bank.
the Federal funds interest rate over this same period averaged N o n co n tro lla b le F a c to rs N o n co n tro lla b le F a c to rs
5.50 percent. Then it would earn a Federal Reserve credit of In creasin g Leg a l R e se rv e s D e cre a sin g Leg al R e se rv e s

Average clearing balance X Annualized Fed funds rate • Surplus position at the • Deficit position at the local
X 14 days/360 days = $1,000,000 X .055 X .0389 local clearinghouse due to clearinghouse due to more
= $2,138.89 (5.9) receiving more deposited checks drawn against the
checks in its favor than bank than in its favor.
checks drawn against it.
4 In September 2006 the U.S. Congress granted the Federal Reserve per­ • Credit from cash letters • Calls of funds from the
mission to pay interest quarterly on reserve balances held by depository sent to the Fed, listing bank's tax and loan account
institutions at a Federal Reserve bank. However, the new law called for a
drafts received by the bank. by the U.S. Treasury.
delay in paying interest on reserve balances until 2011 because the Fed
paying out interest would reduce the earnings the U.S. Treasury receives • Deposits made by the U.S. • Debits received from the
each year from the Federal Reserve banks. Recently the Fed asked Con­ Treasury into a tax and loan Federal Reserve bank for
gress if the effective date for the beginning of interest payments could checks drawn against the
account held at the bank.
be moved up, arguing that it would help stabilize the volume of legal
reserves and the Federal funds rate—the Fed's principal tool to carry out • Credit received from the Fed­ bank's reserve account.
monetary policy. In October 2008 the Fed initiated interest payments on eral Reserve bank for checks • Withdrawal of large
bank reserves, reducing pressure on banks to invest any excess reserves previously sent for collection deposit accounts, often
they might hold and holding more funds at the Fed. Excess reserve bal­
ances at the Fed soared to more than a trillion dollars by 2010. (deferred availability items). immediately by wire.

106 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent

Factoid
The oldest kind of sweep account offered by deposi­
tory institutions is business-oriented sweep programs that
convert business checking accounts, usually overnight,
into interestbearing savings deposits or off-balance-sheet
interest-bearing investments. Recently the U.S. federal
government lifted restrictions against corporate deposi­
tors earning interest income on bank deposits as part of the
Dodd-Frank Regulatory Reform legislation.
In recent years the volume of legal reserves held at the Fed­
eral Reserve by depository institutions operating in the United
States has declined sharply. Today, for example, legal reserves
held by depository institutions at all 12 Federal Reserve banks
are well below their volume during the 1990s. The decline in
legal reserves is largely due to the development of sweep
accounts—a customer service that results in bankers shifting
their customers' deposited funds out of low-yielding accounts
that carry reserve requirements (currently checkable or transac­
tion accounts), usually overnight, into repurchase agreements,
shares in money market funds, and savings accounts (not cur­
rently bearing reserve requirements). Such sweeps yield an
advantage to the offering depository institution because they
lower its overall cost of funds, while still preserving depositor
access to his or her checking account and the ability to make
payments or execute withdrawals.
These sweep arrangements have ballooned in size to cover
well over $500 billion in deposit balances, substantially lower­
ing total required reserves of depository institutions. Sweep
activities have been aided by access to online sites made avail­
able from the Federal Reserve banks that track on a real-time
basis any large dollar payments flowing into or out of reserve
accounts, allowing money managers to better plan what hap­
pens to their legal reserve positions on a daily basis. Today
the sweep accounts depository institutions offer include retail
sweeps, involving checking and savings accounts of individuals
and families, and business sweeps, where commercial checkable
deposit balances are changed overnight into commercial savings
deposits or moved off depository institutions' balance sheets
into interest-bearing investments and then quickly returned.
The sweeps market is likely to change in form and importance
due to the recent passage of FINREG—the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2009. Among
many provisos this extensive legislation knocked down the
long-standing prohibition against banks paying interest on com­
mercial checking accounts which had stood for about 75 years.
The U.S. Congress of the 1930s believed that many banks got
into trouble because they granted interest on business depos­
its. Recent research has suggested quite the opposite. Now
C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies
bankers can compete for corporate deposits and more easily
attract capital, which was going abroad more often than not,
and bring cash accounts back to their home offices inside the
United States.
The key goal of money position management is to keep legal
reserves at the required level, with no excess reserves and no
reserve deficit large enough to incur a penalty. If a depository
institution has an excess reserve position, it will sell Federal
funds to other depositories short of legal reserves, or if the
excess appears to be longer lasting, purchase securities or
make new loans. If the depository institution has a legal reserve
deficit, it will usually purchase Federal funds or borrow from the
Federal Reserve bank in its district. If the deficit appears to be
especially large or long lasting, the institution may sell some of
its marketable securities and cut back on its lending.
An Example
Table 5.6 illustrates how a bank, for example, can keep track of
its reserve position on a daily basis. This example also illustrates
the money desk manager's principal problem—trying to keep
track of the many transactions each day that will affect this partic­
ular bank's legal reserves. In this example, the money desk man­
ager had estimated that his bank needed to average $500 million
per day in its reserve account. However, at the end of the first
day (Thursday) of the new reserve maintenance period, it had a
$550 million reserve position. The money manager tried to take
advantage of this excess reserve position the next day (Friday) by
purchasing $100 million in Treasury securities. The result was a
reserve deficit of $130 million, much deeper than expected, due
in part to an $80 million adverse clearing balance (that is, this
bank had more checks presented for deduction from its custom­
ers' deposits than it received from other depository institutions
for crediting to its own customers' accounts).
To help offset this steep decline in its reserve account, the
money manager borrowed $50 million from the Federal Reserve
bank's discount window on Friday afternoon. This helped a little
because Friday's reserve position counts for Saturday and Sunday
as well, when most depository institutions are closed, so the
$130 million reserve deficit on Friday resulted in a $390 million
Factoid
Two of the most important regulations focusing on the man­
agement of reserves and liquidity for depository institutions
are Regulations Q and D of the Federal Reserve Board. Q
impacts the interest rates that depository institutions are
allowed to pay on deposits, while D sets out the rules for
calculating and meeting legal reserve requirements in the
United States.
■ 107
o
00

Table 5.6 An Example: Daily Schedule for Evaluating a Bank's Money Position (all figures in millions of dollars)
Required Daily Adjustments to the Bank's Legal Reserve Balance Closing
Daily Daily Excess Cumulative Cumulative
Federal Funds Fed's Discount Check
Days in the Average Average or Deficit Excess Closing
Transactions Window Treasury Securities Clearing
Reserve Legal Legal in Legal or Deficit Balance
Maintenance Reserve Purchases Sales Borrow Repay Redeem Purchase Credit Debit Reserve Reserve in Legal in Legal
Period Balance (+) (- ) (+) (- ) (+) (- ) (+) (- ) Balance Position Reserves Reserves

Carryover excess (+) or deficit (-) in legal reserves from previous period:
0

Thursday $500 + 50 -2 5 -2 5 + 50 $550 +50 + 50 $550

Friday 500 + 50 - 1 0 0 -8 0 370 -130 -8 0 920
Saturday 500 + 50 - 1 0 0 -8 0 370 -130 - 2 1 0 1,290
Sunday 500 + 50 - 1 0 0 -8 0 370 -130 -340 1,660
Monday 500 -2 5 -5 0 +40 465 -35 -375 2,125
Tuesday 500 + 50 -2 5 525 +25 -350 2,650
Wednesday 500 + 50 -6 0 490 - 1 0 -360 3,140
Thursday 500 +1 0 510 +1 0 -350 3,650
Friday 500 +1 0 0 -5 0 -7 0 480 - 2 0 -370 4,130
Saturday 500 +1 0 0 -5 0 -7 0 480 - 2 0 -390 4,610
Sunday 500 +1 0 0 -5 0 -7 0 480 - 2 0 -410 5,090
Monday 500 +250 -2 5 + 15 740 +240 -170 5,830
Tuesday 500 +1 0 0 600 +1 0 0 -7 0 6,430
Wednesday 500 +70 570 +70 0 7,000
Cumulative $7,000
Daily $500
average
(3 X $130 million) cumulative reserve deficit for the whole
weekend. If the money desk manager had not borrowed the
$50 million from the Fed, the deficit would have been $180 mil­
lion for Friday and thus $540 million (3 X $180 million) for the
entire weekend.
The bank depicted in Table 5.6 continued to operate below its
required daily average legal reserve of $500 million through the
next Friday of the reserve maintenance period, when a fate­
ful decision was made. The money manager decided to bor­
row $100 million in Federal funds, but at the same time to sell
$50 million in Federal funds to other depository institutions.
Unfortunately, the manager did not realize until day's end on
Friday that the bank had suffered a $70 million adverse clearing
balance due to numerous checks written by its depositors that
came back for collection. On balance, the bank's reserve deficit
increased another $10 million, for a closing balance on Friday
of $480 million. Once again, because Friday's balance carried
over for Saturday and Sunday, the money desk manager faced a
cumulative reserve deficit of $410 million on Monday morning,
with only that day plus Tuesday and Wednesday to offset the
deficit before the reserve maintenance period ended.
Federal Reserve regulations require a depository institution to
be within 4 percent of its required daily average reserve level
or perhaps pay a penalty on the amount of the deficit. Trying to
avoid this penalty, the bank money manager swung into high
gear, borrowing $250 million in Federal funds on Monday and
$100 million on Tuesday. Over two days this injected $350 mil­
lion in new reserves. With an additional borrowing of $70 million
in the Federal funds market on Wednesday, the last day of the
reserve maintenance period (known as "bank settlement day"),
the bank in our example ended the period with a zero cumula­
tive reserve deficit.
Use of the Federal Funds Market
In the foregoing example, the money position manager had a
large reserve deficit to cover in a hurry. This manager elected to
borrow heavily in the Federal funds market—usually one of the
cheapest places to borrow reserves, but also frequently volatile.
The effective interest rate on Federal funds changes minute by
minute so money position managers must stay abreast of both
the level and upward or downward movements in the effec­
tive daily Fed funds rate. One factor that aids the manager in
anticipating changes in the funds market is the fact that the
Federal Reserve sets a target range for the Fed funds rate and
intervenes periodically to move the current funds rate closer to
its target. As Exhibit 5.2 indicates, the effective daily funds rate
hovers close to the Fed's target (intended) Fed funds rate range,
generally within a few basis points of that target range. The
C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies
R E S E R V E M A R K E T RATES
Percent
--- Effective Federal Funds Rate
— Intended Federal Funds Rate
2008 2009 2010 2011
Note: Effective December 16, 2008, FOMC reports the intended Federal
funds rate as a range.
Exhibit 5.2 M ovem ents in the Effective Federal
Funds Rate, Its Target (the Intended Federal Funds)
Rate, and the Discount (Prim ary Credit) Rate for
D epository Institutions Seeking C redit from the Federal
Reserve Banks.
Source: Federal Reserve Bank of St. Louis, Monetary Trends, March 2011,
p. 3.
most volatile day in terms of trying to anticipate which way and
by how much the funds rate will move is during bank settlement
day (usually a Wednesday), when many depository institutions
may find themselves short of required reserves with the door
(i.e., the reserve maintenance period) about to slam shut on
them at day's end!
Other Options besides Fed Funds
While the Federal funds market is usually the most popular route
for solving immediate shortages of reserves, the money position
manager usually has a fairly wide range of options to draw upon
from both the asset (stored liquidity) and liability (purchased
liquidity) sides of the balance sheet. These include selling liquid
securities the institution may already hold, drawing upon any
excess correspondent balances placed with other depository
institutions, entering into repurchase agreements for temporary
borrowing, selling new time deposits to the largest customers,
and borrowing in the Eurocurrency market. The money position
manager's job is to find the best options in terms of cost, risk,
and other factors.
Bank Size and Borrowing and Lending Reserves
for the Money Position
Recent research on money position management suggests that
smaller depository institutions tend to have frequent reserve
■ 109
surpluses, particularly when loan demand is low in their market
areas, and, therefore, are interested in lending these surpluses
out to larger institutions. If smaller depositories do have reserve
deficits, these normally occur late in the reserve maintenance
period. In contrast, the largest depository institutions tend to
have reserve needs day after day and find themselves on the
borrowing side of the money market most of the time.
Overdraft Penalties
Depository institutions operating inside the U.S. financial system
run the risk of modest penalties if they run an intraday overdraft
and possibly a stiffer penalty if overnight overdrafts occur in
their reserves. Avoiding intraday and overnight overdrafts is
not easy for most institutions because they have only partial
control over the amount and timing of inflows and outflows of
funds from their reserves. Because of possible overdraft penal­
ties, many financial institutions hold "precautionary balances"
(extra supplies of reserves) to help prevent overdrafting of their
reserve account.
5.7 FACTORS IN CH O O SIN G AM O N G
THE D IFFER EN T SO U R CES O F
R ESER V ES *1
In choosing which source of reserves to draw upon to cover a
legal reserve deficit, money position managers must carefully
consider several aspects of their institution's need for liquid
funds:
1. Immediacy o f need. If a reserve deficit comes due within
minutes or hours, the money position manager will normally
tap the Federal funds market for an overnight loan or con­
tact the central bank for a loan from its discount window. In
contrast, a depository institution can meet its nonimmedi-
ate reserve needs by selling deposits or assets, which may
require more time to arrange than immediately available
borrowings normally do.
2. Duration of need. If the liquidity deficit is expected to last
for only a few hours, the Federal funds market or the central
bank's discount window is normally the preferred source of
funds. Liquidity shortages lasting days, weeks, or months,
on the other hand, are often covered with sales of longer-
term assets or longer-term borrowings.
3. Access to the market for liquid funds. Not all depository
institutions have access to all funds markets. For example,
smaller depositories cannot, as a practical matter, draw
upon the Eurocurrency market or sell commercial paper.
110 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Liquidity managers must restrict their range of choices to
those their institution can access quickly.
4. Relative costs and risks of alternative sources of funds. The
cost of each source of reserves changes daily, and the avail­
ability of surplus liquidity is also highly uncertain. Other
things being equal, the liquidity manager will draw on the
cheapest source of reliable funds, maintaining constant con­
tact with the money and capital markets to be aware of how
interest rates and credit conditions are changing.
5. The interest rate outlook. When planning to deal with a
future liquidity deficit, the liquidity manager wants to draw
upon those funds sources whose interest rates are expected
to be the lowest. New futures and options contracts, espe­
cially the Fed funds futures and options contracts and the
Eurodollar futures contracts traded on the Chicago Mer­
cantile Exchange and Chicago Board of Trade (now part of
the CME Group), have greatly assisted liquidity managers
in forecasting the most likely scenario for future borrowing
costs. These contracts provide estimates of the probability
that market interest rates will be higher or lower in the days
and weeks ahead.
. Outlook for central bank monetary policy. Closely con­
6
nected to the outlook for interest rates is the outlook for
changes in central bank monetary policy which shapes
the direction and intensity of credit conditions in the
money market. For example, a more restrictive monetary
policy implies higher borrowing costs and reduced credit
availability for liquidity managers. The Federal funds
and Eurodollar futures and options contracts mentioned
above have proven to be especially useful to liquid­
ity managers in gauging what changes in central bank
policies affecting interest rates are most likely down
the road.
7. Rules and regulations applicable to a liquidity source. Most
sources of liquidity cannot be used indiscriminately; the
user must conform to the rules. For example, borrowing
reserves from a central bank frequently requires the borrow­
ing institution to provide collateral behind the loan. In the
United States and Europe two key liquidity sources—the
Federal funds and Eurocurrency markets—close down near
the end of the trading day, forcing borrowing institutions
that are in danger of overdrafting their accounts to quickly
arrange for their funding needs before the door closes or
look for cash elsewhere.
The liquidity manager must carefully weigh each of these factors
in order to make a rational choice among alternative sources of
reserves.
 CONCEPT CHECK
5.15. What is money position management?
5.16. What is the principal goal of money position
management?
5.17. Exactly how is a depository institution's legal reserve
requirement determined?
5.18. Fi rst National Bank finds that its net transaction
deposits average $140 million over the latest reserve
computation period. Using the reserve requirement
ratios imposed by the Federal Reserve as given in
the textbook, what is the bank's total required legal
reserve?
5.19. A U.S. savings bank has a daily average reserve bal­
ance at the Federal Reserve bank in its district of
$25 million during the latest reserve maintenance
period. Its vault cash holdings averaged $1 million
and the savings bank's total transaction deposits (net
of interbank deposits and cash items in collection)
averaged $ 2 0 0 million daily over the latest reserve
maintenance period. Does this depository institution
currently have a legal reserve deficiency? How would
5.8 CEN TRA L BAN K R ESER V E
REQ U IREM EN TS ARO UN D
THE G LO B E
We should note that not all central banks impose legal reserve
requirements on the depository institutions they regulate.
For example, the Bank of England has not established official
reserve requirements for its banks and there is a trend among
central banks around the globe to eliminate, suspend, or at least
make less use of the reserve requirement tool, in part because
it is so difficult to control. A notable exception is the European
Central Bank (ECB), whose reserve requirements are often a
binding constraint on European banks, with the latter frequently
accessing the additional liquidity they need to meet these cash
requirements by participating in the ECB's weekly auction of
liquid funds.
Finally, it is important to recognize that even if central banks
imposed no reserve requirements at all, the managers of deposi­
tory institutions would still have a demand for cash reserves. All
depository institutions at one time or another need immediately
available funds to handle customer withdrawals, meet new loan
C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies
you recommend that its management respond to the
current situation?
5.20. What factors should a money position manager con­
sider in meeting a deficit in a depository institution's
legal reserve account?
5.21. What are clearing balances? Of what benefit can clear­
ing balances be to a depository that uses the Federal
Reserve System's check-clearing network?
5.22. Suppose a bank maintains an average clearing balance
of $5 million during a period in which the Federal funds
rate averages 6 percent. How much would this bank
have available in credits at the Federal Reserve Bank in
its district to help offset the charges assessed against
the bank for using Federal Reserve services?
5.23. What are sweep accounts? Why have they led to a sig­
nificant decline in the total legal reserves held at the
Federal Reserve banks by depository institutions oper­
ating in the United States?
5.24. What impact has recent financial reform legislation had
on raising short-term cash?
demand, and satisfy other emergency cash needs. Capable
liquidity managers are indispensable in the modern world.
SUM MARY *•
Managing the liquidity position for a financial institution can be
one of the most challenging jobs in the financial sector. In this
chapter we reviewed several fundamental principles of liquidity
management and looked at several of the liquidity manager's
best tools. Key points in the chapter include:
• Liquidity needs are generally met either by selling assets (i.e.,
converting stored liquidity into cash) or by borrowing in the
money market (i.e., using purchased liquidity) or by a combi­
nation of these two approaches.
• Managers of financial firms have developed several differ­
ent methods to estimate what their institution's true liquidity
needs are likely to be. One of these estimation methods is
the sources and uses of funds method in which total sources
and uses of funds are projected over a desired planning hori­
zon and liquidity deficits and surpluses are calculated from
the difference between funds sources and funds uses.
■ 111
• Another popular liquidity estimation technique is the struc­
ture of funds method. This requires each financial firm to clas­
sify its funds uses and sources according to their probability
of withdrawal or loss.
• Still another liquidity estimation approach focuses on liquid­
ity indicators, in which selected financial ratios measuring a
financial firm's liquidity position with the liquidity manager
looking for evidence of adverse trends in liquidity.
• Financial institutions today can draw upon multiple sources
of liquid assets and borrowed liquidity. Key sources of liquid­
ity on the asset side of the balance sheet include correspon­
dent balances held with depository institutions and sales of
highly liquid money market instruments. Important borrowed
liquidity sources include borrowing from the central bank's
discount window, purchasing Federal funds, employing
repurchase agreements (RPs), and issuing CDs or Eurocur­
rency deposits.
• One of the most challenging areas of funds management among
depository institutions centers upon the money position man­
ager who oversees the institution's legal reserve account. These
legal reserves include vault cash held on a depository institu­
tion's premises and may also encompass deposits kept with the
central bank, which must be managed to achieve a target level
of legal reserves over each reserve maintenance period.
• Liquidity and money position managers choose their sources
of liquidity based on several key factors, including ( 1 ) imme­
diacy of need; (2) duration of need; (3) market access; (4) rel­
ative costs and risks; (5) the outlook for market interest rates;
(6 ) the outlook for central bank monetary policy; and (7) gov­
ernment regulations.

K E Y TERM S
liquidity, 8 8 sources and uses of funds method, 94 reserve computation period, 103
net liquidity position, 89 liquidity gap, 94 reserve maintenance period, 104
asset conversion, 91 structure of funds method, 97 clearing balance, 106
liquid asset, 91 liquidity indicators, 1 0 0 sweep accounts, 107
opportunity cost, 91 money position manager, 103 Federal funds market, 109
liability management, 92 legal reserves, 103
balanced liquidity management, 93 lagged reserve accounting (LRA), 103

112 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

PROBLEM S AN D PRO JECTS

1. Ocean View State Bank estimates that over the next

April 90 485 700 175
24 hours the following cash inflows and outflows will occur
(all figures in millions of dollars): May 105 465 710 160
June 80 490 700 2 0 0
Deposit withdrawals $ 1 0 0 Sales of bank assets 40
July 90 525 700 175
Deposit inflows 95 Stockholder dividend 150
payments August 1 0 0 515 675 150

Scheduled loan 90 Revenues from sale of 95 4. Queen Savings is attempting to determine its liquidity require­
repayments nondeposit services ments today (the last day in August) for the month of Septem­
Acceptable loan 60 Repayments of bank 60 ber. September is usually a month of heavy loan demand due
requests borrowings to the beginning of the school term and the buildup of busi­
Borrowings from the 80 Operating expenses 50 ness inventories of goods and services for the fall season and
money market winter. This thrift institution has analyzed its deposit accounts
thoroughly and classified them as explained below.
What is this bank's projected net liquidity position in the
next 24 hours? From what sources can the bank cover its Management has elected to hold a 85 percent reserve in
liquidity needs? liquid assets or borrowing capacity for each dollar of hot
money deposits, a 25 percent reserve behind vulnerable
2. Mountain Top Savings is projecting a net liquidity deficit
deposits, and a 5 percent reserve for its holdings of core
of $ 1 0 million next week partially as a result of expected
funds. Assume time and savings deposits carry a zero per­
quality loan demand of $32 million, necessary repayments
cent reserve requirement and all checkable deposits carry
of previous borrowings of $15 million, planned stockholder
a 3 percent reserve requirement. Queen currently has total
dividend payments of $ 1 0 million, expected deposit inflows
loans outstanding of $2,500 million, which two weeks ago
of $26 million, revenues from nondeposit service sales of
were as high as $2,550 million. Its loans indicate annual
$18 million, scheduled repayments of previously made cus­
growth rate over the past three years has been about
tomer loans of $23 million, asset sales of $10 million other
6 percent. Carefully prepare low and high estimates for
operating expenses of $15 million, and money market bor­
Queen's total liquidity requirement for September.
rowings of $15 million. How much must Mountain Top's
expected deposit withdrawals be for the coming week? Checkable Savings Time
3. First National Bank of Belle Mead has forecast its checkable Millions of Dollars Deposits Deposits Deposits
deposits, time and savings deposits, and commercial and Hot money funds $ 1 0 $5 $1 , 2 0 0
household loans over the next eight months. The resulting
Vulnerable funds 65 152 740
estimates (in millions) are shown below. Use the sources
and uses of funds approach to indicate which months are Stable (core) funds 85 450 172
likely to result in liquidity deficits and which in liquidity
5. Using the following financial information for Wilson
surpluses if these forecasts turn out to be true. Explain
National Bank, calculate as many of the liquidity indicators
carefully what you would do to deal with each month's pro­
discussed in this chapter for Wilson as you can. Do you
jected liquidity position.
detect any significant liquidity trends? Which trends should
management investigate?
Time and
Checkable Savings Commercial Consumer Most Previous
Deposits Deposits Loans Loans Recent Year Year
January $ 1 2 0 $550 $650 $160
Assets:
February 115 500 650 230
Cash and due from depository $345,000 $358,000
March 1 0 0 500 700 2 1 0 institutions

C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies ■ 113
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

the simplified balance sheet provided in the previous prob­

Most Previous
lem to answer the following questions:
Recent Year Year
a. If asset conversion is used and securities are sold to
U.S. Treasury securities 176,000 178,000 provide money for the loans, what happens to the size
Other securities 339,000 343,000 of Bank of Your Dreams?
Pledged securities 287,000 223,000 b. If liability management is used to provide funds for
Federal funds sold and reverse 175,000 131,000 the loans, what happens to the size of Bank of Your
repurchase agreements Dreams?

Loans and leases net 2,148,000 1,948,000 8. Suppose Abigail Savings Bank's liquidity manager estimates
that the bank will experience a $375 million liquidity deficit
Total assets 3,500,000 3,250,000
next month with a probability of 15 percent, a $ 2 0 0 mil­
Liabilities: lion liquidity deficit with a probability of 35 percent, a $100
Demand deposits 600,000 556,000 million liquidity surplus with a probability of 35 percent,
Savings deposits 730,000 721,000 and a $250 million liquidity surplus bearing a probability of
15 percent. What is this savings bank's expected liquidity
Time deposits 1 ,1 0 0 , 0 0 0 853,000
requirement? What should management do?
Total Deposits 2,430,000 2,130,000
9. First Savings of Rainbow, Lowa, reported transaction depos­
Core deposits 850,000 644,000 its of $75 million (the daily average for the latest two-week
Brokered deposits 58,000 37,000 reserve computation period). Its nonpersonal time deposits
over the most recent reserve computation period aver­
Federal funds purchased and 217,000 237,000
repurchase agreements aged $37 million daily, while vault cash averaged $5 million.
Assuming that reserve requirements on transaction depos­
Other money market 25,000 16,000
its are 3 percent for deposits over $10.7 million and up to
borrowings
$58.8 million and 10 percent for all transaction deposits
6 . The Bank of Your Dreams has a simple balance sheet. The over $58.8 million while time deposits carry a 3 percent
figures are in millions of dollars as follows: required reserve, calculate this savings institution's required
daily average reserve balance.
Assets Liabilities and Equity
10. Elton Harbor Bank has a cumulative legal reserve deficit
Cash $ 1 0 0 Deposits $4,000
of $44 million as of the close of business this Tuesday. The
Securities 1 ,0 0 0 Other liabilities 500 bank must cover this deficit by the close of business tomor­
Loans 4,000 Equity 600 row (Wednesday).

Total assets 5,100 Total liabilities and equity 5,100 Charles Tilby, the bank's money desk supervisor, examines
the current distribution of money market and long-term
Although the balance sheet is simple, the bank's manager
interest rates and discovers the following:
encounters a liquidity challenge when depositors withdraw
$500 million. Current
a. If the asset conversion method is used and securities Money Market Instruments Market Yield
are sold to cover the deposit drain, what happens to
Federal funds 1.98%
the size of Bank of Your Dreams?
Borrowing from the central bank's discount 2.25
b. If liability management is used to cover the deposit window
drain, what happens to the size of Bank of Your Dreams?
Commercial paper (one-month maturity) 2.33
7. The liquidity manager for the Bank of Your Dreams needs
Bankers' acceptances (three-month maturity) 2.30
cash to meet some unanticipated loan demand. The loan
officer has $600 million in loans that he wants to make. Use Certificates of deposit (one-month maturity) 2.52

114 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

Check-clearing estimates over the next 14 days are as

Current
follows:
Money Market Instruments Market Yield

Eurodollar deposits (three-month maturity) 3.00 Credit Balance in Debit Balance in

Day Millions ( + ) Millions ( —)
U.S. Treasury bills (three-month maturity) 1.85
U.S. Treasury notes and bonds (1-year maturity) 2.57 1 + 10

U.S. Treasury notes and bonds (5-year maturity) 3.65 2 -6 0

U.S. Treasury notes and bonds (10-year 4.19 3 Closed

maturity) 4 Closed
One week ago, the bank borrowed $20 million from the 5 -4 0
Federal Reserve's discount window, which it paid back
6 -25
yesterday. The bank had a $5 million reserve deficit during
the previous reserve maintenance period. From the bank's 7 +30
standpoint, which sources of reserves appear to be the 8 -45
most promising? Which source would you recommend to 9 -5
cover the bank's reserve deficit? Why?
10 Closed
11. Gwynn's Island Building and Loan Association estimates the
11 Closed
following information regarding this institution's reserve
position at the Federal Reserve for the reserve mainte­ 12 +20
nance period that begins today (Thursday): 13 -7 0

Calculated required daily average legal — $760 million 14 + 10

reserve balance
12. Parvis Bank and Trust Co. has calculated its daily average
A loan received from the Fed's discount $70 million deposits and vault cash holdings for the most recent two-
window a week ago that comes due on week computation period as follows:
Friday (day 9)
Planned purchases of U.S. Treasury secu­ Net transaction deposits = $90,000,000
rities on behalf of the association and its
Nonpersonal time deposits under = $169,000,000
customers:
18 months to maturity
Tomorrow (Friday) — $80 million
Eurocurrency liabilities = $ 7,000,000
Next Wednesday (day 7) — $35 million
Daily average balance in vault cash = $ 2,000,000
Next Friday (day 9) — $18 million
Suppose the reserve requirements posted by the Board
Gwynn's Island also had a closing reserve deficit in the of Governors of the Federal Reserve System are as
preceding reserve maintenance period of $5 million. What follows:
problems are likely to emerge as this savings association
tries to manage its reserve position over the next two Net transaction accounts:
weeks? Relying on the Federal funds market and loans from
$10.7 to $58.8 million 3%
the Federal Reserve's discount window as tools to manage
More than $58.8 million 10%
its reserve position, carefully construct a pro forma daily
worksheet for this association's money position over the Nonpersonal time deposits:
next two weeks. Insert your planned adjustments in discount Less than 18 months 3%
window borrowing and Federal funds purchases and sales
18 months or more 0%
over the period to show how you plan to manage Gwynn's
Island's reserve position and hit your desired reserve target. Eurocurrency liabilities—all types 3%

C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies ■ 115
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
What is this bank's daily average required level of legal
reserves? How much must the bank hold on a daily average
basis with the Federal Reserve bank in its district?
13. Frost Street National Bank currently holds $750 million in
transaction deposits subject to reserve requirements but
has managed to enter into sweep account arrangements
with its transaction deposit customers affecting $150 mil­
lion of their deposits. Given the current legal reserve
requirements applying to transaction deposits (as men­
tioned in this chapter), by how much would Frost Street's
total legal reserves decrease as a result of these new sweep
account arrangements, which stipulate that transaction
deposit balances covered by the sweep agreements will be
moved overnight into savings deposits?
14. Bridgewater Savings Association maintains a clearing
account at the Federal Reserve Bank and agrees to keep
a minimum balance of $30 million in its clearing account.
Over the two-week reserve maintenance period ending
today Sweetbriar managed to keep an average clear­
ing account balance of $33 million. If the Federal funds
interest rate has averaged 1.75 percent over this particu­
lar maintenance period, what maximum amount would
Bridgewater have available in the form of Federal Reserve
credit to help offset any fees the Federal Reserve bank
might charge this association for using Federal Reserve
services?
CA SE ASSIGN M EN T FO R CH APTER 5
YOUR BANK'S LIQUIDITY REQUIREMENT:
AN EXAMINATION OF ITS LIQUIDITY
INDICATORS
Chapter 5 describes liquidity and reserve management.
Within the chapter we explore how liquidity managers evalu­
ate their institution's liquidity needs. Four methodologies
are described: ( 1 ) the sources and uses of funds approach,
(2) the structure of funds approach, (3) the liquidity indica­
tor approach, and (4) signals from the marketplace. In this
assignment we will calculate and interpret several of the ratios
associated with the liquidity indicators approach. By compar­
ing these ratios across time and with a group of contemporary
banks, we will examine the liquidity needs of your BHC. In
doing so, you will familiarize yourself with some new terms and
tools associated with real data. This assignment involves some
data exploration that are best described as a financial analyst's
"treasure hunt."
116 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Internet Exercises
1. Evaluate the cash assets, including legal reserves, held by
the Bank of America and Citigroup. How has their liquid­
ity position changed recently? One website that provides
this information for all the depository institutions in a bank
holding company (BHC) is www2.fdic.gov/sdi/. You are par­
ticularly interested in the items identified as "Cash and Due
from Depository Institutions."
2. With reference to the BHCs mentioned in exercise 1, what
was their ratio of cash and due from depository institutions
to total assets at last year's year-end? Do you notice any
significant trends in their liquidity position that you think
have also affected the banking industry as a whole? Exam­
ine the ratios for all FDIC-insured banks. This can also be
accomplished at www 2 .fdic.gov/sdi/.
3. In describing reserve management, we referenced some
numbers that change eveiy year based on U.S. bank
deposit growth. The reservable liabilities exemption
determines which banks are exempt from legal reserve
requirements, and the low reserve tranche is used in calcu­
lating reserve requirements. Go to www.federalreserve
.gov/bankinforeg/reglisting.htm and explore information
concerning Regulation D. Find and report the low reserve
tranche adjustment and the reservable liabilities exemption
adjustment that are being used this year.
Application of the Liquidity Indicator Approach:
Trend and Comparative Analysis
A. Data Collection: To calculate these liquidity ratios, we will
use some data collected in prior assignments and visit the
Statistics for Depository Institutions website (www2.fdic
.gov/sdi/) to gather more information for your BHC and its
peer group. Use SDI to create a four-column report of your
bank's information and the peer group information across
years. In this part of the assignment, for Report Selection
you will access a number of different reports. We suggest
that you continue to collect percentage information to
calculate your liquidity indicators. The additional informa­
tion you need to collect before calculating the indicators
is denoted by**. All data are available in SDI by the name
given next to the**. As you collect the information, enter
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

the percentages for items marked** in Columns B-E as an E. Write one or two paragraphs summarizing the liquidity
addition to the spreadsheet used for comparisons with Peer comparisons with the peer group created in Part D. An illus­
Group as illustrated below with data for BB&T. tration for BB&T follows:

B. Having collected the additional data needed, use the newly All bank holding companies need to maintain adequate liquid­
collected and previously collected data to calculate the 1 0 ity at all times. We have assessed the liquidity of BB&T by cal­
liquidity indicators. For instance, the percentage data you culating a set of 10 liquidity indicators and comparing BB&T's
have can be used to calculate the pledged securities ratio. liquidity to a group of peer institutions. In the above table, if
The formula to enter for cell B92 is B93/B6. BB&T's liquidity or access to liquidity is greater relative to the
peer institution's, it is given a " + " in the Grade column for the
C. Compare the set of liquidity ratios for your BHC across
identified year. BB&T appears comparable to the peer group
years. Write a paragraph describing changes you observe
in 2010 and 2009, having five indicators that are stronger and
between the two years.
five indicators that are identified as weaker. The Liquid Securi­
D. Compare and contrast the set of liquidity ratios for the peer ties Indicator, Deposit Brokerage Index, Core Deposit Ratio,
group in Columns C and E to your BHC's ratios in Columns Deposit Composition Ratio, and Loan Commitments Ratio
B and D. Grade your BHC as being more liquid or having were indicative of BB&T's liquidity strengths. These ratios
greater access to liquidity (+) or less liquid or having less focus on deposit composition and securities that could be liq­
access to liquidity (—) for each year. (See grades for BB&T uidated if the BHC needed cash. We conclude that BB&T has
for 2010 and 2009 in above illustration.) adequate access to liquidity to meet potential needs.

Real Numbers for Real Banks Chapter 5 - Microsoft Excel

File Page Layout Formulas Data Review View Acrobat Q Tell me what you want to do...

^ Cut 1 X Ai
Calibn - 111 * A* A’ 9/ * i f Wrap Text General * N o rm al Bad G ood N e u tra l C a lc u la tio n
^(3) Copy - ^ ® Fil
Paste
Format Painter
B / y - EB- <5*- ^ - t= 1= H ] Merge & Center • ^ • % * *oo +°o Conditional Format as
Formatting * Table *
1 Ex p lan a to ry ... Inp ut L in k e d C e ll N o te V
Insert Delete Format
- . „ Cl
Clipboard r„ Font r. Alignment Number rm Styles Cells

A85 f* L iq u id ity In d ica to rs

A B C D E F G H 1 J K L M N O P Q R S T
84
85 L iq u id ity In d ic a to rs BB& T P e e r G ro u p BB&T P e e r G ro u p G ra d e G ra d e
86 D a te 31-12-2010 31-12-2010 31-12-2009 31-12-2009 31-12-2010 31-12-2009
87 (1) C a st P o s itio n In d ica to r 1.31% 7.69% 1.28% 8.61% - -

88 (2) L iq u id S e c u r it ie s In d ica to r 11.97% 11.74% 17.71% 10.46%

89 • * U .S . G o v e r n m e n t S e c u ritie s 11.97% 11.74% 17.71% 10.46%
90 (3) N e t F e d F u n d s a n d RP In d ica to r -0.64% -0.34% -1.51% -1.16% - -

91 (4) C a p a c ity R a tio 66.64% 50.48% 62.57% 50.07% - -

92 (5) P le d g e d S e c u r it ie s R atio 84.18% 44.68% 62.70% 48 .6 2 % - -

93 • • P le d g e d S e c u r it ie s 12.61% 8.60% 12.79% 9.01%

94 (6) H ot M o n e y R atio 11.33% 45 .6 6 % 9.27% 43 .2 0 % - -
• • F ix e d a n d F lo a tin g r a te d e b t s e c u r it ie s w ith
95 re m a in in g m a tu rity o f o n e y e a r o r le s s 0.01% 1.48% 0.09% 1.39%
96 • • V o la t ile L ia b ilit ie s 15.97% 29.42% 18.34% 32.08%
97 (7) D e p o s it B ro k e ra g e In d e x 2.72% 6.23% 5.69% 5.54% + ■f
98 * • B ro k e re d D e p o s its 1.91% 3.57% 4 .05% 3.78%
99 (8) C o re D e p o s it R atio 60.07% 48.40 % 58.83% 46 .5 2 % + ■F

100 • • C o re D e p o s its 60.07% 48.40% 58.83% 46 .5 2 %

101 (9) D e p o s it C o m p o s itio n R a tio 21.71% 58.00% 12.31% 41 .1 2 % + •F

102 • • D e m a n d D e p o s its 3.89% 5 .22% 3.19% 4 .98%

103 • • T o ta l T im e D e p o s its 17.92% 9.00% 25.92% 12.11%
104 (10) Loan C o m m itm e n ts R atio 24.07% 46.09% 2.29% 50.59% ♦ ■F

105 • • T o ta l U n u s e d C o m m ittm e n ts 24.07% 46.09% 22.29% 50.59%

106
107

Basic inform ation Y ear-to -Y ear C o m p ariso n s C o m p a ris o n s w ith P e e r G ro u p © i L<J_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Ready

C hap ter 5 Liquidity and Reserves M anagem ent: Strategies and Policies ■ 117
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

Selected References
The following studies discuss the instruments often used to
manage the liquidity positions of financial institutions and their
customers:
1. Bartolini, Leonardo, Svenja Gudell, Spence Hilton, and
Krista Schwarz. "Intraday Trading in the Overnight Federal
Funds Market." Current Issues in Economics and Finance,
Federal Reserve Bank of New York, vol. 11, no. 11 (Novem­
ber 2005), pp. 1-7.
2. Hilton, Spence, "Trends in Federal Funds Rate Volatility."
Current Issues in Economics and Finance, Federal Reserve
Bank of New York, vol. 11, no. 7 (July 2005), pp. 1-7.
For a review of the rules for meeting Federal Reserve deposit
reserve requirements, see the following:
3. Hein, Scott E., and Jonathan D. Stewart. "Reserve Require­
ments: A Modern Perspective." Economic Review, Federal
Reserve Bank of Atlanta, Fourth Quarter 2002, pp. 41-52.
For an examination of market discipline as a force in the liquidity
management of financial firms, see especially:
4. Stackhouse, Julie L., and Mark D. Vaughan. "Navigating the
Brave New World of Bank Liquidity." The Regional Econo­
mist, Federal Reserve Bank of St. Louis, July 2003, pp. 12-13.
For an explanation of how regulatory agencies in Great Britain han­
dled the first significant bank run in modern times, see especially:
For the latest developments in liquidity and reserve manage­
ment see, for example:
6 . Anderson, Richard G ., and Charles S. Gascon. "The
Commercial Paper Market, the Fed, and the 2007-2009
Financial Crisis," Review, Federal Reserve Bank of
St. Louis, vol. 91, no. 6 (November/December 2009),
pp. 589-612.
7. Judson, Ruth, and Elizabeth Klee. "Whither the Liquidity
Effect: The Impact of Federal Reserve Open Market Opera­
tions in Recent Years," Finance and Economics Discussion
Series, Federal Reserve Board, Washington, D.C., 2009-25,
Z. 11.
8. Keister, Todd, and James J. McAndrews. "Why Are Banks
Holding So Many Excess Reserves?" Current Issues in Eco­
nomics and Finance, Federal Reserve Bank of New York,
vol. 15, no. 8 (December 2009), pp. 1-10.
9. Lopez, Jose A. "What Is Liquidity Risk?" FRBSF Eco­
nomic Letter, Federal Reserve Bank of San Francisco,
no. 2008-33, October 24, 2008, pp. 1-3.
10. Mora, Nada. "Can Banks Provide Liquidity in a Financial
Crisis?" Economic Review, Federal Reserve Bank of Kansas
City, vol. 95, no. 3 (Third Quarter 2010), pp. 31-68.

5. Milne, Alistair, and Geoffrey Wood. "Banking Crisis Solutions

Old and New, Review, Federal Reserve Bank of St. Louis,
September/October 2008, vol. 90, no. 5, pp. 517-530.

118 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Intraday Liquidity
Risk Management

Learning Objectives
After completing this reading you should be able to:

Identify and explain the uses and sources of intraday Differentiate between methods for tracking intraday flows
liquidity. and monitoring risk levels.

Discuss the governance structure of intraday liquidity risk

management.

Excerpt is Chapter 4 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen Baird.
6.1 INTRODUCTION
The banking industry's interest in intraday liquidity risk in the
United States can be traced back to the early 1980s. This was
an era of extremely high interest rates and tight money, engi­
neered by Paul Volcker, who was appointed chairman of the
Board of Governors of the Federal Reserve System (Federal
Reserve) in August of 1979. Chairman Volcker is widely cred­
ited with ending the "stagflation" crisis in the United States by
dramatically raising the Federal Funds rate upon taking office
(from an average of 11.2% in 1979 to a peak of 20% in June of
1981), and ushering in an extended period of high real interest
rates. Regulators and major industry players became aware of
the large overdrafts that were endemic in the banking systems
in the middle of the business day during this period, as the dis­
incentives for banks to leave idle cash reserves at the Federal
Reserve and correspondent banks began to grow.
With the opportunity cost of cash so high, major banks employed
aggressive cash management techniques to minimize their cash
balances on deposit. At the time, the Federal Reserve did not
pay interest on bank deposits and correspondent banks could
not pay interest on operating balances in demand deposit
accounts (both of which are now permitted). As a result, banks
actively managed their balances down to the minimums called
for by: (a) reserve requirement regulations (at their Federal
Reserve accounts); and (b) compensation arrangements for ser­
vices provided by correspondent banks. This often meant their
accounts were in a negative position during the day (hence the
terms intraday daylight and overdraft). Against this backdrop, the
Federal Reserve released a policy in 1985 that began the process
of containing, and eventually shrinking, daylight overdrafts in the
banking system.
There were two reasons why central banks were concerned
about daylight overdrafts. First, central banks wished to avoid
inadvertently extending credit to their member banks. If one
of the banks were to fail during the day when its account was
in a large deficit position, the central bank (and potentially
the taxpayers) would be on the hook for any losses. Second,
when viewed across the whole system, intraday overdrafts
Table 6.1 Relationship of U.S. Banks' Average Peak Intraday Overdrafts to M1 Money Supply
1986 1991
Peak Intraday Overdraft ($billions) 62.9 106.2
M1 Money Supply ($billions) 666.3 859.0
OD as % of M1 9.4% 12.4%
Data Source: Federal Reserve Board of Governors website (www.federalreserve.gov), money supply data.
120 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
were significantly expanding the effective money supply,
causing central bankers to worry that their policy actions could
be blunted or accentuated by this "shadow" money supply.
Table 6.1 compares the annual average peak intraday overdraft
(calculated system-wide) and the M1 money supply in five-year
snapshots beginning in 1986, when the Federal Reserve began
measurements. As Table 6.1 indicates, peak overdrafts routinely
approached 1 0 % or more of the money supply in those early
years. Conversely, in today's environment, which is character­
ized by low interest rates and accommodative monetary policy,
intraday overdrafts are much smaller, both in nominal terms and
in proportion to the M1 money supply.
The trend in aggregate intraday overdrafts illustrated in
Table 6.1 demonstrates the success of the Federal Reserve's
efforts to more effectively manage payment systems risk. As
mentioned earlier, in 1985, the Federal Reserve issued its first
policy addressing intraday credit, which focused on daylight
overdrafts incurred as a result of Fedwire funds transactions.
This policy sought to limit intraday overdrafts by requiring all
institutions that incurred intraday overdrafts in their Federal
Reserve Bank accounts to establish a maximum limit, called
a net debit cap, which was determined by a self-assessment
process, and required approval by the institution's board of
directors. Since then, the Board of Governors has continued
to expand and modify its payment systems risk policies by
introducing new tools and refining existing ones to reduce the
aggregate level of intraday overdrafts. Subsequent significant
revisions include:
• Extension of payment types beyond wire transfers to include
Automated Clearing House (ACH), Fedwire Securities Service
transfers, and off-shore dollar clearing (1985-1992).
• Assessment of a 24 basis point fee for intraday overdrafts in
excess of a deductible equal to 1 0 % of the institution's risk
based capital (1994).
• Increase in the fee for intraday overdrafts to 36 basis points
(1995).
• Expansion and enhancement of the Federal Reserve's Net
Settlement Services for private clearing and settlement
1996 2001 2006 2011 2013
67.4 99.4 140.0 29.4 16.6
1106.9 1140.2 1374.8 2009.6 2511.3
6 .1 % 8.7% 1 0 2. % 1.5% 0.7%
 systems, provided initially to Clearing House Interbank Risk (PSR) policy to adopt the CPSS-published Core Principles
Payments System (CHIPS) in 1981 (1999). for Systemically Important Payment Systems (the Core Princi­
• Acceptance of collateral to secure intraday overdrafts for a ples) , 3 and the Recommendations for Securities Settlement
select few institutions, enabling them to exceed their net Systems (RSSS) , 4 as the minimum standards for systemically
debit caps (the so-called "max cap") (2 0 0 1 ). important payment and securities settlement systems, respec­
tively. To this day, the Federal Reserve, Commodity Futures
• Increase in the fee for unsecured intraday overdrafts to
Trading Commission (CFTC), and the Securities and Exchange
50 basis points, along with the introduction of a zero fee
Commission (SEC) continue to incorporate the work of CPSS
for fully collateralized overdrafts. The Federal Reserve also
into their rulemaking and regulatory guidance.
adjusted net debit cap multiples, eliminated the deductible
amount, and increased the penalty fee to 150 basis points for CPMI has worked in conjunction with the Basel Committee on
institutions that do not have discount window access (e.g., Banking Supervision (BCBS), another committee of central bank
a government sponsored entity or Banker's Bank) and incur a experts that is part of BIS. BCBS began publishing guidance on
daylight overdraft (2008). managing liquidity risk in banking organizations in 1992 and has
been updating it periodically since. In response to the 2007-08
International interest in intraday liquidity risk began to acceler­
financial crisis, BCBS significantly expanded its work in liquidity
ate during the mid-1980s as well. In 1980, the central banks of
risk and began incorporating intraday liquidity risk into its
the Group of Ten (G10) countries established a working group
framework. In April 2013, BCBS published Monitoring Tools for
called the Group, of Experts on Payment Systems, which in 1990
Intraday Liquidity Management, a paper designed to help
became the Committee on Payment and Settlement Systems
regulators and banks track intraday risk more empirically. 5 The
(CPSS) and is now the Committee on Payments and Market
reader is encouraged to reference the various papers on
Infrastructures (CPMI), a committee of the Bank for International
liquidity risk management available on the BIS website. This
Settlements (BIS). The Group of Experts on Payments Systems
continuum of work demonstrates how the industry focus has
began compiling data on payments systems in the G10 coun­
evolved from identifying and understanding intraday liquidity
tries, which was first published by the BIS in 1985, and has con­
risk to measuring and managing it.
tinued as a series that has become known as "red books." In
1989, the Group of Experts on Payments Systems published the
Report on Netting Schemes, which focused on the efficiency of
6.2 USES AND SO U R CES
financial markets and payment systems, and the effects of net­
ting on counterparty credit and liquidity risks. 1 It is in this early O F INTRADAY LIQUIDITY
work that the Group of Experts on Payments Systems identified
This section provides an overview of the challenges faced
reduction of daylight overdrafts as an objective and driver of
by a bank treasurer in managing intraday liquidity risk and
netting arrangements.
enumerates the sources and uses of intraday funds for a typical
Most recently, the CPMI (which now consists of representation large bank.
from twenty-five central banks) has been focused on develop­
To understand how to better manage intraday liquidity risk,
ing, promulgating, and monitoring implementation of its
it is useful to start with an analysis of how daylight overdrafts
Principles for Financial Market Infrastructure, a set of standards
are created in the first place. The U.S. banking system starts
and policies designed to guide credit, liquidity, and systemic risk
and ends the day with plenty of cash on deposit at the Federal
management at payments, clearing, and settlement systems. 2
Reserve (nearly $1.5 trillion as of December 31, 2012, per the
Reflecting the influence of CPMI, the central banks of most
Federal Reserve's balance sheet). In fact, some level of depos­
developed countries around the world are striving to align their
its at the Federal Reserve is mandated by reserve requirement
regulations with the risk management principles espoused by
regulations. So, why do banks face a shortage of liquidity during
CPMI (formerly CPSS). In the United States, this first began in
the day? The answer is twofold.
2004, when the Federal Reserve modified its Payment System

CPSS. "Core Principles for Systemically Important Payment Systems."

1 Group of Experts on Payment Systems of the Central Banks of
the Group of Ten Countries. February 1989. http://www.bis.org/cpmi/
publ/d02.pdf.
2 CPSS. "Principles for Financial Market Infrastructures." April 2012.
http://www.bis.org/cpmi/publ/d101 a.pdf.
January 2001. http://www.bis.org/cpmi/publ/d43.pdf.
4 CPSS. "Recommendations for Securities Settlement Systems."
November 2001. http://www.bis.org/cpmi/publ/d46.pdf.
5 BCBS. "Monitoring Tools for Intraday Liquidity Management."
April 2013. http://www.bis.org/publ/bcbs248.pdf.

C h ap ter 6 Intraday Liquidity Risk M anagem ent ■ 121

First, certain market conventions and behaviors that have been
engrained over decades serve to institutionalize intraday over­
drafts. For instance, a bank can borrow fed funds in the inter­
bank market any time during the business day with delivery of
funds occurring almost immediately, but the return of borrowed
funds typically takes place as a first order item the following
morning. Even though the transaction is priced as a one-day
loan, in reality, the borrower has use of the funds for less than
twenty-four hours. The typical pattern is to borrow to cover
funding shortfalls in the afternoon, and return the funds at open­
ing of business the next day. Thus, a bank that is a net borrower
of fed funds may overdraft ifs Federal Reserve account during
the middle of the day after returning borrowed funds from the
previous day.
Another example is the settlement of positions at financial
market utilities (FMUs). Many (but not all) FMUs have one
settlement window, typically at the end of day, during which
bank participants settle their accounts with the clearinghouse
by transferring (or receiving) funds to (from) the clearing­
house accounts, which may be held at another bank or the
central bank. Let's assume that a bank participant is expect­
ing a large credit in its account from a clearinghouse at end
of day in conjunction with having sold a large block of securi­
ties. The bank likely would not be able to sell off or invest
those funds upon receipt at end of day. Rather than maintain
a large, un-invested balance overnight, it will prefer to have its
account in a deficit position until the credit is received from the
clearinghouse.
The second type of behavior that generates daylight overdrafts
is the provision of intraday credit to clients. Many banks allow
their corporate and institutional clients to deploy cash intraday
without sufficient funds in their accounts. For instance, a com­
mercial client may expect a large wire transfer to be received in
the afternoon but still wish to fund its payroll in the morning. In
another example, a bank that provides securities-related cus­
tody services may extend intraday credit by allowing its client to
purchase an asset prior to receiving credit for a maturing asset
or selling an investment later in the day. Banks establish daylight
overdraft lines of credit to help facilitate these transactions for
their clients and typically do not receive direct compensation for
doing so.
With all of this occurring, the funds management group of a
large bank's treasury has a difficult task in managing intraday
liquidity. A bank's cash position is impacted by literally thou­
sands of transactions per hour, both client- and bank-related
activity, much of it not known in advance by the treasury group.
Additionally, most banks do not have all of their cash position­
ing data in one system. They can monitor their central bank
122 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
accounts real-time (and often correspondent accounts) through
online account reporting tools, while other data resides in
systems managed by lines of business and operations. Table 6.2
contains the common uses of intraday liquidity. The list that
follows provides further explanation:
Outgoing wire payments, on
O u tg o in g w ire tra n sfe rs.
behalf of clients or the bank's own account, are typically
the largest use of intraday liquidity. Payment activity runs
the entire length of the business day and typically follows a
fairly predictable pattern. Some large banks have to care­
fully manage the volume of outgoing payments when their
daylight overdraft approaches the level of their debit cap.
This is accomplished by "throttling" outgoing payments and
closely monitoring incoming credits to ensure the cap is not
exceeded, 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 limits.
Most PCS systems have one
S e ttle m e n ts, at P C S sy ste m s.
settlement per day, with many occurring in the late after­
noon timeframe. This may serve as either a source or use of
funds depending on the net position of a participant on any
given day.
Banks manage the cash they
Fu n d in g of n o stro a cco u n ts.
place in correspondent bank accounts to a target average
monthly balance as part of the compensation provided to the
correspondent for its banking services. On any given day, the
account funding position may act as a source or use of funds
to the bank's overall liquidity profile, depending on the net
position of the activity flowing through the account that day.
Nostro account balances are replenished or drawn down on a
daily basis.
Some banking activities, such as
C o lla te ra l p le d g in g .
over-the-counter capital markets trading and deposits of
certain public funds, require a bank to earmark and set
aside collateral. Acquiring additional collateral to support an
increasing liability (or as a result of a mark-to-market induced
margin call) is a frequent use of intraday funding. Collateral
positions are adjusted on a daily basis.
Funding other balance sheet
A sse t p u rch a ses/fu n d in g .
assets, such as securities purchases for the investment
portfolio, client loans, and fixed asset purchases, is another
common use of intraday liquidity.
Fortunately for the bank treasurer, there are multiple sources of
intraday funding available. Each source varies in its contribution
to overall funding from day-to-day, but each is critical to the
overall funding landscape. Table 6.3 lists the common sources
 Table 6.2 Uses of Intraday Credit

Funding Requirement Description Impacted by Client Activity Impacted by Bank Activity Ability to Forecast

Outgoing Wire Transfers Payments on LVPS Yes, clients provide bank Yes, Bank Treasury and lines Bank activity can usually be
such as Fedwire and instructions of business have payment forecasted with 1 to 2 days' notice;
CHIPS needs client payment activity is more
difficult to predict
Settlements at Payment, Net cash settlements Not directly initiated by Yes, position monitored by Can be forecast for securities that
Clearing and Settlement at payments systems, clients, but includes client operations groups have multi-day settlements (e.g.,
(PCS) Systems clearinghouses activity T+3); more difficult for same day
settlement activity
Funding of Nostro Cash transfer to a Not directly initiated by Yes, position monitored by Securities settlements are generally
Accounts correspondent bank clients, but includes client operations groups predictable; client payment activity
for services provided activity flowing through correspondents is
less predictable

C h ap ter 6
Collateral Pledging Obtaining and Yes, some clients require Yes, banks are required to Dependent on trading volumes
earmarking of collateral to cover bank trad­ post collateral for margin and asset price changes, generally
collateral required by ing liabilities or deposits at FMUs or other trading known one day in advance
an outside beneficiary counter-Parties
Asset Purchases/Funding Exchange of bank cash Yes, clients can draw down Yes, assets may be securities Bank fixed asset activity should
for another asset such on lines of credit or letters for the bank's investment be known in advance; securities
as a client loan of credit portfolio or fixed assets purchases may be same day
settlement; client loans are more
difficult to predict

Intraday Liquidity Risk M anagem ent

■
123
 ro
-Ft

Table 6.3 Sources of Intraday Credit

Funding Requirement Description Client Activity Bank Activity Ability to Forecast

Cash Balances Deposits at the No, clients do not directly Yes, Bank Treasury Bank activity can usually be
central bank and at impact closing/start of day determines level of closing/ forecasted with 1 to 2 days' notice;
correspondent bank cash balances start of day cash balances client payment activity is more
nostro accounts difficult to predict
Incoming Funds Flow Incoming cash payments Yes, incoming client Yes, activities conducted Bank activity can usually be
and cash credits from payments are credited for the bank's business can forecasted with 1 to 2 days' notice;
FMU to the bank's accounts impact cash balances client payment activity is more
at the central bank and difficult to predict. FMU credit
correspondents can be forecast for securities that
have multi-day settlements (e.g.,
T+3); more difficult for same day
settlement activity
Intraday Credit Credit line or overdraft No, client activity does not Yes, counterparties will Some intraday credit facilities are
permitted during directly impact the amount often adjust intraday disclosed and well known to a bank
business hours and of intraday credit extended credit extensions to reflect (e.g., FRB net debit cap). Others
covered by close of to a bank business activity from other are not disclosed but can often be
business. Lines are areas of the bank (e.g., OTC inferred from historical data
often uncommitted trading)
and provided without
interest charges.
Liquid Assets Cash, money market Yes, client may be sources of Yes, bank trading and Liquid assets held in the investment
deposits, and short­ liquidity in converting liquid investment portfolio activity portfolio and in other money market
term government debt assets to cash (e.g„ repo can impact the amount of investments tend to have low volatil­
(e.g., T-Bills) which can transaction) liquid assets available. ity and as a result are predictable
be quickly converted to
cash
Overnight Borrowings Fed Funds, Eurodollar Yes, clients may be direct No, other Bank lines of Client supply of overnight borrowing
borrowing, overnight sources of liquidity for business do not regularly tends to be fairly predictable, but
deposits overnight borrowing (e.g.,. supply overnight funding with moderate volatility
overnight deposit)
Other Term Funding Other term deposits, Yes, clients may be direct No, other Bank lines of Client supply of term funding tends
repos from FHLB, money sources of liquidity for term business do not regularly to be fairly predictable, with low
market funds, etc. funding supply term funding volatility

Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
of intraday liquidity. The list that follows provides further Home Loan Banks (FHLB) borrowings, term repos) further
explanation: out on the maturity curve if the lenders are able to provide
funding at a time of day that meets the bank's intraday
The most obvious source of intraday liquidity
C ash b a la n ce s.
funding needs. Again, the bank would only do this if it
is the starting cash held on the bank's balance sheet at the
has the appetite for longer-term funding (one week, one
beginning of the day. This includes deposits at the central
month, etc.). This type of borrowing is generally viewed as
bank and at a correspondent bank's accounts.
an incremental factor to include in a given day's liquidity
Incoming flows from payments and
Incom ing fu n d s flow . positioning ledger rather than a consistent source of intra­
FMU settlements are the largest source of intraday funding day funding.
in periods of normal market function. Some inflows, includ­
The bank treasurer's challenge is to manage the cacophony gen­
ing LVPS payments, are real-time. Other credits are batch-
erated by high volumes of incoming and outgoing cash transac­
oriented, such as net settlements with clearinghouses, retail
tions (originated at multiple sources all over the bank) in a way
payments systems, etc.
that ensures the bank remains within the limits of its daylight
Central banks serve as a large source of
In trad ay cre d it: credit resources, and ends the day with the appropriate target
intraday credit for the banking system and their borrowing balances in its accounts. This challenge is exacerbated by sev­
terms vary across jurisdictions. The Federal Reserve provides eral factors.
an unsecured committed line of credit (in the form of its Net
The first factor is the variability of cash flow patterns. While
Debit Cap program) and charges interest for tapping the line.
many activities generate consistent patterns of inflows and
The Bank of England requires intraday overdrafts to be col­
outflows over time, there can be high levels of volatility day-
lateralized by the highest quality government securities, but
to-day with little advance notice of large cash requirements or
does not charge interest.
sources.
FMUs and other banks may also provide intraday credit.
The second factor is the impact of market forces. Daily volatility
Interbank daylight overdraft lines of credit are generally
in asset prices can result in unanticipated margin calls that
uncommitted and free, but there are some signs of change,
require additional cash funding. In addition, central bank money
especially in Europe. FMUs extend daylight credit by allowing
desks that implement monetary policy directly may influence
a participant to enter trades or transactions during the day
available liquidity in the marketplace, impacting a bank's ability
while potentially accumulating a large settlement position
to source or deploy intraday funds.
that must be met at end of day. The final section of this chap­
ter discusses multiple risk management tools used by FMUs The final factor is the lack of real-time data. Most bank
to mitigate these exposures. treasurers today do not have a comprehensive, single source
for real-time balances and expected transaction flows, which
Liquid a sse ts. Banks typically carry a buffer of highly liquid,
complicates the task of determining and forecasting cash
near-cask investments that can be liquidated for cash within
throughout the day.
short order. This pool of assets includes money market instru­
ments, time deposits, banker's acceptances, and high-quality,
short-term government debt.
Fed funds, London Interbank Offered
O v e rn ig h t b o rro w in g s.
Rate (LIBOR), and Eurodollar deposits are examples of over­
6.3 RISK M ANAGEM ENT,
night borrowings that can provide quick, intraday liquidity M EASU REM EN T AND M ONITORING
for a bank. These types of borrowings are not repaid on the TO O LS FO R FIN AN CIAL INSTITUTIONS
same day, so they will remain on the borrower's balance
sheet overnight. When determining whether or how much to This section provides an overview of the leading practices for
borrow overnight, the bank treasury must weigh the potential managing intraday liquidity risk at large banks.
cost of having excess liquidity at the end of the day against
the risk of not being able to complete the current day's busi­
ness (or facing reputational risk exposure from delayed trans­ Governance of Intraday LRM
actions) due to breaching a daylight overdraft limit.
All risk management frameworks start with a governance struc­
Similar to overnight borrowing, a
O t h e r te rm fu n d in g . ture that defines the roles and responsibilities of various bank
bank can tap into other funding sources (e.g., Federal employees and committees in overseeing risk-related activities.

C h ap ter 6 Intraday Liquidity Risk M anagem ent ■ 125

The following list provides characteristics of an effective gover­
nance structure for overseeing intraday liquidity risk:
In many institutions, intraday
A c tiv e risk m a n a g e m e n t.
liquidity risk is accepted as a cost of doing business and is
not as actively managed with the same level of rigor as other
types of enterprise risk or even other liquidity risks. The
leading banks with large volumes of PCS activities recognize
the criticality of understanding and working to reduce their
intraday liquidity risks. These institutions classify settlement
and systemic risks as components of their risk taxonomy,
and critically, incorporate them into the firm's risk appetite
framework.
Oversight of intraday
In teg ratio n w ith risk g o v e rn a n c e .
liquidity risk management is integrated into the bank's overall
risk oversight structure. This ensures that:
• The intraday liquidity risk management framework follows
the industry's three lines of defense model, with particular
emphasis on expertise in the second line of defense to
coordinate across the institution.
• Roles and responsibilities for all aspects of intraday liquid­
ity risk management in all lines of defense are clearly
defined.
• Treasury is the first line of defense, actively managing
the intraday and end-of-day funding positions of the
bank as well as the risk management programs related
to funding activities.
• Corporate Risk Management is the second line of
defense, responsible for overseeing funding-related
policy and procedures: advising in the development
of risk management programs, monitoring the ongo­
ing risk-taking activities across all of a bank's funding
desks, aggregating reporting across the bank, and
providing an independent view of the effectiveness of
the bank's overall intraday liquidity risk management
programs.
• Internal Audit is the third line of defense, responsible
for independently assessing the bank's adherence to its
intraday risk policies and procedures.
• Key decisions are made and reviewed by the appropriate
level of management.
• Oversight committees have the appropriate representa­
tion from the critical areas (e.g., treasury, operations, IT,
lines of business).
Risk a sse ssm e n t. At leading institutions, intraday liquidity risk
is incorporated into the risk taxonomy and is a component of
risk self-assessments. Through this analysis, settlement risks
related to existing and potential new products and opera­
tional processes are identified, measured, and evaluated. The
126 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
line of business and risk management review the effective­
ness of controls in mitigating settlement risk.
Risk m e a su re m e n t and m o n ito rin g . There are two perspec­
tives from which leading institutions monitor their intraday
liquidity risk: ( 1 ) the amount of intraday credit the institution
is extending to clients, and (2 ) the amount of intraday credit
the institution utilizes. For the first perspective, systemically
important financial institutions (SIFIs) with large transaction
banking and/or capital markets businesses have made sig­
nificant investments in recent years to upgrade their ability
to compile and monitor their clients' real-time cash positions.
This has historically been a significant challenge due to the
wide array of client activities that can impact cash accounts
and the batch-orientation of DDA and other feeder systems.
Banks with these capabilities are well positioned to pass on
the intraday over-draft charges they receive from central
banks onto clients, if the industry moves in that direction.
The second measurement perspective should provide a holistic
and comprehensive view of all intraday credit used by an institu­
tion. This is more challenging for several reasons:
• While many FMUs
A v a ila b ility of d ata fo r its cash a cco u n ts.
can provide useful statistics on intraday credit usage, not
all of them can provide real-time account position data,
especially in a way that can be captured and stored. Data
on intraday credit usage from correspondent banks is also
spotty.
• D ata a g g re g a tio n . Consolidating data into a single reposi­
tory that enables comprehensive analysis and monitoring
poses significant institutional challenges. Few banks have
made the investments required in technology infrastructure
to provide full, real-time position monitoring across all of
their PCS activities, in all markets, and in all of their lines of
business and subsidiaries.
Measurement of Intraday Liquidity
This subsection describes commonly used measures that are
useful for understanding and tracking bank intraday liquidity
risk. Many of these items were highlighted in the BCBS'
"Monitoring Tools for Intraday Liquidity Management. " 6 The
first set of measures is helpful for understanding the profile of
the institution's intraday flows. The second set of measures
provides ratios for monitoring risk levels. Institutions may wish
to set risk limits/thresholds, and perform ongoing monitoring
against these measures.
6 BCBS. "Monitoring Tools for Intraday Liquidity Management." April
2013. http://www.bis.org/publ/bcbs248.pdf.
Measures for Understanding Intraday
Flows
Total Payments
A bank and its intraday risk management teams should maintain
statistics concerning the amount of payments it makes on all
electronic payments systems in which it participates. For every
payment, a bank would store in a data warehouse the criti­
cal information needed for analysis, such as payment amount,
time received or originated, times for each processing step in
the payment workflow, routing information, payer and payee,
payment system used, any suspensions of the payment, and
so on. Compiling this information would allow a risk manager
to summarize the data for a variety of purposes, including, for
example, the following:
• Total payments sent and received for non-financial institution
clients
• Total payments sent and received for financial institution
clients
• Total payments sent and received for bank activity
• Net position in the settlement account at any time of day in
aggregate
• Net position in the settlement account at any time of day,
filtered by payment type
• Trend in payments volumes over time, for correlation analysis
Other Cash Transactions
A bank should also track its intraday and end-of-day settlement
positions at all financial market utilities in which it participates.
The bank should try to maximize the amount of transaction-
level detail captured and stored for further analysis. Securities
settlements networks (SSN), particularly those utilizing a central
counterparty (CCP) model, often manage their intraday and
overnight risk exposures through collateralization (discussed
in more detail in the next section). A bank participating in an
SSN should strive to capture snapshots of its account and col­
lateral positions throughout the trading day. For example, the
Federal Reserve uses one minute intervals for tracking collateral
positions.
Settlement Positions
If complete data to reconstruct account positions at any time
of day is not available, at a minimum a bank should maintain
data on its settlement positions with all its FMUs. These criti­
cal, deadline specific payments, often with large transaction
amounts, are critical to managing intraday liquidity and systemic
risk. A bank should monitor patterns in settlement positions and
C h ap ter 6
correlate them with external market factors to improve its ability
to predict upcoming liquidity requirements earlier in the day
Time Sensitive Obligations
Similar to settlement positions, these transactions require
completion at a specific time during the day. Examples include
transactions concerning market activities (such as the return
of borrowings), margin payments, and other payments criti­
cal to a bank's business or reputation (e.g., client closing on a
corporate acquisition). Failure to settle certain time sensitive
obligations could result in a financial penalty or other negative
consequences. A bank should monitor the volume and settle­
ment patterns of these time specific obligations by recording
the amounts and deadline times.
Total Intraday Credit Lines to Clients
and Counterparties
A bank risk manager looking after the bank's own intraday
liquidity risk needs to understand the potential and actual
amounts of intraday credit the bank is extending to clients and
counterparties. In some cases, these intraday credit lines could
be committed and disclosed to the client, but most are uncom­
mitted and undisclosed. In addition to the credit lines, the bank
should have data regarding average and peak usage, and the
ability to model activity at the client and portfolio levels.
Total Bank Intraday Credit Lines Available
and Usage
As demonstrated through the requirements for preparing
resolution plans, regulators increasingly expect financial institu­
tions to understand and manage the amount of systemic risk
they pose to the overall financial system (in addition to the risk
posed to taxpayers and industry-funded insurance plans). A key
component of that analysis is the amount of intraday credit that
a bank relies on in business-as-usual conditions and the maxi­
mum amount of intraday borrowing it can draw down. This data
captures the amount of committed and uncommitted intraday
credit (and usage thereof) the bank has at its disposal, ideally
across all of its cash and settlement accounts.
Measures for Quantifying and Monitoring
Risk Levels
Daily Maximum Intraday Liquidity Usage
This is a measure of the bank's usage of an intraday credit
extension. While many cash accounts can facilitate real-time
reporting, this calculation does not require real-time monitoring
of an account (provided the bank has the ability to recreate all
Intraday Liquidity Risk M anagem ent ■ 127
of a day's positions ex-post) to capture all of the negative posi­
tions. The measure is the ratio of the day's largest net negative
balance relative to the size of the committed or uncommitted
credit line. Typically, the peak and average of this metric is
tracked over a period of time (e.g., monthly).
At a minimum, this measure should be tracked for every cash
account held at the central bank, FMUs, and correspondent
banks. Ideally, a bank should also monitor its consolidated posi­
tion across all accounts between which liquidity can be readily
transferred intraday without restrictions in order to get a true
picture of its intraday liquidity usage. This is logically done for
accounts denominated in the same currency and connected to
a common payment system but can be done for multiple cur­
rencies and in different jurisdictions if cash and collateral can be
freely transferred between the jurisdictions intraday.
Intraday Credit Relative to Tier 1 Capital
This measure is a broad representation of the intraday settle­
ment risk posed by a bank. The measure should be tracked for
total intraday credit and unsecured intraday credit, available
and used, under the theory that posting high-quality collateral
mitigates intraday settlement risk. Available, unsecured intraday
credit relative to an institution's tier 1 capital is a rough measure
of the inadvertent systemic risk that the institution poses to the
financial system. Such measures, when viewed as, a time series,
as well as horizontally in comparisons to other institutions, pro­
vide bank risk managers with an understanding of the relative
systemic risk of their business model as well as changes in their
risk profile over time.
Client Intraday Credit Usage
This measure is derived by comparing a client's peak daily intra­
day overdraft to the established (committed or uncommitted)
credit line. Tracking aggregate intraday credit exposures pro­
vides a bank with an indicator of required liquidity needed to
support its clients' business activities. Monitoring the averages,
volatility, and correlation of these measures to other money
market indicators provides useful insights for understanding
how client activity impacts the bank's ability to manage its own
intraday liquidity.
Tracking client usage of intraday credit lines at the individual
client level enables risk managers to pinpoint clients that run fre­
quent overdrafts and determine if these clients need to change
their practices or if the bank needs to increase its charges for
this credit extension. Monitoring these measures over time can
provide indicators of the success of any initiatives undertaken
to modify client behavior in order to reduce reliance on intraday
credit. Finally, bank risk managers can use this data to inform
128 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
policies regarding the provision and size of intraday credit lines
relative to industry cohorts and client risk levels.
Payment Throughput
These measures track the percentage of outgoing payment
activity relative to time of day. For banks that are direct
participants in FMUs, it is useful to actively-measure and moni­
tor the flow of outgoing payment transactions relative to total
payments or time markers for several reasons: (1 ) to track its vol­
ume patterns and help ensure that all of the day's payments are
processed in time; (2) in some cases, to meet FMU requirements
for submitting a target percentage of payments by a deadline;
and (3) to help the bank identify and monitor its peak periods
over time and the correlation of this activity with its intraday
liquidity on hand and intraday credit usage.
In addition, a bank can track its peak intraday credit usage rela­
tive to total volumes with an FMU to provide an indicator of the
efficiency of the FMU's usage of daylight credit. FMUs employ
different system rules and operating models resulting in varia­
tions in how efficiently they use intraday liquidity. Understanding
these differences can enable a bank to redirect payment flows
as a tool to manage intraday liquidity needs, assuming it has the
requisite operational capabilities.
Role of Stress Testing
The previous indicators are important in understanding and
monitoring a bank's need for and use of intraday credit under
business-as-usual (conditions. However, intraday liquidity
requirements and usage patterns can change substantially dur­
ing periods of market stress. As a result, a bank that regularly
relies on intraday credit should have the ability to model the
impact of different events on its requirements and the avail­
ability of intraday liquidity (i.e., modeling the impact of differ­
ent scenarios on the indicators mentioned). While the banking
industry has historically developed effective stress tests of over­
all liquidity management that have been instrumental in devel­
oping liquidity contingency plans, the industry as a whole needs
to extend these capabilities to intraday position modeling.
(Regulators may push the industry to develop these capabilities
as the focus on intraday liquidity risk increases over time.
The process of stress testing of intraday liquidity risk manage­
ment can yield multiple benefits for a bank. As is typical in
stress testing exercises, the benefits are not just the empirical
results but, more importantly, the interactions and discussions,
brainstorming, and other critical thinking that senior manage­
ment engages in when working through the scenarios. Bringing
together the right set of people with subject matter expertise in
liquidity, risk management, client management, correspondent
banking, operations, and technology to think through the sce­
narios can be beneficial in yielding new insights and ideas.
Understanding how a proposed stress event might impact a
bank's positions and the behavior of other market participants
helps it to identify key vulnerabilities and their sensitivity to
external factors. Developing and modeling potential responses
to a stress event helps in formulating contingency plans and
playbooks for how a bank might respond to an event. Finally,
developing the technology infrastructure to support robust
modeling provides the institution with an extremely useful
capability for working through an actual crisis. This implies the
need for a data aggregation capability (either a data warehouse
or tools that can assimilate and transform data "on the fly")
with data updated frequently, ideally daily. In addition, the bank
would need tools that enable it to pull historical data, modify
the data with different sets of assumptions, and simulate a pro­
cessing day under those assumptions.
Banks should continuously build and expand the types of sce­
narios they can model in stress testing. In its April 2013 guid­
ance, the BCBS suggests that a bank have at least the following
four scenarios: 7
• O w n financial stre ss. A bank suffers or is perceived to be
suffering from, a stress event.
• C o u n te rp a rty stre ss. A major financial institution
counterparty suffers an intraday stress event which prevents
it from making payments.
• The customer bank of a correspondent
C u sto m e r stre ss.
bank suffers a stress event.
• M a rk e t-w id e cre d it or liq u id ity stre ss.
These four items can be thought of as stress categories as within
each one of these, a bank could develop multiple scenarios
with different characteristics. For example, in the "own finan­
cial stress" category, there could be different scenarios for a
deteriorating credit portfolio and an idiosyncratic operational
risk event that results in a large loss. Counterparty stress could
involve a trading partner, an FMU, or a correspondent bank
through which the bank routes payment and/or securities trans­
actions. Finally, a market-wide category could, for instance, have
scenarios for extremely tight honey market conditions, multiple
bank failures, widespread decrease in the market value of securi­
ties held as collateral, a very large corporate action, of opera­
tional failures.
7 BCBS. "Monitoring Tools for Intraday Liquidity Management." April
2013. http://www.bis.org/publ/bcbs248.pdf.
C h ap ter 6
BCBS guidance also encourages banks to develop reverse stress
testing capabilities, and testing other scenarios such as the
impact of natural disasters, currency crises, and so on.
6.4 RISK M ANAGEM ENT,
M EASUREM ENT, M ONITORING
TO O LS FO R FMUS
This subsection provides a high level overview of risk manage­
ment practices at FMUs. FMUs comprise payments systems,
securities settlement networks, exchanges, and central securities
depositories. There are a number of characteristics that render
each entity unique, including: clearing and settlement services
provided, ownership structure, membership and operating rules,
degree and nature of central bank involvement and support,
and risk management practices. As a result of this diversity, a
comprehensive discussion of FMU risk management practices
is beyond the scope of this book. However, a discussion of
intraday liquidity would be incomplete without a discussion
FMUs due to their importance in intraday funds manage­
ment. This subsection will provide a brief overview of FMU risk
management, and focus on selective risk practices observed in
the industry that are relevant to the discussion of intraday liquid­
ity risk.
Overview of FMU Risk Management
FMUs have long focused on how they would handle the failure
of one of their participants to complete its settlement obliga­
tions. FMUs have evolved to have several lines of defense in
managing participant risk.
The first line of defense is membership criteria. FMUs often
have size and creditworthiness criteria that constrain the pro­
files of direct members. In addition, some FMUs permit indirect
members which do not participate in the interbank payment
system itself, but rely on direct or "corresponding" members
to send their payments to the clearing system. In those cases,
the direct members are underwriting the risk of the indirect
participants.
While this approach allows FMUs to more easily apply credit risk
analysis to their counterparties, membership "tiering" poten­
tially introduces intraday settlement risks to the system. This
risk is particularly acute because of exposures between first-and
second-tier banks and the concentration of all payment activ­
ity at a smaller number of settlement banks. The particular risks
of tiering are: (1 ) the failure of a direct member affecting the
indirect members that are relying on it to handle their payments;
Intraday Liquidity Risk M anagem ent ■ 129
(2 ) other members may be hesitant to send payments to the
member clearing bank of a large, failing institution; and
(3) increased operational interdependence.
Recognizing these concerns, some FMUs have tried to reduce
their tiering. In 2010, the Bank of England made the reduction
of tiering in the Clearing House Automated Payment System
(CHAPS) one of its key risk reduction objectives. At the time,
CHAPS had only eighteen banks as direct members of the pay­
ment system. By comparison, Target2 had 8 6 6 direct members,
Fedwire had more than 7,000 direct members, and direct mem­
bership of the Hong Kong interbank payment system is compul­
sory for all licensed banks in the territory. Since then, CHAPS
has taken steps to encourage more members to join as direct
members by waiving new member fees and replacing its propri­
etary messaging system with Swift, as most banks already have a
Swift connection.
Monitoring the risks of their participants is the second line
of defense used by most FMUs. This can take several forms,
depending on the FMU and the risk level. Most EMUs have peri­
odic (annually or quarterly) reviews of their participants' financial
statements to ensure maintenance of minimum capital levels
and other financial guidelines that are stipulated in the member­
ship rules. Some FMUs require submission of monthly financial
statements for the direct member legal entity (e.g„ the broker-
dealer sub of a large bank).
In addition to the financial conditions of the participants, FMUs
also monitor their participants' settlement positions and mar­
gin collateral. Securities settlement networks have monitoring
programs that, during their overnight cycle (some are more fre­
quently), recalculate the risk potential and the collateral values
of each participant's account to ensure the bank has sufficient
margin posted.
When an FMU is concerned about the default risk of one of its
members, there are several risk mitigation actions it may con­
sider to reduce intraday settlement risk. For example:
• Securities settlement networks that run risk margining may
decide to run cycles several times per day for higher risk par­
ticipants. This means the FMU may make an intraday margin
call, requiring additional collateral from the participant pursu­
ant to changes in its risk and collateral positions.
• A payment system may reduce a member's net debit cap
(which is essentially an intraday credit line), or require a par­
ticipant to pre-fund its account and not permit it to run intra­
day overdrafts.
• An FMU may require a participant to post additional collat­
eral, or post a letter of credit or performance bond from a
third party institution to backstop its credit risk.
130 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The third line of defense for many FMUs is a mechanism to
facilitate settlement in the event of a participant failure. This is
accomplished by mutualizing the default risk, thereby dispers­
ing credit risk and potential losses, across a broad number of
entities. FMUs commonly build risk mutualization provisions
into their operating rules to ensure than any realized losses do
not result in an interruption of service. The operating rules are
intended to establish a process by which a failed participant's
positions can be quickly, covered and settled so that the FMU
can re-open for normal activity.
Risk mutualization can take several forms. Many FMUs (particularly
those employing a CCP model) utilize a "guarantee" fund (also
commonly; referred to as a default or settlement fund). Guaran­
tee funds are prefunded pools of cash and highly liquid assets
reserved for the potential failure of one or more participants. This
typically requires participants to contribute cash to an asset pool,
with the amounts based on their volumes or risk levels. If a partici­
pant fails with a debit that cannot be fully covered by its margin
collateral, then the FMU would draw on the guarantee fund to
settle the failed participant's positions and then allocate the losses
back to the remaining participants. Each participant would then
need to replenish its contribution to the guarantee in order to
resume a normal level of trading the next day.
Similarly, the involvement of a central bank in underwriting
PCS activities could be considered risk mutualization due to
the central bank's ability to pass on losses to governments and
ultimately taxpayers. This model is frequently observed with
LVPSs that are operated by the central bank. In order to achieve
immediate finality of payment (meaning the payment is final
when the amount is credited to the participant's account), many
central banks underwrite all of the participant credit risk on their
national LVPS. This is the model used by the Federal Reserve for
Fedwire.
FMU Tools to Manage Intraday
Settlement Risk
As mentioned above, the second line of defense for an FMU is
monitoring the risk exposures of its participants. For its highest
risk exposures, an FMU typically monitors the participant's set­
tlement requirements on a real-time, intraday basis. FMUs use
several tools to monitor and manage these intraday exposures
and to assist their participants with their own intraday liquidity
risk management.
Net Debit Caps
Many FMUs utilize a net debit cap to limit their risk exposure
to a single participant. A net debit cap constrains the size of a
negative position in a cash account, typically suspending further
transactions until additional liquidity is added to the account.
Net debit caps are standard at large value payment systems,
and used at other types of FMUs as well. In managing a deterio­
rating credit risk situation, an FMU may reduce or even eliminate
a participant's net debit cap, requiring the participant to provide
more liquidity to settle its positions.
Collateral
Cash or securities collateral is a key component for FMU risk
management. As with net debit caps, in a deteriorating credit
situation, an FMU may begin to monitor a participant's risk posi­
tion and its initial and variation margin collateral values in real­
time to ensure sufficient coverage. Depending on a number of
factors, the FMU may require a participant to adjust its collateral
position by modifying the acceptable composition of collateral,
advance rates on certain securities, and concentration limits.
Liquidity Savings Mechanism
FMUs have to balance their risk management considerations
with their business objectives of minimizing cost and maximiz­
ing value to participants. Many FMUs have developed inno­
vative ways to clear and settle transactions that reduce the
overall operating liquidity required by the system (i.e., liquidity
savings mechanism). These tactics essentially increase transac­
tion throughput for a given amount of liquidity. This achieves
both objectives by reducing the size of settlement positions
(and settlement risk) and minimizing the cost of idle liquid­
ity for a participant. Examples of liquidity savings mechanisms
include transaction netting (bilateral and multilateral), net credit
caps (which may suspend transactions to a participant until
they provide more outgoing liquidity), transaction throughput
requirements (e.g., requiring a certain percentage of outgoing
transactions to be submitted by a mid-day deadline), transac­
tion prioritization capabilities, and intra-system lending (e.g.,
securities lending).
Settlement Windows
Some FMUs have established settlement deadlines in a way
that reduces intraday liquidity risk. Instead of having one
consolidated settlement position, typically at end of day, some
FMUs have staggered multiple settlement windows throughout
the day. This can be achieved by having individual settlement
times for specific asset classes or currencies.
Contingent Liquidity
FMUs maintain backup credit lines from both commercial banks
and central banks to be able to provide liquidity in a crisis
C h ap ter 6
situation. These lines are not used under business-as-usual
conditions and are only maintained for emergencies.
CO N CLU SIO N
While initial management efforts concerning intraday liquidity
risk date back to the 1980s, the 2007-08 financial crisis high­
lighted a number of deficiencies in industry practices and led to
more rigorous research efforts and industry focus on this area.
It is fair to say that, across the financial services industry, under­
standing intraday liquidity risk and developing tools to man­
age it remain works in progress. While some banks and FMUs
exhibit leading-edge capabilities, in general, industry partici­
pants need to make significant investments to enhance their risk
management frameworks, systems, and data management to
truly understand their intraday liquidity risk profile and be able
to manage that risk during periods of market stress. With the
implementation of Basel III, regulators are increasingly focused
on liquidity risk in general and have signaled their intent to
ensure that banks include intraday liquidity risk in their liquidity
risk programs. As a result, this will be an exciting area of bank­
ing to watch over the next few years.
G LOSS ARY
This section provides definitions for key terms that are frequently
used in discussions of intraday liquidity risk management.
D
Daylight Overdraft (DOD)
Daylight overdraft, also referred to as intraday overdraft (IOD),
refers to a cash account with a negative cash position during
the business day. This results when the cumulative amount of
debit transactions posted to the account exceeds the sum of the
opening balance plus posted credit transactions
F
Financial Market Utility
An organization whose purpose is to process and settle
payments and securities transactions; these entities are also
referred to as Financial Market Infrastructure (FMI) or Value
Transfer Networks (VTNs). This includes:
• Wholesale payments systems, such as wire transfer networks,
also referred to as Large Value Payment Systems (LVPSs)
• Retail payment systems, typically low value transfer networks
settling large numbers of transactions such as automated
clearinghouses and credit card networks
Intraday Liquidity Risk M anagem ent ■ 131
• Trade execution facilities, such as exchanges
• Securities settlement networks (SSNs), including clearing and
settlement networks
• Central securities depositories (CSDs) that hold book-entry
issued assets
Some FMUs are referred to as central counterparties (CCP). In
this model, which is used frequently for securities settlements,
an FMU inserts itself as a legal intermediary in the transaction,
centralizing the counterparty credit exposure of settling
transactions in a single entity. CCPs net and clear exchange and
OTC-based trading securities transactions, often handing off to
a CSD for final settlement.
I Financial institutions of significant size that provide market-
Intraday Liquidity
Cash funding which can be accessed at any point during the
business day to enable banks to continue processing transac­
tions; this can include the interbank funds markets, wholesale
money markets, and intraday credit lines provided by central
banks or FMUs.
Intraday Liquidity Risk
The risk that a bank or FMU is unable to meet a payment or
settlement obligation at the expected time due to inadequate
liquid funds (cash); also known as settlement risk
N credit extensions made in the ordinary course of business (such
Net Debit Cap
A risk management tool utilized by providers of intraday liquid­
ity to limit their risk exposure; a debit cap constrains the size
of a negative position in a cash account, typically suspending
further transactions until additional liquidity is added to the
account.
Netting/Net Settlement
The process of offsetting obligations between two or more
banks, which reduces the size of final settlements and intraday
liquidity risk; "bilateral" netting occurs between two banks;
"multilateral" netting occurs on a payments or securities settle­
ment system.
Nostro Account
A cash account maintained by a bank outside of its home mar­
ket at another correspondent bank to support payments and/or
securities transactions in that market.
132 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
P
Payment Finality
Refers to the point at which the value (payment) received by a
beneficiary becomes final and cannot be reversed for any rea­
son. This is the point which the beneficiary has full, irrevocable
ownership of the value transferred.
Payments, Clearing, and Settlem ent Services (PCSs)
PCS is used to describe a broad range of services that support
funds transfers, securities transfers, foreign exchange transac­
tions, trade execution, and derivative transactions.
S
Systemically Important Financial Institutions (SIFIs)
critical services are generally defined as systemically important.
In general, the label if implies that the failure of a SIFI has the
potential to spread loss and market distress to other institutions
by nature of the SIFI's size and interconnectedness.
Systemic Risk
The risk of simultaneous failure of multiple participants in a
financial system or market; systemic risk generally refers to a
"contagion effect" in which the failure of a single entity has a
cascading effect, causing multiple subsequent failures because
of the amounts owed by the first failed entity to other partici­
pants. Exposures to the failed entity can be either deliberate
as loans, trading activity, balances related to correspondent
banking) or inadvertent or unforeseen credit exposures.
Inadvertent exposures could arise, for example, as a result of
the allocation to a solvent bank of credit losses pursuant to the
loss sharing arrangement of an FMU. In fact, one could argue
that all intraday settlement risks exposures are inadvertent in the
sense that they are viewed as a cost of doing business and not
a risk exposure for which a bank is being directly compensated.
One of the objectives of managing intraday liquidity risk is to
minimize or eliminate inadvertent credit exposures.
T
Time Critical Payment
A payment obligation that is due at a specific time during the
day such as a clearinghouse settlement deadline or a client
payment required to close on a financial transaction (e.g., a
mortgage loan or an acquisition of a company).
Monitoring
Liquidity
Learning Objectives
After completing this reading you should be able to:

Distinguish between deterministic and stochastic cash Interpret the term structure of expected cash flows and
flows and provide examples of each. cumulative cash flows.

Describe and provide examples of liquidity options, and Discuss the impact of available asset transactions on cash
explain the impact of liquidity options on a bank's liquidity flows and liquidity generation capacity.
position and its liquidity management process.

Define liquidity risk, funding cost risk, liquidity generation

capacity, expected liquidity, cash flow at risk.

Excerpt is Chapter 6 of Measuring and Managing Liquidity Risk, by Antonio Castagna and Francesco Fede.
7.1 A TAXO N O M Y O F CASH FLOW S
The identification and taxonomy of the cash flows that can occur
during the business activity of a financial institution is crucial to
building effective tools to monitor and manage liquidity risk.
Many classifications have been proposed (see, amongst others,
[8 6 ]; a good review is [107]). The taxonomy we suggest, not
too different from the others just mentioned, focuses on two
main dimensions: time and amount; it is sketched in Figure 7.1.
Like any other classification, this one also depends on the refer­
ence point of view. More specifically, in our case, we classify
cash flows by considering them from a certain point in time; for
example, cash flows may fall in one of the categories we will
present below when we look at them from, say, today's point of
view of. They can also change category when we shift the point
of view in some other date in the future.
The first dimension to look at, when trying to classify future
cash flows, is time: cash flows may occur at future instants that
are known with certainty at the reference time (e.g., today), or
they may manifest themselves at some random instants in the
future. In the first case we say that, according to the time of
their appearance, they are deterministic. In the second case we
define them as stochastic (again, according to time).
reference time, or alternatively their amount cannot be fully
determined. For the amount, the main distinction will be
between deterministic cash flows, if they fall in the first case, or
stochastic cash flows, if they belong to the second case. Classi­
fication according to the amount, though, can be further broken
down such that subcategories can be identified.
Moreover, when the amount is deterministic, cash flows can be
labelled simply as fixed as a result of being set in such a way by
the terms of a contract.
When the amount is stochastic, it is possible to recognize four
possible subcategories labelled as follows: credit related when
amount uncertainty can be due to credit events, such as the
default of one or more of the bank's clients; indexed/contingent,
when the amount of cash flows depends on market variables,
such as Libor fixings; behavioural, when cash flows are depen­
dent on decisions made by the bank's clients or counter-parties:
these decisions can only be loosely predicted according to
some rational behaviour based on market variables and some­
times they are based on information the bank does not have;
and, finally, the fourth subcategory is termed new business: in
which cash flows originated by new contracts that are dealt in
the future and more or less planned by the bank, so that their
amount is stochastic.

The second dimension to consider is the amount: cash flows Based on the classification we have introduced, we can pro­
may occur in an amount that is known with certainty at the vide some examples of cash flow, with the corresponding
category they belong to, according to the
time/amount criterion. The examples are also
Time shown in Figure 7.1.

Deterministic Stochastic Let us begin with deterministic amount/deter-

J
ministic time cash flows: they are typically related
r
to financial contracts, such as fixed rate bonds or
Risk-free Fixed Rate Bonds Pay-out of a one touch option
Coupons when barrier is hit fixed rate mortgages or loans. These cash flows
Capital Am ortisation of W ithdrawals by the Bank are produced by payments of periodic interests
Risk-free Fixed Rate from credit lines received
Mortgage (e.g., every six months) and periodic repayment
y V. of the capital instalments if the asset is amortiz­
Recovery of NPV on client's
ing. It should be noted that not only bonds or
Credit default loans held in the assets of the bank generate
Related Missing cash-flow after client's
default these kinds of cash flows, but also bonds issued
o and loans received by the bank held in its liabili­
E • Risk-free Floating- Rate Bond Pay-out on an Am erican
< Indexed / Coupons option's exercise ties. Moreover, when considering assets, that
U Contingent • Pay-out of a European O ption's
•
+
■ »
if) Exercise cash flows belong to the fixed amount/deter-
CD J
U Withdrawals from deposits ■'N
ministic time category can only be ensured if the
O
■
H Withdrawals of credit lines to
to Behavioural client obligor, or the bond's issuer, is risk free, so that
Prepayments of mortgages
Prepayment of deposits _y
credit events cannot affect the cash flow sched­
ule provided for in the contract.
New New Debt Issuance by the Bank New deposits
Business New loans
Renewal of Expiring Contracts New assets Deterministic amount cash flows can also occur
J V at stochastic times, either because the con­
Fiaure 7.1 Taxonomy of the cash flows. tract can provide for a given sum to be paid

134 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
or received by the bank, or because the amount depends on a
choice made by the bank. An example of the first kind of cash
flow can be represented by the payout of one-touch options: in
fact, the buyer of this type of option receives a given amount
of money when the underlying asset breaches some barrier
level, from below or from above. The time is unknown from the
reference instant, but the amount can easily be deducted from
the contract's terms. An example of cash flows that depend on
the bank's decisions can be represented by the positive cash
flows originated by the withdrawals of credit lines received by
the bank. In this case, the amount can safely be assumed to be
some level between 0 and the limit of the credit line chosen by
the bank depending on its needs, but it can occur at any time
until the expiry of the contract, since liquidity needs may arise at
some stochastic time.
Shifting the analysis to the stochastic amount category, we first
identify credit-related cash flows that are due to the default of
one or more clients, so that once the default time is fixed, their
amount can be implied. The default time is obviously not known
at the reference time, so that the time when these cash flows
occur is stochastic. An example can be represented by the miss­
ing cash flows, after the default, of the contract stream of fixed
interests and of capital repayment of the loan. A missing cash
flow may be considered a negative cash flow that alters a given
cash flow schedule: if a loan, for example, is fixed rate amortiz­
ing, then we have a modified cash flow schedule on the contract
interest rate and capital repayment times. Moreover, the recovery
value after default can be inserted in this category of cash flows.
Stochastic amount cash flows we can also be indexed/contin-
gent (i.e., linked to market variables). Examples of such cash
flows are, amongst others, floating rate coupons that are 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. In these the time of the occurrence
of cash flows is known (the coupon payment, the exercise date),
but there may also be indexed/contingent cash flows that can
manifest at stochastic times. Examples are the payout of Ameri­
can options, both when the bank is long or short them, because
the exercise time is stochastic and depends on future market
conditions that determine the optimality of early exercise.
Again, here we have to stress that we are referring to contracts
whose counterparty to the bank is default risk free.
Anther type of stochastic amount cash flow is behavioural; for
example, when a bank's clients decide to prepay the outstand­
ing amount of their loans or mortgages. In this case the bank
may compute the prepaid amount received on prepayment:
the prepayment time cannot be predicted with certainty by the
bank, so that the time when the cash flows occur is stochastic
in this case. Missing cash flows with respect to the contract
schedule can be determined once prepayment occurs. If the
prepaid mortgage, as before, is fixed rate amortizing, then we
have a modified cash flow schedule on the contract interest rate
and capital repayment times.
Other behavioural cash flows, befalling at stochastic times, are
those originated by credit lines that are open to clients: with­
drawals may occur at any time until the expiry of the contract
and in an uncertain amount, although within the limits of the
line. Withdrawals from sight or saving deposits belong to this
category too.
Finally, we have stochastic amount cash flows related to the
replacement of expiring contracts and to new business activity.
For example, the bank may plan to deal new loans to replace
exactly the amount of loans expiring in the next two years,
and this will produce a stochastic amount of cash flows since it
is unsure whether new clients will want or need to close such
contracts. Old contracts expire at a known maturity so that cash
flows linked to their replacement are known as well. Moreover,
the new issuance of bonds by the bank can be well defined
under a time perspective, but the amount may not be com­
pletely in line with the plans.
By the same reasoning, the evolution of completely new con­
tracts may not follow the pattern predicted in business develop­
ment documents, so that related cash flows are both amount
and time stochastic. For example, new retail deposits, new, mort­
gages and new assets in general may be only partially predicted.
In general, cash flows due to new business, or to the rollover of
existing business, are quite difficult to model and to manage.
7.2 LIQUIDITY OPTIONS
Some of the categories of cash flows described above are con­
nected with the exercise of so-called liquidity options. These
kinds of options are conceptually no different from other
options, yet the decision to exercise them depends on their
particular nature.
More specifically, a liquidity option can be defined as the right
of a holder to receive cash from, or to give cash to, the bank at
predefined times and terms. Exercising a liquidity option does
not directly entail a profit or a loss in financial terms, rather it is
as a result of a need for or a surplus of liquidity of the holder.
This does not necessarily exclude linking the exercising of a
liquidity option to financial effects; on the contrary, such a link
is sometimes quite strong: this is clear from the examples of
liquidity options we provide below.
Comparing these options with standard options usually traded
in financial markets, the major difference is that the latter are
C h ap ter 7 Monitoring Liquidity ■ 135
exercised when there is a profit, independently of the cash
flows following exercise, although typically they are positive.
For example, a European option on a stock is a financial option
that is exercised at expiry if the strike price of the underlying
asset is lower than the market price. The profit can immediately
be monetized by selling the stock in the market so that the
holder receives a positive net cash flow equal to the difference
between the strike price (paid) and the sell price (received).
Alternatively, options may be exercised and the stock not
immediately sold in the market, so that only a negative cash
flow occurs: this is because the holder wants to keep the stock
in her portfolio, for example, and it is more convenient to buy
it at the strike price instead of the prevailing market price. The
convenience to exercise is then independent of the cash flows
after exercise.
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. For
example, consider the liquidity option that a bank sells to a cus­
tomer when the bank opens a committed credit line: the obligor
has the right to withdraw whatever amount up to the notional of
the line whenever she wants under specified market conditions,
typically a floating rate (say, 3-month Libor) plus a spread, that
for the moment we consider determined only by the obligor's
default risk. The option to withdraw can be exercised when it
also makes sense under a financial perspective; for example,
if the spread widened due to worsening of the obligor's credit
standing: in this case funds can be received under the contract's
conditions (which are kept fixed until expiry) and hence there
is a clear saving of costs in terms of fewer paid interests on the
line's usage rather than opening a new line. On the other hand,
the line can be used even if the credit spread shrinks, so that
it would be cheaper for the obligor to get new funds in the
market with a new loan, but for reasons other than financial con­
venience it chooses to withdraw the needed amounts from the
credit line.
Another example of a liquidity option is given by sight and sav­
ing deposits: the bank's clients can typically withdraw all or part
of the deposited amount with no or short notice. The withdrawal
might be due to the possibility to invest in assets with higher
yields more than compensating for higher risks, or it might be
due to the need of liquidity for transaction purposes. So, even in
this case there may exist some financial rationale behind exercis­
ing a liquidity option, but it can also be triggered by many other
different reasons that are hardly predictable, or can be forecast
on a statistical basis.
Exercising a liquidity option can also work the other way round:
the bank's client has the right to repay the funds before the
136 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
contract ends. Although the bank would benefit in this case
from the greater amount of liquidity available, economic effects
are usually negative and thus cause a loss. An example is given
by the prepayment of fixed rate mortgages or loans: they can
be paid back before the expiry for exogenous reasons, often
linked to 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 current mar­
ket conditions if the interest rate falls. In the first case the bank
would not suffer any loss if market rates rose or stayed constant,
on the contrary it could even reinvest at better market condi­
tions 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.
In the end, although liquidity options can be triggered by fac­
tors other than financial convenience, the effect on the bank can
be considered twofold:
1. A liquidity impact on the balance sheet, given by the
amount withdrawn or repaid.
2. A (positive or negative) financial, impact, given by the dif­
ference between the contract's interest rates and credit
spread and the market level of the same variables at the
time the liquidity option is exercised, applied on the with­
drawn or repaid amount.
Sometimes the second impact is quite small, as, for example,
when a client closes a savings account: the bank's financial loss
is given in this case by the missing margin between the con­
tract 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. The liquidity impact, on the other hand, can be quite sub­
stantial if the deposit has a big notional.
While the financial effects of liquidity options can be directly,
although partially, hedged by a mixture of standard and statisti­
cal techniques, the liquidity impact can only be managed by
the tools that we analyse in the following. These tools, loosely
speaking, involve either cash reserves or a constrained allocation
of the assets in liquid assets or easy access to credit lines (i.e.,
a long position in liquidity options for the bank). All of these
imply costs that have to be properly accounted for when pric­
ing contracts to deal with clients, so that models to price long
and short liquidity options have also to be designed. Since, as
shown above, liquidity options also produce financial profits
or losses when exercised, so that they can also be seen under
some respects as financial options, models must jointly consider
liquidity and financial aspects.
7.3 LIQUIDITY RISK
Risk is always related to uncertainty about the future: this may
turn out to be more favourable than initially expected or, on
the contrary, more adverse than forecast. Although positive
and negative outcomes should be balanced, in practice it is the
adverse unexpected states of the world that is of interest. Bear­
ing this in mind, a very general definition of liquidity risk for a
financial institution is the following.
Definition 7.3.1 (Liquidity risk). The event that in the future
the bank receives smaller than expected amounts of cash flows
to meet its payment obligations.
We have analysed the different kinds of liquidity concepts and
related risks. Definition 7.3.1 encompasses both funding liquid­
ity risk and market liquidity risk. In fact, if a bank is not able to
fund its future payment obligations because it is receiving less
funds than expected from clients, from the sale of assets, from
the interbank market or from the central bank, this risk may
produce an insolvency situation if the bank is absolutely unable
to settle its obligations, even by resorting to very costly alter­
natives. Market liquidity risk according to the definition above
is the result of the inability to sell assets, such as bonds, at fair
price and with immediacy, and leads to a situation in which
the bank receives smaller than expected amounts of positive
cash flows.
at Figure 7.2, which shows the rolling series of the CDS Itraxx
Financial spread. We use this as a proxy for funding spread over
the risk-free curve for top European banks on a 5-year maturity.
As is manifest, the spread was almost constant and low until
2007 (the outbreak of the subprime crises in the US). This means
that banks were considered virtually default risk free and fund­
ing costs, meant as the spread over the risk-free curve, had a
very limited effect on the profitability of banks.
Moreover, it should be stressed that in such a constant low-
spread environment, the rollover of the bank's liabilities that
expire entails negligible risk in terms of unexpected spread
levels. This combined with abundant liquidity such that the
quantity of funding available was in practice without relevant
limits, banks were able to decide how to finance their assets as
they preferred; the rollover of maturity was an almost risk-free
activity. For these reasons, trying to predict funding costs was
a futile exercise and their inclusion in the pricing of contracts
was straightforward.
Since the middle of 2007, financial institutions have no longer
been able to always raise funds at low spreads: the volatility
of spreads even over interbank market rates (e.g., Libor) dra­
matically increased, and the amount of funding available in the
capital market declined, at least for the banking sector. As a
consequence of these two reasons, the funding policy of banks
is now subject to constraints so as to abate the average funding

The risk dimension considered in Defini­

tion 7.3.1 refers to the quantity of flows, 600
so we call this quantitative liquidity risk.
Nonetheless, we claim that another
risk dimension for liquidity should be
considered: the cost of liquidity, or cost
of funding, and the related risk can be
400
defined as follows.

Definition 7.3.2 (Funding cost risk).

The event that in the future the bank 300
has to pay greater than expected cost
(spread) above the risk-free rate to
receive funds from sources of liquidity
that are available.

This can be defined as cost of liquid­

ity risk or cost of funding risk. Not too
much attention has been paid to the
modelling of funding cost risk, although
02/01/2006 02/01/2007 02/01/2008 02/01/2009 02/01/2010 02/01/2011 02/01/2012
in the past it was always recognized as
such but deemed to have little impact Fiaure 7.2 CDS Itraxx Financial rolling series from September 2004 to
on banking activity. The reason for this is September 2011.
quite simple to understand if one looks Source: Market quotes from major brokers.

C h ap ter 7 Monitoring Liquidity ■ 137

cost, reduce rollover risk (regarding both the quantitative and
risk dimension) and hence make credit intermediation activity
still a profitable business.
The conclusion we can draw from this is that modern liquidity
risk management must consider both the quantitative dimen­
sion and the cost dimension as equally important and robust
modelling must be developed for the two dimensions. We can
synthesize both dimensions of liquidity risk in the following com­
prehensive definition.
Definition 7.3.3 (Liquidity risk). The amount o f economic
losses due to the fact that on a given date the algebraic sum
of positive and negative cash flows and of existing cash avail­
able at that date, is different from some (desired) expected
level.
This definition includes a manifestation of liquidity risk as:
1. Inability to raise enough funds to meet payment obliga­
tions, so that the bank is forced to sell its assets, thus caus­
ing costs related to the non-fair level at which they are sold
or to suboptimal asset allocation. The complete inability to
raise funds would eventually produce an insolvency state for
the bank. These costs refer to the quantitative dimension of
liquidity risk.
2. Ability to raise funds only at costs above those expected.
These costs refer to the cost dimension of liquidity risk.
3. Ability to invest excess liquidity only at rates below those
expected. We are in the opposite situation to point 2,
and it is a rarer risk for a bank since business activity usu­
ally hinges on assets with longer durations than liabilities.
These (opportunity) costs also refer to the cost dimension of
liquidity risk.
7.4 QUANTITATIVE LIQUIDITY
RISK M EASURES
We introduce a set of measures to monitor and manage quantita­
tive liquidity risk. These measures aim at monitoring the net cash
flows that a bank might expect to receive or pay in the future and
ensure that it stays solvent. Cash flows, however, classified accord­
ing to the taxonomy above are produced by two classes of
factors.
Definition 7.4.1 (Causes of liquidity). All factors referring to
existing and forecast future contracts originated by the ordinary
business activity of a financial institution can be considered as
the causes of liquidity risk. Cash flows generated by the causes
of liquidity can be both positive and negative.
The other class of factors is given by Definition 7.4.2.
138 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Definition 7.4.2 (Sources of liquidity). All factors capable of
generating positive cash flows to manage and hedge liquidity
risk and can be disposed of promptly by the bank determine
the liquidity generation capacity (defined in the following) of the
financial institution.
First we set the notation. Let us indicate with cfg(t0, t() = E[cf+(t0, t,)]
the sum of expected positive cash flows occurring at time
tj from the reference time t0. Similarly, we indicate by
cf“ (t0, tj) = E[cf~(t0, t,)] the sum of expected negative cash flows
occurring on the same date.
We analysed above the different categories of cash flows and
saw that many are stochastic in terms of the amount or time
of occurrence or both. This is the reason we have stressed the
fact that the sum of cash flows, either positive or negative, is
just expected. On the other hand, if cash flows are expected,
this also means that their distribution at each time should be
determined so as to recover measures other than the expected
(average) amount, to increase the effectiveness of liquidity man­
agement. We will come back to this later on, but for the moment
we can formally define the positive and negative cash flows for
the set of contracts and/or securities {d-1, d z ,. . . , d^} as:
N
cfe(to/ T) = E 2 cf+(to, dii (7.1)
L ;= 1
and similarly
N
cfe(t0, tj) = E 2 cf (f0' U dj)
L;=1
(7.2)
Assume we are at the reference time tg: we define by CF(tg, tj)
the cumulative amount of all cash flows starting from date ta up
to time tb:
b
CF(tg, ta, tb) = ^ (eft(t0, tj) + Cf;(tg, tj)) (7.3)
i= a
Expected cash flows and cumulated cash flows allow us to con­
struct the basic tools for liquidity monitoring and management:
the term structure of expected cash flows.
7.4.1 The Term Structure of Expected
Cash Flows and the Term Structure
of Expected Cumulated Cash Flows
The term structure of expected cash flows (TSECF) can be
defined as the collection, ordered by date, of positive and
expected cash flows, up to expiry referring to the contract with
the longest maturity, say tb:
TSECCF(tg, tb) = {cfg(tg, to), cf;(tg, tg), cf+(tg, t^, cf^tg, t^, . . . ,
Cfe(t0/ %), Cf;(tg, tb)} (7.4)
At the end of the TSECF, with an indefinite expiry correspond­ Table 7.1 Assets and Liabilities Reclassified
ing to the end of business activity, there is reimbursement of According to Maturity
the equity to stockholders. TSECF is often referred to as the
Expiry Assets Liabilities
maturity ladder: we reserve this name for the initial part, up
to one-year maturity, of the TSECF. It is also standard practice 1 2 0

to identify short-term liquidity, up to one year, and structural 2 10

liquidity, beyond one year.
5 50
The term structure of cumulated expected cash flows (TSECCF)
7 70
is similar to the TSECF: it is the collection of expected cumu­
lated cash flows, starting at to and ending at 15 , ordered by date: 10 30

TSECCF(tg, tfc,) = {CF(tg, to, t|), CF(tg, to, t2 ), • • • , CF(tg, to, tfc,)} > 1 0 2 0

(7.5) 1 0 0 1 0 0

The TSECCF is useful because banks are interested not only in

monitoring the net balance of cash flows on a given date, but
also how the past dynamic evolution of net cash flows affects its
total cash position on that date. If on a given date the balance
of inflows and outflows is net negative, this position can be net­
ted out with a positive cash position originated by past inflows.
Obviously the reverse can also be true and the bank can use a
net positive inflow on a given date to cover a short cash posi­
tion deriving from past outflows, although in this case it should
be noted that short cash positions must be financed in any case,
typically with new liabilities (see below), so that positive inflows
are used to pay back these debts.
Conceptually, building the TSECF and TSECCF is quite simple
and can be shown with an example.
and loans; they are financed with deposits, bonds and equity.
Assume that the assets bear no default risk and no liquidity
options are embedded within deposits. The first step to build
the TSECF is to order the assets and the liabilities according to
their maturity, disregarding which kind of contract they are. This
is shown in Table 7.1.
When assets expire positive cash flows are received by the bank,
whereas when liabilities expire negative cash flows must be paid
by the bank. The amount of the cash flows is simply the notional
of each contract in the assets and liabilities and, under the
assumptions we are working with, these amounts are determin­
istic both under a time and amount perspective. Collecting them
and ordering them by date, we obtain the TSECF in Figure 7.4.

Cash flows in themselves are not enough to monitor the liquidity

of a bank, since what matters in the end is the cash available up
Example 7.4.1
to a given time, which is given by the cumulated cash flows. At
Consider a bank with a simplified balance sheet like the one
in Figure 7.3. The assets comprise investments in bonds
Positive cash-flows
Negative cash-flows
Assets Liabilities
Cumulated cash-flows
r r
Bonds
30 Bonds
v ______J 40

v
( “A

Deposits
40
-40
V_____

Equity -60 -
20
V -80 -L

Fiqure 7.3 Balance sheet of a bank with types of Fiqure 7.4 Term structure of expected cash flows for
and liabilities and their quantities. the simplified balance sheet reclassified in Table 7.1.

C h ap ter 7 Monitoring Liquidity ■ 139

§Table
023^ 7.23 Interest Yield of the Assets and Liabilities In Example 7.4.1 shows a very simple balance sheet producing a
of the Simplified Balance Sheet Reclassified in Table 7.1 very simple TSECF and related TSECCF. In a real balance sheet
the number and type of contracts entering into the analysis is
Interest Yield
much greater and is not just limited to those existent at the
Expiry Assets (%) Liabilities (%) reference time, but also all new activities that can be reasonably
expected to be operated and in most of cases belonging to the
1 5.00%
category of new business of Figure 7.1.
2 4.00%
In greater detail, the cash flows of the TSECF are those pro­
5 .
6 0 0 % duced by all the causes of cash flows, as defined above. This
7 4.50% means that the TSECF
10 6.50% • includes the cash flows from all existing contracts that com­
> 1 0
prise the assets and liabilities: in many cases cash flows are
stochastic because they can be linked to market indices, such
as Libor or Euribor fixings (interest rate models are needed to
each date, cash flows from the initial date t0 up to each date t(-
compute expected cash flows);
are cumulated according to formula (7.3) and entered in the
TSECCF: the result is also shown in Figure 7.4. • cash flows are adjusted to consider credit risks: credit mod­
els have to be used to take into account defaults on an
This overly simplified example can be made a bit more realistic if
aggregated basis by also considering the correlation existing
we also consider the interest payments that assets and liabilities
amongst the bank's counterparties;
yield. Assume a yearly period for coupon payments and an aver­
age yield common to all contracts expiring on a given date: the • cash flows are adjusted to account for liquidity options:
behavioural models are used for typical banking products
interest yielded by each contract is shown in Table 7.2.
such as sight deposits, credit link usage and prepayment of
When interest payments are added, the TSECF is built as in mortgages;
Table 7.3, where there is also the TSECCF. In Figure 7.5 the
• cash flows originated, by new business increasing the assets
TSECF is represented for each date, decomposed in positive
should be included: they are typically stochastic in both the
and negative cash flows, and in the bottom diagram cumulated
amount and time dimensions, so they are treated by means
cash flows are also shown.
of models that consider all related risks;
• the rollover of maturing liabilities, by similar or different
Table 7.3 The Term Structure of Cash Flows contracts, and new bond issuances (which could also be
and of Cumulated Cash Flows included in the new business category) to fund the increase
cf+ cf- in assets, have to be taken into account. The risks related
to the stochastic nature of these flows have to be properly
Notional Interest Notional Interest TSECCF measured as well resulting in a need to set up proper liquid­
1 2 0 5.95 0 -3.55 22.40 ity buffers.

The TSECF, and hence the TSECCF, do not include the flows
2 0 4.95 - 1 0 -3.55 13.80
produced by the sources of cash flows, which we analyse below.
3 0 4.95 0 -3.15 15.60 The sources of cash flows are tools to manage the liquidity risk
4 0 4.95 0 -3.15 17.40 originated by the causes of cash flows.

5 50 4.95 0 -3.15 69.20 The task of the Treasury Department is to monitor the TSECF
6 0 1.95 0 -3.15 6 8 .0 0
and the TSECCF. The perfect condition is reached if the TSECCF
is positive at all times. This means that positive cash flows are
7 0 1.95 -7 0 -3.15 -3.20
able to cover negative cash flows, both of which are generated
8 0 1.69 0 0 -1.51 by usual business activity. Although this is the ideal situation it
cannot be verified for two reasons:
9 0 1.69 0 0 0.18
10 30 1.69 0 0 31.87
1. Many of the cash flows belong to categories that are sto­
chastic in the amount and/or the time dimension, such that
> 1 0 0 0 - 2 0 0 11.87 the TSECF always forecasts just the expected value of a

140 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 □ Interest Neg CFs the future TSECCF is always positive. But since we have
□ Notional Neg. CFs seen that this ideal situation cannot always be fulfilled, we
□ Interest Pos CFs need to discover which tools can be used to cope with
■ Notional Pos. CFs the case when the TSECCF has negative values.

7.4.2 Liquidity Generation Capacity

Liquidity generation capacity (LGC) is the main tool
a bank can use to handle the negative entries of the
TSECCF. It can be defined as follows.

Definition 7.4.3 (Liquidity generation capacity). The

ability of a bank to generate positive cash flows,
beyond contractual ones, from the sources of liquid­
ity available in the balance sheet and off the balance
sheet at a given date.

80 n The LGC manifests itself in two ways:

Cumulated
70 - 1. Balance sheet expansion with secured or unse­
cured funding.
60 -
2. Balance sheet shrinkage by selling assets.
50-
Balance sheet expansion can be achieved via
40 -
• borrowing through an increase of deposits, typically
30 in the interbank market (retail or wholesale unse­
cured funding);
20
• withdrawal of credit lines the financial institution
10
has been granted by other financial counterparties
0 (wholesale unsecured funding);

-10 J
Fiaure 7.5 Term structure of expected cash flows for
the simplified balance sheet reclassified in Table 7.1
including interest payments (top) and term structure of
expected cumulated cash flows (bottom).
• issuance of new bonds (wholesale and retail unse­
cured funding).
It is worth noting that new debt is not the same as that planned
to roll over existing contracts or to fund new business: in this
case the related cash flows would be included in the TSECF and
in the TSECCF, as seen above.

distribution of flows. As a result the TSECCF contains only
expected values as well: if it is positive on average most of
the time, the distribution of cumulated cash flows at a given
time can also actually envisage negative outcomes with an
assigned probability.
2. The temporal distribution of the maturities of the assets
and the liabilities could produce periods of negative cumu­
lated cash flows. These periods may be accepted if they
are short and can be managed effectively with the tools we
introduce below.
When the TSECCF shows negative values, on an expected basis,
this means that the bank may become insolvent and eventually
go bankrupt. This is why the treasurer's main task is to ensure that
Balance sheet shrinkage is operated by selling assets, starting
from more liquid ones such as Treasury bonds, corporate bonds
and stocks: they are traded in the market actively and can be
sold within a relatively short period. Reduction may also include
the sale of less liquid assets, such as loans or even buildings
owned by the bank, within a more extended time horizon.
Repo transactions can also be considered separately from the
other cases and labelled as "balance sheet neutral".
The bank may prefer to consider only liquidity that can be gener­
ated without relying on external factors, such as clients or other
institutional counterparties. It is easy to recognize that LGC
related to balance sheet expansion is dependent on these exter­
nal factors, whereas balance sheet reduction, or "balance sheet

C h ap ter 7 Monitoring Liquidity ■ 141

neutral" repo transactions, are not. So it is possible to present an
alternative distinction within LGC; namely, we can identify
• balance sheet liquidity (BSL), or liquidity that can be gener­
ated by the assets existing in the balance sheet. BSL is tightly
linked to balance sheet reduction LGC and it is also the
ground on which to build liquidity buffers.
• remaining liquidity, originated by the other possible ways
mentioned above, which relates to balance sheet expansion.
A similar classification within LGC is based on the link between
the generation of liquidity and the assets in the balance sheet,
so that we have:
• Security-linked liquidity including
- secured withdrawals of credit fines received from other
financial institutions;
- secured debt issuance;
- selling of assets and repo.
• Security-unlinked liquidity including
- unsecured borrowing from new clients through new
deposits;
- withdrawals of credit lines received from other financial
institutions;
- unsecured bond issuance;
It is immediate clear that security-linked liquidity is little more
than BSL liquidity, or the liquidity obtained by balance sheet
reduction.
To sum up, we can identify three types of sources of liquidity
that can be included in the classifications above:
1. Selling of assets, AS.
2. Secured funding using assets as collateral and via repo
transactions, RP.
3. Unsecured funding via withdrawals of committed credit
lines available from other financial institutions and via
deposit transactions in the interbank market, USF.
The first two sources generate security-linked BSL by reduc­
ing the balance sheet or keeping it constant. The third source
generates security-unlinked non-BSL by expanding the balance
sheet. It is worth stressing that the unsecured funding of point
3 is not the same as the unsecured funding we inserted in the
TSECF and TSECCF, but is mainly related to the rollover of
existing liabilities or the issuance of new debt to finance busi­
ness expansion. In fact, while in the latter case we referred to
existing and planned activity funding usual banking activity, the
operations involved in LGC refer to shorter term exceptional
unsecured funding, in most cases unrelated to a bank's bond
issuance and other forms of fundraising.
142 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
We can now define the term structure of LGC as the collection,
at reference time t0, of liquidity that can be generated at a given
time t;, by the sources of liquidity, up to a terminal time tb:
TSLGC(t0, tb) = {AS(t0, tO, RP(t0, q), USF(t0, t ^, . . . , AS(t0, tb),
RP(t0, tt), USF(t0, tb)} (7.6)
where AS(t0, q) is the liquidity that can be generated by the sale
of assets at time t,, computed at the reference time t0; RP(t0, t|)
and USF(to, t-i) are defined similarly.
Analogously, the term structure of cumulated LGC is the collec­
tion, at the reference time t0, of the cumulated liquidity that can
be generated at a given time t„ by the sources of liquidity, up to
a terminal time tb:
f 1 2
TSCLGCtto, t,J = { 2 T S L G C (t0, t,), 2 T S L G C (t0, t,)...........
L #=o /=o
b
2 T S L G C (t0, tj)
;=o
Remark 7.4.1. The quantities entering in the TSLGC and hence
the TSCLGC are expected values, since they all depend on
stochastic variables such as the price of assets and the haircut
applied to repo transactions. Moreover, the stochasticity of the
amount of unsecured funding that it is possible to raise in the
market could and should be considered.
The sources of liquidity contributing to the TSLGC belong either
to the banking or the trading book. In the banking book the
sources of liquidity are all the bonds available for sale 1 (AFS) and
other assets that can be sold and/or repoed relatively easily:
they are referred to collectively as eligible assets. In all cases
these assets are unencumbered; that is, they are not already
pledged to other forms of secured funding such as the ones we
present just below. To determine at a given date t, the liquidity
that can be generated by these sources, one needs:
• AFS bonds: the expected future value of each bond, consid­
ering the volatility of interest rates and credit spreads, and
of the probability of default. Moreover, the possibility that
the bonds may become more illiquid, thus increasing bid-ask
spreads and lowering the selling price, has to be considered
in the analysis.
• For other assets the selling period and the expected selling
price have to be properly taken into account.
As mentioned above, assets in the banking book can be also
repoed; that is, the bank can sell them via a repo transaction
and buy them back at expiry of the contract. The repo can be
1 The term "available for sale" in our context is not related to the same
definition used for accountancy purposes. We simply refer to assets
that can be sold because they are unencumbered, as explained in the
following.
seen as a collateralized loan that the bank may receive: as such
it can be safely assumed that liquidity can be obtained more
easily than unsecured funding, since the credit risk of the bank
is considerably abated. For the same reason the funding cost,
meant as the spread over the risk-free rate, is also dramatically
reduced for the bank.
Besides the factors that affect liquidity that AFS bonds can gen­
erate, there is another factor determining the actual liquidity
that can be obtained by a repo or a collateralized loan transac­
tion: the haircut, or the cut in the market value of the bond indi­
cating how much the counterparty is willing to lend to the bank,
given an amount of bonds transferred as collateral. The haircut
will depend on the volatility of the price of the collateral bond
and on the probability of default of the issuer of the bond.
Haircuts have to be modelled not only for unencumbered assets
to assert their liquidity potential, but also for encumbered
assets, involved in collateralized loans, to forecast possible
margin calls and reintegration of the collateral when their prices
decline by an appreciable amount.
Finally, received committed credit lines, which are not exactly
in the balance sheet until they are used (in which case they
become liabilities) have to be included in the TSLGC and their
amount and future actual existence taken into account. In fact,
although it is also quite reasonable to receive committed credit
lines from other financial institutions after the expiry of the lines
currently received, their amount could be constrained by pos­
sible systemic liquidity issues. Moreover, the costs in terms of
funding spreads and other fees to be paid have to be consid­
ered as well.
If we move to the trading book, we can identify bonds and other
assets similar to those included in the banldng book as sources
of liquidity. Amongst the other assets that can be used to gener­
ate liquidity we may add stocks and also some structured prod­
ucts, such as eligible ABSs or even more complex structures. 2
These assets, provided they are unencumbered, can be sold or
they can be pledged in collateralized loans or repoed. In these
cases the same considerations we have made above can be
repeated here and the same factors have to be included in the
assessment of the liquidity potential to include in the TSLGC.
Unsecured funding on the interbank market via deposit transac­
tions, usually up to one-year expiry, are part of the banking book
for accounting reasons. Also here, the possibility to resort to this
source of liquidity should be carefully weighted by the possibility
2 The liquidity of structured products can be strongly dependent on the
more general economic environment. For example, it used to be quite
easy to pledge ABSs as collateral before 2007, but after the subprime
crisis in the US banks were no longer willing to accept them as collateral.
to experience systemic liquidity crises (e.g., as in 2008) that
strongly limit the availability of funds via this channel. The other
important factor is the costs related to the funding spread.
Building the TSLGC can be very difficult, since the assumptions
made for a given period affect other periods. For example,
if the bank wants to compute the liquidity-generating capac­
ity provided by a given bond held in the assets, assuming it is
pledged as collateral for a loan starting in t-, and expiring in t2 to
cover negative cumulated cash flows occurring during the same
period, then the same bond has to be excluded for the same
period and other overlapping periods from the TSLGC. This
means that the process to build the actual TSLGC should be
carried out in a greater number of steps.
It should also be stressed that the TSLGC is intertwined with the
TSECF (and thus the TSECCF): there are feedback effects when
defining the TSLGC that affect expected cash flows, which makes
the building process a recursive procedure to be repeated until
an equilibrium point is reached. For example, if we still consider
that the TSLGC for a given period can be fed by a bond that can
be pledged as collateral or repoed, then the cash flows of this
bond should be excluded from the TSECF for the period of the
loan or repo contract. 3 Missing cash-flows for the corresponding
period worsen the cash flow term structure (although marginally),
but this means that they must also be included in the analysis.
In the end, most of the problems in building the TSLGC are
caused by unencumbered assets (most of which are what we
earlier referred to as AFS bonds), both because the bank must
keep track of how many are either sold or repoed out, and
because the liquidity amount that can be extracted from these
assets depends on several risk factors. It is useful then to intro­
duce a tool that helps monitoring this part of the LGC more
thoroughly: it is the term structure of available assets (TSAA)
and will be described in the next section.
7.4.3 The Term Structure
of Available Assets
In the previous section we stressed that BSL is originated by
selling assets and/or by the repo transactions made on them.
When building the TSLGC, it is important to ascertain whether
BSL is the result of setting assets or carrying out repo transac­
tions, since both operations have different consequences in
terms of liquidity.
3 At the end of the loan or repo, cash flows generated by the bond are
usually given back to the borrower by the counterparty, although the
contract may sometimes provide for different solutions.
C h ap ter 7 Monitoring Liquidity ■ 143
When an asset, such as a bond, is purchased by a bank a cor­
responding outflow equal to the (dirty) price is recorded in the
cash position of the bank. During the life of the bond coupon
flows are received by the bank and finally, at expiry, the face
value of the bond is reimbursed by the issuer. All these cash
flows should be considered contract related, so that they are
included in the TSECF and the TSECCF. The likelihood of the
issuer defaulting should also be taken into account.
The TSAA is affected by purchases, since it records increases in
the security for the amount bought. When the asset expires, the
TSAA records a reduction to zero of its availability, since it no lon­
ger exists. During the life of the asset, the availability is affected
by total or partial selling of the position, and by repo transactions.
The TSAA is also affected by other kinds of transactions that
can be loosely likened to repo agreements, but have different
impacts. Namely, we also have to analyse buy/sellback (and sell/
buyback) transactions and security lending (and borrowing).
What matters in terms of availability for liquidity purposes is the
possession of the asset rather than its ownership. We summarize
all possible cases in the following:
• Repo transactions: at the start of the agreement the bank
receives cash for an amount equal to the price of the asset
reduced by the haircut; at the same time it delivers the asset
to the counterparty. Although the asset is still owned by
the bank, its possession passes to the counterparty, so that
the bank no longer has availability of the security. This will
become encumbered and cannot either be sold or used as
collateral until the end of the repo agreement, when it is
returned. Payments by the asset during the repo agreement
belong to the bank since it is the owner, so that the TSECF
and in the TSECCF are not affected in any way. The TSAA
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 TSLGC. Repo transactions produce a
liability in the balance sheet, since they can be seen as collat­
eralized debts of the bank.
• Reverse repo transactions: at the start of the agreement the
bank pays cash for an amount equal to the price of the asset
reduced by the haircut and receives the asset. The asset is
owned by the counterparty, but it is now in the possession of
the bank, so that it can be used as collateral by the bank for
other transactions until the end of the repo agreement, when
the obligation that it is to be returned to the counteparty has
to be honoured by the bank. The payments by the asset dur­
ing the repo agreement belong to the counterparty, so that
they do not enter the TSECF or the TSECCF, but we include
the cash flow paid by the bank at the start and the cash flow
received at the end as contract, but only once. The TSAA of
144 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
the asset is increased by an amount equal to the notional of
the repo agreement. The TSLGC is not affected but the asset
can be repoed until the end, so that it can be altered until
this date. Reverse repo transactions are treated as assets in
the balance sheet, since they can be seen as collataralized
loans to the counterparty.
• Sell/buyback transactions: similar to repo transactions in
terms of the exchange of cash and of the asset, with the dif­
ference that ownership passes to the buyer (the counter­
party) at the start of the contract together with the
possession. All payments received for the asset before the
buyback belong to the counterparty. 4 The cash flows
between the start and end of the contract will be taken from
the TSECF and the TSECCF. The TSAA of the asset decreases
by an amount equal to the notional of the sell/buyback con­
tract. The TSLGC is affected in the same way as in the repo
agreement, since sell/buyback transactions are a way to gen­
erate BSL. Sell/buyback transactions represent a commitment
for the bank at the end of the contract.
• Buy/sellback transactions: similar to reverse repo transactions
in terms of the exchange of cash and of the asset, with the
difference that ownership passes to the buyer (the bank) at
the start of the agreement together with the possession. This
implies that the payments received for the asset before the
sellback belong to the bank, so that they enter the TSECF
and the TSECCF, along with the cash flows at the start and
end that relate to the purchase and sale, since they are con­
tract flows. The TSAA of the asset is increased by an amount
equal to the notional of the buy/sellback agreement. The
TSLGC is not affected but the asset can be repoed until the
end, so that it can be altered until this date. Buy/sellback
transactions represent an asset for the period of the contract.
• Security lending: similar to sell/buyback transactions in terms
of exchange of the asset, but no cash is paid by the counter­
party to the bank (except a periodic fee as service remunera­
tion). Only possession passes to the counterparty, so that
the payments received for the asset before the end of the
contract belong to the bank and they enter the TSECF and
the TSECCF, as does the interest paid by the countertparty at
expiry when returning the asset to the bank. The TSAA of the
asset decreases by an amount equal to the notional of the
4 This was generally true until an annex was incorporated in the standard
GMRA (the master agreement signed by banks for all repo-like transac­
tions). Currently sell/buyback (and buy/sellback that we will address in
the following point) are treated very similarly to a repo agreement, so
that all payments are returned to the seller, although only at the end of
the contract and not on each payment date as in the repo case. In this
case the effects on the different term structures are similar to those we
have shown for repo (and reverse repo for buy/sellback) transactions.
 lending, since the bank cannot use it as collateral or sell it.
The TSLGC is not affected and the asset cannot produce any
liquidity until the end of the contract. Security lending repre­
sents an asset of the bank for the period of the contract.
• Security borrowing: similar to buy/sellback transactions in
terms of exchange of the asset, but no cash is paid by the
bank to the counterparty (except a periodic fee as service
remuneration). Possession passes to the bank, so that the
payments received for the asset before the end of the con­
tract belong to the counterparty. The TSECF and the TSECCF
are not affected apart from the interest paid by the bank at
expiry of the borrowing. The TSAA of the asset increases by
an amount equal to the notional of the borrowing, since the
The TSAA can now be built keeping these results in mind, since
for a given asset it is defined as the collection, for each date
from an initial time t0 to a terminal date tb, of the quantity in
possession of the bank, regardless of its ownership. In fact, the
main purpose of the TSAA is to indicate how much of the asset
can be used to extract liquidity and thus its contribution to
global LGC. In more formal terms, for an asset A-| we have:
TSAAA'(t0, tt) = {Aftto), A f(t,)...........Af(tb)} (7.8)
where Ai(t,)is the quantity of the asset in possession of the
bank at time tr On an aggregated basis, regarding a set of M
securities in possession of the bank, the total TSAA including all
the assets is:

bank can use it as collateral provided it returns it to the coun­
terparty at expiry. The TSLGC is not affected but the asset
can produce liquidity until the end of the contract. Security
borrowing represents a liability of the bank.
Other assets, such as stocks, do not have a specific expiry
date. In this case contract cash flows entering the TSECF
and the TSECCF are just the initial outflow representing the
price paid to purchase the asset and the periodic dividend
received. Moreover, non-maturing assets can be the underly­
ing of repo transactions, buy/sellback (sell/buyback) contracts
and security lending (and borrowing): the analysis is the same
as above.
In Table 7.4 we recapitulate the results for all types of con­
tracts that can be written on assets. It is worth noting that
TSLGC is always affected either because the contract is dealt
to generate BSL or because LGC is potentially increased
over its lifetime. The only contract that does not increase
the TSLGC is security lending, which actually decreases LGC
related to BSL.
{
m m m ^
2 Am(to), ...........(7.9)
m= 1 m—1 m=1 J
The TSAA only shows how many single securities, or all of them,
are available for inclusion in LGC. Obviously, this does not imply
that the notional amount can be fully converted into liquidity.
According to the type of operation (selling or repo) the price
and/or the haircut are factors that need to be considered to
determine the actual amount of liquidity that can be generated.
Hence, we need proper models that allow the bank to forecast
expected (or stressed) values for the price and the haircut, both
at the single and aggregated assets level.
In Example 7.4.2 we show how the interrelations amongst the
different term structures operate in practice.
Example 7.4.2
The bank buys a bond at time 0 for a notional amount of
1,000,000 at a price o f 98.50; the payment is settled after
3 days, when the bond's possession also passes to the bank.

Table 7.4 Types of Contracts Involving Assets and Effects on the TSECF/TSECCF, TSAA and TSLGC
Changes to

Type Ownership Possession TSECF/TSECCF TSAA TSLGC

Buy Bank Bank Yes Yes No/Possible

Sell Counterparty Counterparty Yes Yes Yes
Repo Bank Counterparty No Yes Yes
Reverse repo Counterparty Bank Yes Yes No/Possible
Sell/buyback Counterparty Counterparty Yes Yes Yes
Buy/sellback Bank Bank Yes Yes No/Possible
Security lending Bank Counterparty Yes Yes No
Security borrowing Counterparty Bank Yes Yes No/Possible

C h ap ter 7 Monitoring Liquidity ■ 145

Table 7.5 Purchase of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0 .0 1 Settlement -985,000 -985,000 ,
1 0 0 0 ,0 0 0 99.85 15
0.25 ,
1 0 0 0 ,0 0 0 99.85 15
0.5 Coupon 50,000 -935,000 ,
1 0 0 0 ,0 0 0 99.85 15
0.75 ,
1 0 0 0 ,0 0 0 99.90 15
1 Coupon 50,000 -885,000 ,
1 0 0 0 ,0 0 0 99.90 15
1.25 ,
1 0 0 0 ,0 0 0 99.90 15
1.5 Coupon 50,000 -835,000 ,
1 0 0 0 ,0 0 0 99.95 15
1.75 ,
1 0 0 0 ,0 0 0 99.95 15
2 Coupon + 1,050,000 215,000 1 0 0 .0 0 15
Reimbursement

In Table 7.5 we show what happens to the term structures.
The bond pays a semiannual coupon of 10% p.a. and it expires
in 2 years.
The TSECF records an outflow equal to the notional amount of
the bond times the price (we assume the bank buys the bond
upon a coupon payment, so that the dirty price and the clean
price are the same) occurring on the settlement date, 3 days after
the reference time 0 (or 0.01 years). The TSAA records an increase
of the quantity available to the bank of the bond until its expiry,
when it is reset to zero. The TSLGC is unaffected. The last two
columns show the price and the haircut. They are expected values
and for the moment we consider them as given, although they
can be the output of some model or just assumptions of the bank.
Assume now the bank decides to sell a quantity of the
bond equal to a notional of 500,000 after 9 months (or
0.75 years). We know that this trade can be dealt to gener­
ate liquidity, so that the TSCLGC records an inflow equal to
the amount times the price, including the accrued interests
(500,000 X (99.90/100 + 10% X 0.25) = 512,000 as well.
The TSECF and the TSECCF are modified so as to show the
reduced amounts of interest and capital received on the sched­
uled dates. The TSAA records a cut in the available amount
for 500,000 until expiry o f the bond, when it drops to zero.
Table 7.6 shows the results.
Let us now analyse the effects of repo and reverse repo trans­
actions on term structures. Assume the bank repoes the bond

Table 7.6 Selling of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0 .0 1 Settlement -985,000 -985,000 ,
1 0 0 0 ,0 0 0 99.85 15
0.25 99.85 15
0.5 Coupon 50,000 -935,000 99.85 15
0.75 Sell 500,000 512,000 99.90 15
1 Coupon 25,000 -910,000 512,000 99.90 15
1.25 512,000 99.90 15
1.5 Coupon 25,000 -885,000 512,250 99.95 15
1.75 512,250 99.95 15
2 Coupon + 525,000 -360,000 512,500 1 0 0 .0 0 15
Reimbursement

146 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Table 7.7 Repo and Reverse Repo of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0 .0 1 Settlement -985,000 -985,000 ,
1 0 0 0 ,0 0 0 99.85 15
0.25 Repo -985,000 500,000 424,469 99.85 15
0.5 Coupon 50,000 -935,000 500,000 424,469 99.85 15
0.75 End repo -19,101 -954,101 ,
1 0 0 0 ,0 0 0 99.90 15
1 Coupon 50,000 -904,101 ,
1 0 0 0 ,0 0 0 99.90 15
1.25 Reverse repo -424,681 -1,328,782 1,500,000 99.90 15
1.5 Coupon 50,000 -1,278,676 1,500,000 99.95 15
1.75 End reverse 471,396 -807,386 1,500,000, 99.95 15
repo
2 Coupon + 1,050,000 195,899 1 0 0 .0 0 15
Reimbursement

after 3 months (0.25 years) for a notional amount equal to
500,000 and a period of 6 months. Given the price and the
haircut of the bond, and keeping accrued interest in mind, the
amount of cash received by the bank is:
(500,000 X (99.85% + 10% X 0.25) X (1 - 15%) = 424,469
In Table 7.7 the TSCLGC indicates an increase of liquidity,
whereas the TSAA indicates that the available quantity of the
bond dropped to 500,000.
which should be considered fully as a contract cash flow, thus enter­
ing the TSECF; the bond is returned to the counterparty and conse­
quently the TSAA is set back to 1,000,000 as shown in Table 7.7.
When the bank operates buy/sellback (or sell/buyback) operations,
the effects are different. Assume that after 3 months (0.25 years)
the bank buys 400,000 bonds and sells it back after 6 months
at the forward price. At the start of the contract the bank pays:
400.000 X (99.85% + 10% X 0.25) = 409,400

The bank pays 9% as interest on this repo transaction, so that This sum enters the TSECF and the quantity of the bond available
the terminal price paid when getting the bond back is: increases to 1,400,000 in the TSAA. The TSCLGC is not modified
by this operation. During the lifetime of the contract the bank is
424,469 X (1 + 9% X 0.5) = 443,569.84
the legal owner of the bond and receives all the payments as well.
The difference 443,569.84 - 424,469 = 19,101.09 should be
At the end of the contract (0.75 years) the bank sells the bond back
considered as a contract cash flow so that it enters the TSECF
at the contract price, typically the forward price prevailing at the
on the date at the end of the repo. The TSCLGC drops to zero
inception of the contract (which we assume equal to the predicted
and the TSAA returns the available amount back to 1,000,000.
price 99.90). The sum it receives also includes accrued interest:5
After 1 year and 3 months (1.25 years) the bank deals a 6-month
reverse repo on this bond for a notional of 500,000. The price it
400.000 X (99.90% + 10% X 0.25) = 409,600

pays to deliver the bond at inception is This sum also enters the TSECF, while the TSAA shows a reduc­
tion of the available quantity back to 1,000,000. All this is shown
500,000 X (99.90% + 10% X 0.25) X (1 - 15%) = -424,681
in Table 7.8.
This amount enters the TSECF and alters the TSECCF as a con­
In Table 7.8 we also show the effects of a sell/buyback of
sequence; what is more, the TSAA increases up to 1,500,000
the bond starting after 1 year and 3 months (1.25 years) and
since the bond is in possession o f the bank. All this is shown in
Table 7.7. The TSCLGC is left unchanged.

A t the end of the reverse repo contract, assuming the interest

rate paid by the counterparty is 11%, the inflow received by the 5 We assume the bank closed a buy/sellback transaction that was not
bank is: following more recent conventions, whereby the effects would be the
same as in the repo case as far as the TSECF is concerned. The effects
424,681 X (1 + 11% X 0.5) = 471,396 on the TSAA would remain the same as those we describe here.

C h ap ter 7 Monitoring Liquidity ■ 147

Table 7.8 Buy/sellback and Sell/buyback of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0 .0 1 Settlement -985,000 -985,000 ,
1 0 0 0 ,0 0 0 99.85 15
0.25 Buy -409,400 -1,394,400 1,400,000 99.85 15
0.5 Coupon 70,000 -1,324,400 1,400,000 99.85 15
0.75 Sellback 409,600 -914,800 ,
1 0 0 0 ,0 0 0 99.90 15
1 Coupon 50,000 -864,800 ,
1 0 0 0 ,0 0 0 99.90 15
1.25 Sell -864,800 700,000 307,200 99.90 15
1.5 Coupon 35,000 -829,800 700,000 307,200 99.95 15
1.75 Buyback -829,800 ,
1 0 0 0 ,0 0 0 -314,726 99.95 15
2 Coupon + 1,050,000 2 2 0 ,2 0 0 1 0 0 .0 0 15
Reimbursement

terminating after 6 months (1.75 years). The price received by
the bank is:
300.000 X (99.90% + 10% X 0.25) = 307,200
which is included in the TSCLGC since the operation can be seen
as a way to extract BSL from the available assets; the TSAA indi­
cates a reduction of the available quantity down to 700,000. At
the end of the contract the bank buys the bond back and pays:
300.000 X (99.95% + 10% X 0.25) = 314,726
which is included in the TSCLGC. The TSAA increases back to
1,000,000. The coupon paid during the life of the contract is
proportional to the available quantity of 700,000.
We now show what happens to the different term structures when
a security lending and borrowing is operated by the bank. Let us
start with a case in which the bank lends 500,000 of the bond after
3 months for a period of 6 months. The TSECF does not record any
cash flow at the inception of the contract, whereas the TSAA shows
a reduction of the available quantity of 500,000. After 6 months
the bond is returned to the bank (the TSAA increase) and the bank
receives a fee for the lending, which we assume equal to 3% p.a.:
500,000 x (3% x 0 .5 )= 7,500
The coupon paid during the lifetime of the contract are pos­
sessed by the legal owner (i.e., the bank). This can be observed
in Table 7.9.

Table 7.9 Lending and Borrowing of a Bond: Effects on Term Structures

Time Operation TSECF TSECCF TSAA TSCLGC Price Haircut (%)

0 Buy 99.85 15
0 .0 1 Settlement -985,000 -985,000 ,
1 0 0 0 ,0 0 0 99.85 15
0.25 Start lending -985,000 500,000 99.85 15
0.5 Coupon 50,000 -935,000 500,000 99.85 15
0.75 End lending 7,500 -927,500 ,
1 0 0 0 ,0 0 0 99.90 15
1 Coupon 50,000 -877,500 ,
1 0 0 0 ,0 0 0 99.90 15
1.25 Start borrowing -877,500 ,
1 0 0 0 ,0 0 0 99.90 15
1.5 Coupon 50,000 -827,500 ,
1 0 0 0 ,0 0 0 99.95 15
1.75 End borrowing -4,500 -832,000 ,
1 0 0 0 ,0 0 0 99.95 15
2 Coupon + 1,050,000 218,000 1 0 0 .0 0 15
Reimbursement

148 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The bank borrows a quantity of 300,000 of the same bond at
1.25 years for a period of 6 Months. The TSAA is only affected
at the start and end of the contract. The TSECF only records the
borrowing fee paid by the bank:
300,000 x (3% x 0.5) = 4,500
7.5 TH E TERM STRUCTURE
O F EX P EC T ED LIQUIDITY
The term structure of expected liquidity (TSLe) is basically a
combination of the TSECCF and the TSLGC. Formally, it can be
written as:
TSLe(t0, tb) = {TSECCF(t0, t0), TSECCF(t0, t,) + TSCLGC(t0, t j ,
TSECCF(t0, t2) + TSCLGC(t0, t2) , . . . ,
TSECCF(t0, tb) + TSCLGC(t0, tb)}
If the Treasury Department aims at preserving a positive sign for
the TSECCF for all maturities, and this cannot always be guaran­
teed, as soon as we add it to our analysis of the TSCLGC we end
up with a total picture for projected expected liquidity and the
means the financial institution has at its disposal to cover nega­
tive cumulated cash flows (i.e., the TSL). The TSL must always be
positive if the financial institution has to be solvent all the time.
The TSLe includes all possible expected cash flows generated
by ordinary business activity, new business, the liquidity policy
operated and the measures taken to cope with negative cumu­
lated cash flows. If in the end it is impossible to exclude nega­
tive expected cumulated cash flows, then it is also impossible to
prevent the financial institution from becoming insolvent.
Exam ple 7.5.1
Let us revert back to Example 7.4.1 and expand it to take
account of the TSAA and the TSCLGC with the objective of
(7.10) finally building a TSLe. The main results are shown in Table 7.10.

where we have included the term TSECCF(to, to): although it
may seem strange, it is simply the cash existing at the initial time
in the balance sheet, so that:
TSECCF(t0, to) = Cash(t0)
The TSLe is in practice a measure to check whether the financial
institution is able to cover negative cumulated cash flows at any
time in the future, calculated at the reference date t0.
First, we start with the TSECF and the TSECCF of Table 7.3 of
Example 7.4.1: the TSECCF is negative between the 7th and 8th
year. This negative cumulated cash flow must be covered and in
the balance sheet there is a bond that can be sold to create (BSL)
liquidity. In fact, in Table 7.10 the TSAA includes an amount for the
bond equal to 30 until the 6th year, then in the 7th year an amount
of 4 is sold at the (expected) price of 99.00, so as to generate a
liquidity of 3.96, which is included in the TSCLGC thereafter.

Table 7.10 The Term Structure of Expected Liquidity and Its Building Blocks

Years TSECF TSECCF TSCLGC TSLe TSAA Price

0 0 0 0 0 30 97.00
1 22.4 22.4 0 22.4 30 97.20
2 - 8 .6 13.8 0 13.8 30 97.45

3 1 .8 15.6 0 15.6 30 97.60

4 1 .8 17.4 0 17.4 30 98.00
5 51.8 69.2 0 69.2 30 98.20
6 - 1 .2 6 8 0 6 8 30 98.60
7 -71.2 -3 .2 3.96 0.76 26 99.00
8 1.69 -1.51 3.96 2.45 26 99.50
9 1.69 0.18 3.96 4.14 26 99.75
10 27.69 27.87 3.96 31.83
1 0 0 .0 0

> 1 0 - 2 0 7.87 0 7.8

C h ap ter 7 Monitoring Liquidity ■ 149


cumulated liquidity generation capacity and of expected liquidity.
It should be noted that selling the bonds affects the TSECF,
and hence the TSECCF, in the two ways shown in the previous
section: there are fewer inflows for interest paid by the bond
and the final reimbursement is lower as well. In this example
the change in the TSEC F does not produce other negative
cumulated cash flows, so the LGC can be limited to selling
the bond.
The TSLe is the sum of the TSEC C F and the TSCLGC at each
period as shown in Table 7.10: it is always greater than or
equal to zero, so the bank is in (expected) liquidity equilib­
rium. Figure 7.6 shows how the TSECCF, the TSCLGC and the
TSLe have evolved: the first and the last term structure clash
on the same line until the seventh year, when the TSECCF
becomes negative and it has to be counterbalanced by
the TSCLGC.
7.6 CASH FLOW S AT RISK
AND THE TERM STRUCTURE
O F LIQUIDITY AT RISK
Section 7.1 discussed a taxonomy of cash flows according to the
time and amount of their occurrence, most cash flows are sto­
chastic in either or both dimensions. This is the resaon we intro­
duced the term structure of expected cash flows, cumulated
cash flows and expected liquidity generation capacity: they flow
into the term structure of expected liquidity which represents
the main monitoring tool of a Treasury Department.
150 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Nonetheless, the fact that cash flows are sto­
chastic suggests that not only one synthetic
metric of the distribution (i.e., the expected
value) should be taken into account, but also
some other measure related to its volatility.
In this way it is possible to build the same
term structure we analysed above from a
different perspective showing the extreme
values that both positive and negative cash
flows may assume during the time of their
occurrence.
In order to achieve this result, we need to link
the single cash flows originated by contracts
on and off the balance sheet to risk factors
related to market, credit and behavioural
variables. Here we show the general prin­
ciples to build term structures that we define
as unexpected with respect to the expected
ones we looked at earlier.
The first concept to introduce is the positive
cash-flow-at-risk, defined as
cfaR+(t0, tj) = cf£(tb, tf, x) - E[cf(t0, tf, x)]
= cf+(t0, tf, x) - cfe(t0, tf, x)
On a given date tj, determined by the reference date to, the
maximum positive cash flow, computed at a given confidence
level a(cf^(t0, t,-; x)), is reduced by an amount equal to the
expected amount of the (sum of positive and negative) cash
flows on the same date (cfe(t0, t,-; x)). It is worthy of note that
we have added a dependency of the cash flows on x: this is an
array x = [xi, X2 , . . . , x r ] of R risk factors, which include market,
credit and behavioural variables.
Analogously, a negative cash-flow-at-risk is defined as:
cfaRT_a(t0, tj) = cf7 _ a(t0, tj; x) - E[cf(t0, t■
, x)]
= cfT_«(t0, U *) - cfe(t0, h; x)
where in this case on a given date tj, determined by the ref­
erence date to, the minimum negative cash flow, computed
at a given confidence level a(cf*(to, t,-; x)), is netted with the
expected cash flow occurring on the same date (cfe(t0, t,-; x)).
Note that the distribution of cash flows ranges from the small­
est, possibly but not necessarily, negative ones to the largest,
possibly but not necessarily, positive ones. Given a confidence
level of a, on the right-hand side of the distribution all cash flows
bigger than cf^(t0, t,-; x), whose total probability of occurrence is
1 - a, are neglected. In the same way, on the left-hand side of
the distribution all cash flows smaller than c ff_a(t0, tf, x), whose
total probability of occurrence is still 1 - a, are not taken into
account.
 Table 7.11 Notional Am ount Indexed to D ifferent Libor Fixings and Fixed Cash Flow s, for Cash Flows Occurring
in a Period of 20 Days

1M 3M 6M 1Y 1M 3M 6M 1Y Fixed Rate
Date Amount Amount Amount Amount Amount

1 - 1 ,0 0 0 , 0 0 0
2

3
4 ,
2 0 0 0 ,0 0 0 -500,000
5
6 1,500,000 -5,000,000 2,500,000 2 ,0 0 0 , 0 0 0 -250,000
7 1 0 0 ,0 0 0 2 0 0 ,0 0 0 -500,000 1 ,0 0 0

8 1,500,000 -5,000,000 3,000,000 - 1 ,0 0 0 , 0 0 0

9 2,500,000 -5,000,000 2,500,000 2 ,0 0 0 , 0 0 0
10 ,
2 0 0 0 ,0 0 0 3,000,000 2,500,000 500,000 25,000
11

12 1,500,000 -5,000,000 2,500,000 2 ,0 0 0 , 0 0 0

13
14 ,
2 0 0 0 ,0 0 0 3,000,000 2,500,000 500,000 25,000

Once we have defined the cfaR, it is straightforward to intro­

duce the term structure of unexpected positive cash flows, given
a confidence level of a. This is the collection of positive cfaR
for all the dates included between the start and the end of the
observation period:
TSCF+(t0, tb) = {cfaR+(t0, t0), cfaRjfo, t ^, . . . , cfaRft (t0, tb) (7.11)
Similarly, the term structure of unexpected negative cash flows,
given a confidence level of 1 - a , is:
TSCF7_a(t0, tb) = {cfaR7_a(t0, t0), cfaR7_a(t0, t ^, . . . , cfaR7_a(t0, tb)
(7.12)
The TSCF^ and TSCF7-a can be described as the upper and
lower bound of the term structure of cash flows, centred
around the expected level that is given by the TSECF. It
does not make much sense to build a cumulated TSCF* and
TSCF7-a, since they will rapidly diverge upward or downward
at unreasonable levels without providing accurate informa­
tion for liquidity risk management. It is much more useful to
build a term structure of unexpected liquidity that includes
both the term structure of cash flows and liquidity generation
capacity jointly computed at some confidence level a. We will
dwell on that below; but first we give an example of TSCF*
and TSCF7-a.
Exam ple 7.6.1
We present a simplified TSCF and TSECF for a set offixed and
floating cash flows for a period covering 14 days. The notional
amount for each date and for each type of index is shown in
Table 7.11. For example, on the first day a contract of 1,000,000
produces an outflow indexed to 1-month Libor: it could be a
bond the bank issued. There are also some dates when cash
flows are not indexed to a floating rate, such as Libor, but have
a fixed rate.
We simulate 10,000 scenarios with a stochastic model for the evo­
lution of the interest rate: the Cox, Ingersoll and Ross model (CIR,
[54]).6 Each simulation allows different fixing levels for each date to
be computed, then correspondingly we can determine the TSCF.
For each date we will have 10,000 possible cash flows that are
ordered from the lowest to the highest. We choose a confidence
level a = 99%, which lets us identify the minimum cash flow as the
6 For those interested in the details of the simulation, we used the fol­
lowing CIR parameters r0 = 2%, k — 0.5%, 6 — 4.5% and a — 7.90%.
We do not consider any spread between the fixing (Libor) rates and the
risk-free rate.

C h ap ter 7 Monitoring Liquidity ■ 151

 the last two dates (as shown in Table 7.12). In this
case, if the index rate to which the cash flows are
linked fixes higher than the cap's strike level the
level is always considered equal to the strike.

The results are shown in Figure 7.8: they are derived

in the same way as above but they take the caps
into account as well. Compared with the results in
Figure 7.7, it is easy to see that caps have the effect
of lowering the maximum cash flow and reducing the
expected (average) level as well. The effects are not
unequivocally predictable, they depend on the strike
level, the notional amount and the buying or selling
of the optionality. In any case a simulation is needed
Fiaure 7.7 Maximum, minimum (at the a = 99% c.l.) and
to verify the distribution of cash flows for a given
expected (average) cash flow s for a period of 20 days.
period.

100th and the maximum cash flow as the 9,900th in the ordered
As anticipated before setting out Example 7.6.1, it makes little
set of cash flows for the 14 days. Moreover, we compute the
sense to construct a TSL-at-risk simply as the sum of the TSCCF
expected level on each date, which is simply the average of the
and the TSCLGC computed separately at a given confidence
10,000 possible cash flows. The result is shown in Figure 7.7. It is
level. In fact, if we try to build a maximum or a minimum TSCCF
worthy of note that the minimum cash flow is not necessarily an
by Slimming the items that comprise the TSCFa or the TSCF-i _ a,
outflow (i.e., a negative number).
we would end up with extreme term structures that would look
To ascertain the impact of possible derivative features on the rather unlikely in practice, unless some dramatic event really
TSCF, we now introduce some caps at different strike levels for happens. This is explained by the fact that negative cash flows,

Table 7.12 Notional Am ount Indexed to D ifferent Libor Fixings and Fixed Cash Flow s, fo r Cash Flow s Occurring
in a Period of 14 Days, with Some Cash Flows Capped

1M 3M 6M 1Y 1M 3M 6M 1Y Fixed Rate
Date Amount Amount Amount Amount Strike Strike Amount

1 - 1 ,0 0 0 , 0 0 0
2

3
4 2 ,0 0 0 , 0 0 0 -500,000
5
6 1,500,000 -5,000,000 2,500,000 2 ,0 0 0 , 0 0 0 -250,000
7 1 0 0 ,0 0 0 2 0 0 ,0 0 0 -500,000 1 ,0 0 0

8 1,500,000 -5,000,000 3,000,000 - 1 ,0 0 0 , 0 0 0

9 2,500,000 -5,000,000 2,500,000 2 ,0 0 0 , 0 0 0
10 2 ,0 0 0 , 0 0 0 3,000,000 2,500,000 500,000 25,000
11

12 1,500,000 -5,000,000 2,500,000 2 ,0 0 0 , 0 0 0 4.00% 4.50% 5.00% 5.50%

13
14 2 ,0 0 0 , 0 0 0 3,000,000 2,500,000 500,000 4.50% 4.75% 5.00% 5.25% 25,000

152 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent

Figure 7.8 Maximum, minimum (at the c* = 99%c.l.)and expected
_____________
(average) cash flows for a period of 20 days, with some cash flows capped.
although calculated at their minimum at the chosen confidence
level, are actually netted by the LG C that is forecast at its m axi­
mum at the same confidence level. So, negative cash flows do
not really cumulate at extrem e values, when considered at the
all-encompassing balance sheet level. W hile it is possible from
a mathematical point of view, and meaningful from a risk man­
agem ent point of view, to build the T S E C C F and the expected
T S C L G C separately and then sum them together in the T S Le, it is
m athematically wrong and managerially misleading to sum two
term structures computed separately at extrem e levels.
From these considerations, we need to calculate at an ag g re­
gated level the net cash flows included in both the T S C F and
the T S L G C . To this end we can use the following procedure.
P ro ce d u re 7 .6 .1 . The ste p s to co m p u te a g g re g a te d cash flow s
and their maxima and minima are:
1. Sim ulate a num ber N o f p o ssib le paths fo r all the R risk fac­
tors o f the array x = [x1# x 2, . . . / X/J; each path contains M
ste p s referring to as many calendar dates.
2 . Fo r each scenario n E { 1 , . . . , N}, the cash flow s in clu ded in
the T S C F and the T S L G C are algebraically sum m ed fo r each
o f M s te p s : w e obtain a matrix N X M o f a g g re g a te d cash
flows:
D
cf (to, tm; n) = 2 c f (t o , tm; dp n)
i= 1
w here {d 1# d2, . . . , d D} are all the con tracts an djor se cu ri­
ties generating cash flow s at date tm, in clu ded in the T S C F
and the T S LG C , un der scenario n.
3 . A t each ste p m E { 1 , . . . , M}, the maximum and mini­
mum cash flow s, at a co n fid en ce level o f a and 1 — a,
resp ectively, are iden tified. We d e n o te
them as cfJ t 0/ t j and c f, _ a(t0, tm),
respectively.
Let us now define the T S L at the maximum
and minimum extrem es. In fact, the T S L with
maximum cash flows at confidence level a is
sim ply the collection of maximum cash flows
derived using Procedure 7 .6 .1 :
T S La(t0, tb) = {cfa(t0, t ^ , . . . , cfa(t0, tb)} (7.13)
with the initial condition that T S La(t0, t0) = Cash
(to). Similarly, the TSL with minimum cash flows
at confidence level 1 — a is:
T S L 1_ a(t0, tb) = { c f , . a(t0l t O , . . . , cf^-aito, tb)}
(7.14)
The two term structures of liquidity that we
have just defined, together with the term
structure of expected liquidity T S L e, allow us
to define a term structure of liquidity-at-risk (TSLaR): this is a col­
lection of unexpected cash flows at each date in a given period
[t0, tb], calculated as the difference between the minimum and
the average level of cash flow s. Although it is possible to com ­
pute the TSLaR for both the unexpected maximum and mini­
mum levels, for risk m anagem ent purposes it is more sensible
to refer to the minimum unexpected levels, since unexpected
levels, since unexpected inflows should not bring about prob­
lems. Then we form ally define the TSLaR , at a confidence level
of 1 — a , as:
T S L a R 1_a(t0, tb) = {c f^ Jto , ^) - T S E C C F (t0, ^) - T S C L G C (t0, t,),
• • • , cf*i-a(t0/ tb) - T S E C C F (t0, tb) - T S C L G C (t0, tb)} (7.15)
It is easy to check, by inspecting form ulae (7.15) and (7.10), that
each elem ent of the T S L a R ^ is the difference between corre­
sponding elem ents of the T S L ^ and the T S L e.
We have already m entioned that the curves presented in this
section have to be com puted by simulating the risk factors
affecting all the cash flows at a balance sheet level. Although
their use is generally restricted to simulation engines to gener­
ate the T S L e and the T S L i_ a, they can be used at a less general
level to:
• calculate single m etrics of interest, such as the T S A A of
a single bond or of a portfolio of bonds, the T S L G C of
the liquidity buffer (i.e., the fraction of LG C that relates
to BSL);
• com pute specific m easure for one or more securities, such
as haircuts and adjustm ents due to a lack of liquidity in their
dealing in the m arket;
Chapter 7 Monitoring Liquidity ■ 153
• measure single phenomena such as prepayments, usage of
credit lines or the evolution of non-maturing liabilities (e.g.,
sight deposits);
• price the liquidity risk embedded in banking and trading
book products.
When used independently the information derived by the mod­
els is useful for pricing and risk management, with the caveat
that we are getting away from the more general picture where
correlation effects play a big role. Thus, results obtained in this
154 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
way should never form the basis for aggregation into a compre­
hensive measure of liquidity risk.
We present models that allow the bank to simulate the cash
flows of the main items on its balance sheet and to build
all the metrics we have described. But before doing so, we
have to spend more time considering the liquidity buffer
and term structure of funding liquidity and the interrelations
existing between them when the bank plans an equilibrium
liquidity policy.
The Failure
Mechanics
of Dealer Banks
Learning Objectives
After completing this reading you should be able to:

Compare and contrast the major lines of business in which Assess policy measures that can alleviate firm-specific and
dealer banks operate and the risk factors they face in each systemic risks related to large dealer banks.
line of business.

Identify situations that can cause a liquidity crisis at a

dealer bank and explain responses that can mitigate
these risks.

Excerpt is Volume 24, Number 1, Winter 2010, pp. 51 to 72 of Journal of Economic Perspectives, by Darrell Duffie.
A bank is conventionally viewed as an intermediary between
depositors, who desire short-term liquidity, and borrowers, who
seek project financing. Occasionally, perhaps from an unex­
pected surge in the cash withdrawals of depositors or from a
shock to the ability of borrowers to repay their loans, depositors
may become concerned over the bank's solvency. Depositors
may then "run," accelerating or worsening the bank's failure.
The standard policy tools for treating the social costs of bank
failures include regulatory supervision and risk-based capital
requirements to reduce the chance of a solvency threatening
loss of capital; deposit insurance to reduce the incentives of
individual depositors to trigger cash insolvency by racing each
other to withdraw their deposits; and regulatory resolution
mechanisms, which give authorities the power to efficiently
restructure or liquidate a bank.
During the recent financial crisis, major dealer banks—that is,
banks that intermediate markets for securities and derivatives—
suffered from new forms of bank runs. The most vivid examples
are the 2008 failures of Bear Stearns and Lehman Brothers.
Dealer banks are often parts of large complex financial organi­
zations whose failures can damage the economy significantly.
As a result, they are sometimes considered "too big to fail."
The mechanics by which dealer banks can fail and the policies
available to treat the systemic risk of their failures differ mark­
edly from the case of conventional commercial bank runs. These
failure mechanics are the focus of this article.
As an illustration, consider a protagonist dealer bank, whom
we shall call Alpha Bank, whose capital position has just been
severely weakened by trading losses. The cause need not be
a general financial crisis, although that would further reduce
Alpha's chances for recovery.
Alpha seeks new equity capital to shore up the value of its
business, but potential providers of new equity question
whether their capital infusions would do much more than
improve the position of Alpha's creditors. They also feel too
uninformed about the value of Alpha's assets and future busi­
ness opportunities to offer a price for new shares that Alpha,
given its own information, is willing to accept.
In a rational gamble to signal its strength and to protect its long-
run brand reputation and customer network, Alpha uses some of
its scarce capital to bail out important clients from the significant
losses that they have suffered through investments arranged by
Alpha. Alpha's managers understand their bank's vulnerability
to the flight of its creditors, clients, and counterparties. As the
cracks in Alpha's finances become more apparent, those who
deal with Alpha nevertheless begin to draw back.
In particular, Alpha has been operating a significant prime bro­
kerage business, offering hedge funds and other major investors
156 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
such services as information technology, trade execution,
accounting reports, and—more important to our story—holding
the hedge funds' cash and securities. These hedge funds have
heard the rumors and have been watching the market prices of
Alpha's equity and debt in order to gauge Alpha's prospects.
They begin to shift their cash and securities to better capital­
ized prime brokers or, safer yet, custodian banks. Because Alpha
had relied in part on its clients' cash and securities to finance
its own business, these departures reduce Alpha's financial
flexibility.
Alpha notices that some of its derivatives counterparties
(entities with whom Alpha has entered derivative contracts)
have begun to lower their exposures to Alpha. Their transac­
tions are more and more slanted toward trades that drain
cash toward the counterparties and away from Alpha. In addi­
tion, other dealer banks are increasingly being asked to enter
derivatives trades, called "novations," that have the effect
of inserting the other dealers between Alpha and its original
derivatives counterparties, insulating those counterparties from
Alpha's default risk. As those dealers notice this trend, they
begin to refuse novations that would expose them to Alpha's
default. This damages Alpha's reputation. Further, the cash
collateral placed with Alpha by its derivatives counterparties,
which had been an extra source of financing to Alpha, is rapidly
dwindling.
Alpha's short-term secured creditors see no good reason to
renew their loans to Alpha. Potentially, they could get caught
up in the administrative mess that would accompany Alpha's
default. Most of them fail to renew their loans to Alpha. A large
fraction of these short-term secured loans are in the form of
repurchase agreements, or "repos." The majority of these repos
have a term of one day. Thus, on short notice, Alpha needs to
find significant new financing or to conduct costly fire sales of its
securities.
Alpha's liquidity position is now grave. In the normal course of
business, Alpha's clearing bank allows Alpha and other dealers
the flexibility of "daylight overdrafts" of cash for the intraday
financing of trades. The clearing bank routinely holds Alpha's
securities in amounts sufficient to cover these overdrafts.
Finally, however, Alpha receives word that its clearing bank has
exercised its right to stop processing Alpha's cash and securities
transactions given the exposure of the clearing bank to Alpha's
overall position. Unable to execute trades or to send cash to
meet its obligations, Alpha declares bankruptcy.
Alpha Bank is a fictional composite, standing for any of a
relatively small group of financial institutions that are significant
dealers in securities and over-the-counter derivatives. These
firms typify relatively large global financial groups that, in
addition to their securities and derivatives businesses, may oper­
ate traditional commercial banks or have significant activities in
investment banking, asset management, and prime brokerage.
Most of these are among the dealer banks listed in Table 8.1
that were invited by the New York Federal Reserve to a meeting
concerning over-the-counter derivatives on April 1, 2009. This
list overlaps substantially with the list of primary dealers in U.S.
government securities. 1 As Table 8.1 suggests, large dealer
banks typically operate under the corporate umbrellas of
holding companies.
This article will first review the main lines of business of large
dealer banks, including: (1 ) securities dealing, underwriting,
and trading; (2) over-the-counter derivatives; and (3) prime
brokerage and asset management. I will include a brief
discussion of sources of financing, including off-balance-sheet
structures and short-term secured credit through repurchase
agreements. I then examine the key failure mechanisms of
dealer banks. As in the story of Alpha Bank, these include
the flight of prime-brokerage clients, the sudden disappear­
ance of short-term secured creditors, the defensive reactions
of derivatives counterparties, and, finally, the loss of cash and
securities settlement privileges at a clearing bank.
In the concluding section, I consider potential policy
implications. Many of the business activities of the companies
that operate large dealer banks are outside of the scope of
traditional bank-failure resolution mechanisms, as explained by
Bliss and Kaufman (2006). Since the financial crisis, however, all
large dealer banks now operate as regulated banks or within
regulated bank holding companies. During the financial crisis,
dealer banks drew support from traditional and new sources
of government and central-bank financing. Concerns remain
over the systemic risk that some of these financial institutions
could pose to the economy in the future. Although access to
government support mitigates the systemic risk associated
with catastrophic failures, it also creates a perverse incentive.
The common knowledge that large financial institutions will
receive support when they are sufficiently distressed—in order
to limit disruptions to the economy—provides an incentive to
large financial institutions to take inefficient risks, and for their
creditors to cooperate by financing them at a lower cost than
would be available without the implicit backstop of government
support. As the financial crisis has made clear, it is important
1 The primary dealers that are not part of financial groups represented
are Cantor Fitzgerald (an inter-dealer broker), Daiwa Securities America
Inc., and Mizuho Securities USA Inc. The dealers that are not also
primary dealers in U.S. government securities are the Royal Bank of
Scotland Group, Societe Generale, and Wachovia Bank (now owned by
Wells Fargo).
C hap ter 8 The Failure Mechanics of D ealer Banks
Table 8.1 Dealers Invited to an A pril 1, 2009,
M eeting on Over-the-Counter D erivatives, Hosted
by the N ew York Federal Reserve Bank
Bank of America, N.A.
Barclays Capital
BNP Paribas
Citigroup
Credit Suisse
Deutsche Bank AG
Dresdner Kleinwort
Goldman, Sachs & Co.
HSBC Group
JPMorgan
Chase Morgan Stanley
The Royal Bank of Scotland
Group Societe Generale
UBS AG
Wachovia Bank N.A., A Wells Fargo Company
Source: New York Federal Reserve Bank.
to consider alternatives to government and central-bank last-
resort financial support. Among the additional mechanisms that
might be used to address large dealer-bank failure processes are
the central clearing of over-the-counter derivatives; dedicated
"utilities" for clearing tri-party repurchase agreements under
strict standards; and automatic recapitalization mechanisms,
such as mandatory rights offerings of equity or forms of debt
that convert to equity contingent on distress triggers.
8.1 WHAT LARGE D EA LER BANKS DO
I will tend to simplify by treating large dealer banks as members
of a distinct class, although in practice they vary in many
respects. I focus here on their most significant lines of business.
These include intermediation of the markets for securities,
securities lending, repurchase agreements, and derivatives;
prime brokerage for hedge funds; and asset management for
institutional and wealthy individual investors. Dealer banks also
conduct proprietary trading—that is, speculation on their own
accounts. As a part of their asset-management businesses, some
dealer banks operate "internal hedge funds" and private equity
partnerships, of which the bank acts effectively as a general
partner with limited-partner clients.
■ 157
Dealer banks are typically parts of large financial organizations
that operate other financial businesses, although these will not
be our focus here. For example, many large dealer-banks have
conventional commercial banking operations, including deposit
taking as well as lending to corporations and consumers. They
may also act as investment banks, which can involve managing
and underwriting securities issuances and advising corporate
clients on mergers and acquisitions. Investment banking some­
times includes "merchant banking" activities, such as buying
and selling oil, forests, foodstuffs, metals, or other raw
materials.
One suspects that some of the risk-management failures discov­
ered during the financial crisis are associated with diseconomies
of scope in risk management and corporate governance. In
other words, some senior executives and boards simply found it
too difficult to comprehend or control some of the risk-taking
activities inside their own firms. 3*
Securities Dealing, Underwriting,
and Trading
Dealer banks intermediate in the primary market between
issuers and investors of securities, and in the secondary mar­
ket among investors. In the primary market, the dealer bank,
sometimes acting as an underwriter, effectively buys equities
or bonds from an issuer and then sells them over time to inves­
tors. In secondary markets, a dealer stands ready to have its
bid prices hit by sellers and its ask prices hit by buyers. Dealer
banks dominate the intermediation of over-the-counter securi­
ties markets, covering bonds issued by corporations, munici­
palities, certain national governments, and securitized credit
products. Over-the-counter trades are privately negotiated.
Trade between dealers in some securities, particularly govern­
ment bonds, can also be intermediated by interdealer brokers
and electronic trading platforms (which are essentially "bulletin
boards" on which bids or offers can be commonly observed
by other dealers). Although public equities are easily traded
on exchanges, dealers are also active in secondary markets for
equities—for example, dealers often intermediate large block
trades. Banks with dealer subsidiaries also engage in speculative
The relevant research, for example Boot, Milbourn, and Thakor (1999),
does not find a strong case for the net benefits of forming large diversi­
fied financial conglomerates of this type. There may exist economies of
scope in information technology, marketing, and financial innovation.
For potential synergies between commercial and investment banking,
see Kanatas and Qi (2003).
3 For a case example of lapses in risk oversight, see UBS (2008) "Share­
holder Report on UBS's Writedowns," especially Chapter 5: "Risk
Management and Risk Control Activities."
158 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
investing, often called proprietary trading, which can be aided
in part by the ability to observe flows of capital into and out of
certain classes of securities.
Securities dealers also intermediate in the market for repur­
chase agreements, or "repos." A repo is in essence a short­
term cash loan collateralized by securities. One counterparty
borrows cash from the other, and as collateral against per­
formance on the loan, that counterparty posts government
bonds, corporate bonds, securities from government-sponsored
enterprises, or other securities such as collateralized debt obli­
gations. For example, a hedge fund that specializes in fixed-
income securities can finance the purchase of a large quantity
of securities with a small amount of capital by placing purchased
securities into repurchase agreements with a dealer, using the
cash proceeds of the repo to purchase additional securities. The
majority of repurchase agreements are for short terms, typi­
cally overnight. These repurchase agreements are commonly
renewed with the same dealer or replaced by new repos with
other dealers. The performance risk on a repo is typically miti­
gated by a "haircut" that reflects the risk or liquidity of the secu­
rities. For instance, a haircut of 10 percent allows a cash loan of
$90 million to be obtained by posting securities with a market
value of $ 1 0 0 million.
For settlement of their repo and securities trades, dealers typi­
cally maintain "clearing accounts" with other banks. JPMorgan
Chase and the Bank of New York Mellon handle most dealer
clearing. Access to clearing bank services is crucial to a dealer's
daily operations. Transactions cannot otherwise be executed.
In order to mitigate counterparty risk, some repurchase agree­
ments are "tri-party." The third party is usually a clearing bank
that holds the collateral and is responsible for returning the cash
to the creditor. In principle, this facilitates trade and insulates
the lender somewhat from the risk of a borrower's default. In
2007, tri-party repos totaled $2.5 trillion (Geithner, 2008). The
same two clearing banks, JPMorgan Chase and the Bank of New
York Mellon, are also dominant in tri-party repos. In Europe, tri­
party repos are also arranged through specialized repo clearing
services: Clearstream and Euroclear.
Over-the-Counter Derivatives
Derivatives are contracts that transfer financial risk from one
investor to another. For example, a call option gives an investor
the right to buy an asset in the future at a prearranged price,
shielding the investor from the risk that the cost of acquiring the
asset could rise. Derivatives are traded on exchanges and over
the counter. Because over-the-counter derivatives are negoti­
ated privately, they can easily be customized to a client's needs.
For most over-the-counter derivatives trades, one of the two
counterparties is a dealer. The dealer usually lays off much or all
of the risk of its client-initiated derivatives positions by running a
"matched book," that is, by aiming for offsetting trades, profit­
ing on the differences between bid and offer terms. As in their
securities businesses, dealer banks also conduct proprietary
trading in over-the-counter derivatives markets.
The notional amount of an over-the-counter derivative contract
is typically measured as the market value—or, in the case of
bond derivatives, the face value—of the asset whose risk is
transferred by the derivative. For example, a call option to buy
one million shares of an equity whose price is $50 per share
represents a notional position of $50 million dollars. The total
notional amount of over-the-counter derivatives outstand­
ing is roughly $600 trillion dollars, according to the Bank of
International Settlements. In notional terms, exchange-traded
derivatives positions total to approximately $400 trillion. The
majority of over-the-counter derivatives are interest-rate swaps,
which are commitments to make periodic exchanges of one
interest rate, such as the variable London Interbank Offered
Rate (LIBOR), for another interest rate, such as a fixed rate, on
a stated notional principal until a stipulated maturity date. The
largest over-the-counter derivatives dealer by volume is
JPMorgan, with a total notional position of approximately
$80 trillion, according to the U.S. Office of the Comptroller of
the Currency (2009).
It is an accounting identity that the total market value of all
derivatives contracts must be zero—that is, the total amount
of positive (purchased) positions is equal to the total amount
of negative (sold) positions. Contingent on events that may
occur over time, derivatives transfer wealth from counterparty
to counterparty, but do not directly add to or subtract from the
total stock of wealth. Indirectly, however, derivatives can cause
net losses through the frictional costs of bankruptcies, such as
legal fees, and other costs associated with financial distress.
Derivatives markets also serve a social purpose of transfer­
ring risk from those less equipped to bear it to others more
equipped to bear it.
In addition to the risk associated with the contingent payments
promised by a derivatives contract, there is also the risk that the
counterparty could fail to meet its promised payments. A use­
ful gauge of counterparty risk in the over-the-counter market is
the amount of exposure to default presented by the failure of
counterparties to perform their contractual obligations. These
exposures can be reduced through collateral. For example,
suppose a hedge who has posted $60 million in collateral
with a dealer defaults, leaving the dealer with a portfolio of
derivatives that would have been worth $100 million had the
hedge fund not failed. This leaves the dealer with a net loss of
$40 million.
C hap ter 8 The Failure Mechanics of D ealer Banks
Normally, various over-the-counter derivatives trades between
a given pair of counterparties are legally combined under a
"master swap agreement" between those two counterparties,
conforming to standards set by the International Swaps and
Derivatives Association (ISDA). Among other provisions, master
swap agreements spell out collateral requirements as well as
the obligations of the two counterparties in the event that one
of them cannot perform. As the market values of the derivatives
contracts between two counterparties fluctuate, the collateral
required is recalculated, normally on a daily basis, and is netted
across the various derivatives held between the two counter­
parties. For example, suppose that A has an exposure to B of
$100 million on an oil derivative, while B has an exposure to A
of $80 million on an interest-rate derivative. If the master-swap
agreement specifies full collateralization of the net exposure,
then B posts $20 million of collateral with A. Thus, netting under
a master swap agreement lowers exposures and lowers collat­
eral requirements.
As the financial crisis that began in 2007 deepened, the range
of acceptable forms of collateral taken by dealers from their
over-the-counter derivatives counterparties was narrowed. By
2008, over 80 percent of collateral for these agreements was in
the form of cash, according to a survey conducted by the Inter­
national Swaps and Derivatives Association (2009). The total
amount of collateral demanded also nearly doubled in 2008,
from about $2 trillion in 2007 to about $4 trillion in 2008.
Table 8.2 shows the total exposures represented by the over-
the-counter derivatives portfolios of major dealers, in each of
the major asset classes, as estimated from dealer surveys by the
Bank for International Settlements (2009a). At least one of the
two counterparties of most over-the-counter derivatives is typi­
cally a dealer. Frequently, both parties are dealers. The final row
of Table 8.2 shows a substantial reduction in exposure due to
netting.
Dealers are especially likely to be counterparties to other deal­
ers in the case of credit default swaps, which are in essence
insurance against the default of a named borrower. When a
hedge fund decides to reduce a credit default swap position,
a typical step is to have its original credit default swap position
"novated" to another dealer, which then stands between the
hedge fund and the original dealer by entering new back-to-
back credit default swap positions with each. In this fashion,
dealer-to-dealer credit default swap positions grew rapidly.
Based on data provided by the Depository Trust and Clearing
Corporation (DTCC) in April 2009, of the current aggregate
notional of about $28 trillion in credit default swaps whose
terms are collected by DTCC's DerivServ Trade Information
Warehouse, over $23 trillion were in the form of dealer-to-dealer
positions. Since mid-2008, when the total notional size of the
■ 159
Table 8.2 Exposures of Dealers in Over-the-Counter
Derivatives Markets by Asset Class, as of June 2009
(net exposures do not include non-U.S. credit default
swaps)
Asset Class Exposure ($ billions)
Credit default swap 2,987
Interest rate 15,478
Equity linked 879
Foreign exchange 2,470
Commodity 689
Unallocated 2,868
Total 25,372
Total after netting 3,744
Source: Bank for International Settlements, November, 2009.
credit default swap market stood at over $60 trillion, the total
amount of credit default swaps outstanding has been reduced
by over one half through "compression trades," by which redun­
dant or nearly redundant positions among dealers are effectively
canceled.
Prime Brokerage and Asset Management
Several large dealers are extremely active "prime brokers" to
hedge funds and other large investors. A prime broker provides
clients a range of services, including management of securities
holdings, clearing, cash-management services, securities lend­
ing, financing, and reporting (which may include risk measure­
ment, tax accounting, and various other accounting services).
A dealer may frequently serve as a major derivatives counter­
party to its prime-brokerage clients. A dealer often generates
additional revenues by lending securities that are placed with
it by prime-brokerage clients. As of the end of 2007, according
to data from Upper, the majority of prime brokerage services
were provided by just three firms: Morgan Stanley, Goldman
Sachs, and Bear Stearns, whose prime brokerage business
was absorbed by JPMorgan when it acquired Bear Stearns in
mid-2008 (Hintz, Montgomery, and Curotto, 2009).
Dealer banks often have large asset-management divisions
that cater to the investment needs of institutional and wealthy
individual clients. The services provided include the holding of
client securities, cash management, brokerage, and alternative
investment vehicles, such as hedge funds and private-equity
partnerships that are often managed by the same bank. Such
an "internal hedge fund" may offer contractual terms similar to
those of external stand-alone hedge funds and in addition can
160 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
wrap the client's limited-partner position within the scope of
general asset-management services for that client.
A limited partner in an internal hedge fund may perceive that
a large dealer bank is more stable than a stand-alone hedge
fund and that the dealer bank might even voluntarily support
an internal hedge fund at a time of extreme need. For example,
near the end of June 2007, Bear Stearns offered to lend
$3.2 billion to one of its failing internal hedge funds, the High-
Grade Structured Credit Fund (Barr, 2007b). In August 2007, at
a time of extreme market stress and losses to some of its inter­
nal hedge funds, Goldman Sachs (2007) injected a significant
amount of capital into one of them, the Global Equity Opportu­
nities Fund. In February 2008, Citigroup provided $500 million
in funding to an internal hedge fund known as Falcon (CNBC,
2008). Such actions can be viewed as a rational attempt by
dealer banks to protect their reputation and to reassure impor­
tant clients that their financial position is secure.
Off-Balance-Sheet Financing
Some large dealer banks have made extensive use of "off-
balance-sheet" financing. For example, a bank can originate
or purchase residential mortgages and other loans that are
financed by selling the loans to a financial corporation or trust
that it has set up for this express purpose. Such a "special pur­
pose entity" pays its sponsoring bank for the assets with the
proceeds of debt that it issues to third-party investors. The
principal and interest payments of the debt issued by the spe­
cial purpose entity are paid from the cash flows that it hopes to
receive from the assets that it has purchased from the sponsor­
ing bank.
Because the debt obligations of a special purpose entity are
usually contractually remote from the sponsoring bank, under
certain conditions banks have not been required to treat the
assets and debt obligations of such entities as their own, at least
for purposes of accounting and of regulatory minimum capital
requirements. In this sense, a special purpose entity is "off bal­
ance sheet." Some large dealer banks used special purpose
entities to operate much larger loan purchase and origination
businesses with a given amount of capital than would have been
possible had they held the associated assets on their own bal­
ance sheets. For example, at June 2008, Citigroup, Inc. reported
over $800 billion in off-balance-sheet assets held in such "quali­
fied special purpose entities."
A particular form of special purpose off-balance-sheet entity
that was popular until the financial crisis is the "structured
investment vehicle," which finances residential mortgages
and other loans with short-term debt sold to investors such as
money-market funds. In 2007 and 2008, when home prices fell
dramatically in the United States and subprime residential mort­
gage defaults rose, the solvency of many structured investment
vehicles was threatened—especially as some short-term credi­
tors to these funds recognized the solvency concerns and failed
to renew their loans.
Some large dealer banks bailed out investors in some of their
structured investment vehicles. For example, in late 2007, HSBC
voluntarily committed about $35 billion to bring elements of its
structured investment vehicles onto its balance sheet (Goldstein,
2007). Citigroup followed in December 2007 by bringing
$49 billion in assets and liabilities of structured investment
vehicles onto its own balance sheet (Moyer, 2007). As with
the support provided to distressed internal hedge funds, the
equity owners and managers of these banks may have feared
that the alternative of providing no recourse to their effective
clients would have resulted in a loss of market value through
a reduction in reputation and market share. Some of these
banks, had they been able to foresee the extent of their later
losses during the financial crisis, might have preferred to allow
their off-balance clients to fend for themselves.
8.2 FAILURE M ECHANISM S
FO R D EA LER BANKS
The relationships between a dealer bank and its derivatives
counterparties, prime-brokerage clients, potential debt and
equity investors, clearing bank, and other clients can change
rapidly if the solvency of the dealer bank is threatened. The
concepts at play are similar to those of a depositor run at a com­
mercial bank. That is, fears over the solvency of the bank lead
others to act so as to reduce their potential losses in the event
of the bank's default. Unlike insured depositors at a commercial
bank, many of those with exposures to dealer banks have no
default insurance, or do not wish to bear the frictional costs of
involvement in the bank's failure procedures even if they do
have insurance. The key mechanisms that lead to the failure of a
dealer bank are the flight of short-term creditors, the departures
of prime-brokerage clients, various cash-draining actions by
derivatives counterparties that are designed to lower their expo­
sures to the dealer bank, and finally and most decisively, the
loss of clearing-bank privileges. We will describe each of these
types of "run-on-the-bank" behavior in turn and then discuss
implications for potential improvements in market infrastructure
or regulation.
The Flight of Short-Term Creditors
Large dealer banks tend to finance their assets in various ways,
including by issuing bonds and commercial paper. Increasingly
C hap ter 8 The Failure Mechanics of D ealer Banks
over recent years, they have financed the purchase of their secu­
rities inventories with short-term repurchase agreements. The
counterparties of these repos are often money-market funds,
securities borrowers, and other dealers. Repos with a term of
one day, called "overnight repo," are common. Under normal
pre-crisis conditions, a dealer bank might have been able to
finance most of its holdings of agency securities, Treasuries, cor­
porate bonds, mortgages, and collateralized debt obligations
by daily renewal of overnight repos with an average haircut of
under 2 percent. The dealer could therefore hold these securi­
ties with little incremental capital.
Before their failures, Bear Stearns and Lehman had leverage
ratios (the ratio of assets to equity capital) of over 30, with sig­
nificant dependence on short-term repo financing. Although the
repo creditors providing cash to a dealer bank have recourse to
collateralizing assets, with haircuts that protect them to some
degree from fluctuations in the market value of the collateral,
they may have little or no incentive to renew repos in the face of
concerns over the dealer bank's solvency. Additionally, the repo
creditors could be legally required to sell the collateral immedi­
ately4 or could potentially face litigation over allegations of
improper disposal of the collateral. The repo creditors can avoid
these risks and other unforeseen difficulties simply by reinvest­
ing their cash in new repos with other dealers.
If a dealer bank's repo creditors fail to renew their positions en
masse, the ability of the dealer to finance its assets with suf­
ficient amounts of new private-sector cash on short notice is
doubtful. The dealer may therefore be forced to sell its assets
in a hurry to buyers that know it needs to sell quickly. This
scenario, called a "fire sale," can easily result in much lower
prices for the assets than might be expected in a more orderly
sale. The proceeds of an asset fire sale could be insufficient to
meet the dealer's cash needs, especially if the dealer's original
solvency concerns were prompted by declines in the market
values of the collateral assets themselves. A fire sale could
also lead to fatal inferences by other market participants of
the weakened condition of the dealer. Further, the low prices
recorded in a fire sale could lower the market valuation of the
securities not sold, and thus reduce the amount of cash that
could be raised through repurchase agreements collateralized
by those securities, prompting a "death spiral" of further fire
sales. For the same reason, fire sales by one large bank could
set off fire sales by other banks, causing a systemic risk.
4 In the United States, money market funds, typically operating under
Rule 2a-7 of the Securities and Exchange Commission, have restrictions
on the types of assets they are permitted to hold and would be required
to immediately sell many of the forms of collateral that they could
receive in the event that a repo counterparty fails to perform.
■ 161
A dealer bank's financing problems could be exacerbated dur­
ing a general financial crisis. For example, haircuts of even
investment-grade corporate bonds rose from under 5 percent
before the financial crisis to around 20 percent in the weeks fol­
lowing the failure of Lehman Brothers, while repo financing of
many forms of collateralized debt obligations and speculatively
rated corporate bonds became essentially impossible.5 Peter
Fisher (2008) of BlackRock, an investment management firm,
wrote: "I would also suggest that the prevalence of repo-based
financing helps explain the abruptness and persistence with
which the de-levering has been translated into illiquidity and
sharp asset price declines." Abate (2009) reported that corpo­
rate bond repo transactions (which include certain mortgage-
backed securities not backed by government-sponsored
enterprises) fell approximately 60 percent between March 2008
and March 2009. During the week leading up to the failure of
Bear Stearns, Cohan (2009) reports on the increasing set of Bear
Stearns' normal repo counterparties who told Bear Stearns that
they would not be renewing their repo financing to Bear or were
applying more onerous haircuts and disputing collateral
valuations.
A dealer bank can mitigate the risk of a loss of liquidity from a
run by short-term creditors in various ways: by establishing lines
of bank credit; by dedicating a buffer stock of cash and liquid
securities for emergency liquidity needs; and by "laddering" the
maturities of its liabilities so that only a small fraction of its debt
must be refinanced within a short period of time. Major dealer
banks have teams of professionals that manage liquidity risk by
controlling the distribution of liability maturities and by manag­
ing the availability of pools of cash and of noncash collateral
that is acceptable to secured creditors.
A common central-bank response to the systemic risk created
by the potential for fire sales is broad and flexible lender-of-last-
resort financing to large banks (Tucker, 2009). Such financing
buys the time needed to liquidate financial claims in an orderly
manner.
The U.S. Federal Reserve has always provided secured financing
to regulated commercial banks through its discount window.
Discount-window financing, however, is available only for a
restricted range of high-quality collateral and is also believed to
5 Ewerhart and Tapking (2008) and Hordahl and King (2008) review the
behavior of repo markets during the financial crisis. Gorton (April, 2009)
provides estimates of the haircuts applied to various classes of securities
before and during the financial crisis. In July 2007, corporate bonds and
structured credit products of many types, both investment grade and
noninvestment grade, had haircuts of 2 percent or less. From the second
quarter of 2008, many classes of these securities had haircuts in excess
of 20 percent, while a number of classes of securities are shown by Gor­
ton's source to have no financing in the repo market.
162 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
stigmatize banks that are so weak as to need to use it. Dealers
that are not regulated as banks do not have access to the dis­
count window. During the financial crisis, special credit facilities
were established by Federal Reserve banks, allowing even deal­
ers that did not have access to the discount window to arrange
the financing of a wide range of assets or to temporarily
exchange relatively less liquid securities for Treasuries.6 Almost
immediately after the failure of Lehman, the last two large deal­
ers that had not been regulated as banks, Morgan Stanley and
Goldman Sachs, became regulated bank holding companies,
giving them access to the discount window, among other
sources of government support like government debt
guarantees.
Other central banks have taken similar steps. The European
Central Bank (ECB) provides repo financing to Eurozone banks
through regular auctions, by which the ECB accepts a wide
range of collateral at moderate haircuts. Cassola, Hortacsu, and
Kastl (2008) show that from August 2007, when the range of col­
lateral that was acceptable in the over-the-counter repo market
narrowed after a rash of sub-prime mortgage defaults, banks in
the Eurozone bid significantly more aggressively for financing
in these repo auctions. Tucker (2009) describes a range of new
secured financing facilities of the Bank of England.
The extent to which a dealer bank is financed by traditional
insured bank deposits may lessen its need during a solvency
crisis to replace cash that is lost from the exits of repo counter­
parties and other less-stable funding sources. Insured deposits
are less likely to run than are many other forms of short-term
liabilities. However, under Rule 23A of the Federal Reserve
Act, U.S.-regulated banks may not use deposits to fund broker-
dealer affiliates of the bank.
The Flight of Prime Brokerage Clients
Prime brokerage, as described earlier, is an important source
of fee revenue to some dealer banks. Under normal conditions,
prime brokers can also finance themselves in part with the
cash and securities that clients leave in their prime brokerage
accounts.
Here's how it works. In the United Kingdom, securities and cash
in prime brokerage accounts are generally commingled with the
prime broker's own assets and are thus available to the prime
6 These facilities include the Single-Tranche OMO Program, the Term
Discount Window Program, the Term Auction Facility, transitional credit
extensions announced on September 21, 2008, the Primary Dealer
Credit Facility, the Term Securities Lending Facility, the Commercial
Paper Funding Facility, and the Term Asset-Backed Securities Loan
Facility.
broker for its business purposes, including secured borrowing.
Cash in London-based prime brokerage accounts is, for practical
purposes, equivalent to uninsured deposits. Prime brokers oper­
ating under United States rules may or may not fully segregate
their client's cash, depending on the situation, according to Rule
15c3-2 of the Securities and Exchange Act of 1934. This SEC
rule governs the treatment of "free credit balances," the cash
that a client has a right to demand on short notice. Under Rule
15c3-3, a U.S.-regulated prime broker must aggregate its
clients' free credit balances "in safe areas of the broker or
dealer's business related to servicing its customers" or otherwise
deposit the funds in a reserve bank account to prevent commin­
gling of customer and firm funds.7
The ability to aggregate cash associated with clients' free credit
balances into a single pool, although separate from the prime
broker's own funds, provides flexibility to a prime broker in
managing the cash needs of its clients. For example, the prime
broker can use one client's cash balances to meet the immediate
cash demands of another. Suppose that a dealer has two prime
brokerage clients. It holds cash belonging to Hedge Fund A
of $150 million and has given a cash loan to Hedge Fund B for
$100 million. The excess cash of $50 million must be held in a
reserve account. But if Hedge Fund A moves its prime broker­
age account to another dealer, then the original prime broker
must come up with $100 million of cash from new sources.
Prime brokers provide financing to their clients, typically hedge
funds, secured by assets of those clients. For U.S. prime bro­
kers, the amounts of such margin loans are limited by regulated
"advance rates" that are set according to asset classes. For
example, the maximum amount of cash that can be advanced
for equities is 50 percent of the market value of the equities.
Margin loans for a dealer bank can also be financed using the
client's own assets as collateral, through "re-hypothecation."
Specifically, the prime broker can obtain the cash that it lends
a client, as well as additional cash for its own purposes, by
using the client's securities as collateral on a secured loan
for itself from a third-party lender. For each $100 of margin
cash that it lends to a prime-brokerage client, the dealer is
permitted by regulation to finance itself by using up to $140
worth of the client's assets as collateral on new secured loans.
Re-hypothecation of securities received from prime brokerage
clients is, under normal conditions, a significant source of financ­
ing for the prime broker.
When a dealer bank's financial position is weakened, hedge
funds may move their prime brokerage accounts elsewhere. A
7 The text of the SEC rules is available on-line at various places, such as
the "Securities Lawyer's Deskbook," published by the University of Cin­
cinnati College of Law.
C hap ter 8 The Failure Mechanics of D ealer Banks
failure to run, as Lehman's London-based clients learned, could
leave a client unable to claim ownership of assets that had not
been segregated in the client's account and had been
re-hypothecated to third parties (for discussions, see Farrell,
2008; Mackintosh, 2008a; Singh and Aitken, 2009).
In the United States, ironically, a prime broker's cash liquidity
problems can be exacerbated by its prime brokerage business
whether or not clients run. Under its contract with its prime
broker, a hedge fund could continue to demand cash margin
loans from the dealer backed by securities that the hedge
fund has left in its prime brokerage account. A prime broker
whose solvency is known to be questionable may not itself be
able to obtain cash by using those same securities as collateral
with other lenders. The dealer's potential secured lenders, as
explained earlier, could find it preferable to lend elsewhere.
Thus, even the absence of a run by prime brokerage clients
could temporarily exacerbate a dealer's liquidity crisis. A dealer
could therefore even have an incentive to "fire" a prime broker­
age client to avoid providing cash margin financing to the client!
If prime brokerage clients do run, however, the cash that they
pull from their free credit balances is no longer available to meet
the demands of other clients on short notice, so the prime bro­
ker may be forced to use its own cash to meet these demands.8
The exit of prime brokerage clients whose assets had been used
by the prime broker as collateral for securities lending can elimi­
nate a valuable source of liquidity to the prime broker. Even cli­
ents that do not move to another prime broker may, in the face
of concerns over their broker's solvency, move some of their
securities into accounts that restrict the access of the prime bro­
ker to the securities.
Sorkin (2009) discusses the extreme stress on Morgan Stanley's
cash liquidity that was caused by the departure of prime bro­
kerage clients during the week of the bankruptcy of Lehman
Brothers. Singh and Aitken (2009) calculate that between
August 2008 and November 2008, the securities that Morgan
Stanley had received from its clients that were available for
Morgan Stanley to pledge to others declined by 69 percent,
from $832 billion to $294 billion. For Merrill Lynch and Goldman
Sachs, the corresponding declines in re-pledgeable client collat­
eral over this short period spanning the default of Lehman were
51 and 30 percent, respectively.
The flight of prime-brokerage clients in the face of a dealer
bank's financial weakness could also raise concerns over the
dealer's long-run profitability among potential providers of
emergency capital.
8 Shortfalls are covered, up to limits, by the Securities Investor
Protection Corporation (SIPC).
■ 163
In the days immediately following Lehman's default, credit collateral, fell from $126 billion in March 2008 to $81 billion in
default swap rates for Morgan Stanley exceeded 1000 basis March 2009, suggesting that counterparties significantly reduced
points, meaning that the cost of insuring $100 million of senior their exposures to a dealer whose solvency was in question. Over
unsecured Morgan Stanley debt against default losses was the same period, by comparison, over-the-counter derivatives
above $10 million per year. Some analysts believe that hedge exposures to comparatively healthy JPMorgan Chase grew from
funds are likely to diversify their sources of prime brokerage fur­ $68 billion to $86 billion.
ther and in the future place more of their assets with custodian
As discussed earlier, over-the-counter derivatives agreements
banks rather than with traditional prime brokers (Hintz, Mont­
often call for posting collateral. Further, they call for increases
gomery, and Curotto, 2009).
in collateral from a counterparty whose credit rating is down­
graded below a stipulated level. For example, in its 10K filing
When Derivatives Counterparties with the Securities and Exchange Commission dated January
Duck for Cover 1, 2009 (p. 82), Morgan Stanley disclosed: "In connection with
certain OTC trading agreements and certain other agreements
If a dealer bank is perceived to have some risk of a solvency
associated with the Institutional Securities business segment,
crisis, an over-the-counter derivatives counterparty would look
the Company may be required to provide additional collateral
for opportunities to reduce its exposure to that dealer bank. A
to certain counterparties in the event of a credit ratings down­
variety of mechanisms are possible here. A counterparty could
grade. As of November 30, 2008, the amount of additional col­
reduce its exposure by borrowing from the dealer. Another
lateral that could be called by counterparties under the terms
strategy is to reduce the exposure by entering new trades with
of collateral agreements in the event of a one-notch downgrade
the dealer that cause that dealer to pay out cash for a deriva­
of the Company's long-term credit rating was approximately
tives position. A counterparty could also seek to harvest cash
$498.3 million. An additional amount of approximately
from any derivatives positions that have swung in its favor over
$1,456.2 million could be called in the event of a two-notch
time, and thereby reduce exposure to the dealer. All of these
downgrade." Collateral-on-downgrade triggers were the most
actions reduce the dealer's cash position. If the dealer wants
proximate cause of the need by the insurance company AIG for
to avoid an adverse signal of its weakness, the dealer cannot
a massive U.S. government bailout.
afford to refuse its counterparties the opportunity to make these
trades at terms prevailing elsewhere in the market. Master swap agreements include terms for the early termina­
tion of derivatives in a selection of contingencies, including the
As we have explained, a counterparty to the dealer could also
default of one of the counterparties. The actual procedures
reduce its exposure through novation to another dealer (Inter­
to be followed can be complicated, as appears to be case in
national Swaps and Derivatives Association, 2004). For instance,
the Lehman bankruptcy (Lehman Bankruptcy Docket, 2008a;
a hedge fund that had purchased protection from a dealer on
2008b). The general thrust of the settlement terms in the event
a named borrower, using a credit default swap contract, could
of a default is that the nondefaulting counterparty is entitled
ask a different dealer for a "novation." The new dealer would
to the replacement cost of the contracts it holds. For any con­
thereby offer protection to the hedge fund and buy protection
tingent claim, including a derivative contract, other dealers
itself from the original dealer, thus insulating the hedge fund
offer one price to buy and a higher price to sell. This bid-offer
from the default of the original dealer. When Bear Stearns'
spread implies an effective transaction cost that increases the
solvency was threatened in mid 2008, some of Bear Stearns'
replacement cost of the derivatives portfolio and thus raises the
counterparties asked other dealers for novations, by which
claim against the defaulting dealer. For example, Citibank had
those dealers would effectively absorb the risk of a failure by
an over-the-counter derivatives portfolio with a total notional
Bear Stearns (Burroughs, 2008; Kelly, 2008; Cohan, 2009, p. 27).
size of roughly $30 trillion in the summer of 2009 (according
Although dealers routinely grant such novations because they
to data from the Office of the Comptroller of the Currency). If
facilitate normal trading strategies, in this case other dealers
the effective average bid-offer spread on this portfolio is, for
began to refuse these Bear Stearns novations. This in turn is
example, 0.2 percent of the notional position amount, then the
likely to have spread alarm over Bear Stearns's difficulties, lead­
effective increase in liability to Citibank associated with a default
ing to actions that are likely to have worsened Bear Stearns's
termination of its derivatives portfolio would be on the order
cash position (for further discussion, see Yavorsky, 2008a; Leis-
of $60 billion. This termination loss on the derivatives portfolio
ing, 2009).
would be above and beyond any loss associated with the fair
Based on analysis by Singh (2009), the exposures of over-the- market value of the portfolio (which is about halfway between
counter derivatives counterparties to Citibank, after netting and the bid value and the offer value).

164 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Further, most over-the-counter derivatives contracts are
exempted by law as "qualifying financial contracts" from the
automatic stay at bankruptcy that holds up other creditors of a
dealer. The effect of unwinding the dealer's derivatives portfolio
is a large post-bankruptcy drain on the defaulting dealer, with
priority to derivatives counterparties. This raises the incentive
of other creditors to run from their exposures before default or
to fail to finance a dealer threatened by a cash liquidity crisis,
further accelerating the default.
One way to reduce the incentive of counterparties to flee from
an apparently weak dealer bank is to have the derivatives con­
tracts guaranteed by a "central clearing counterparty," a
special-purpose financial institution whose only business is to
stand in between the original buyers and sellers of over-the-
counter derivatives (Bank for International Settlements, 2007;
Bliss and Steigerwald, 2006; Duffie and Zhu, 2009, Hills, Rule,
Parkinson, and Young, 1999; Ledrut and Upper, 2007). A central
clearing counterparty collects capital from all members and col­
lateral against derivatives exposures to its members in order to
cover any losses associated with defaults. Assuming that the
central clearing counterparty has sufficient resources, the origi­
nal counterparties to the dealer are insulated from the default of
the dealer. As one example, Global Association of Central Coun­
terparties (2009) describes the performance of central clearing
counterparties in processing some of Lehman's derivatives posi­
tions when it defaulted.9
Central clearing counterparties can handle only derivatives
with relatively standard terms, however, and therefore would
not have been in a position to mitigate the counterparty risks
associated with the infamous credit derivatives of AIG Financial
Products unit, which were highly customized.
Loss of Cash Settlement Privileges
The final step in the collapse of a dealer bank's ability to meet
its daily obligations is likely to be the refusal of its clearing bank
to process transactions. In the normal course of business, a
clearing bank would extend "daylight overdraft privileges" to its
creditworthy clearing customers. For example, the cash required
to settle a securities trade on behalf of a dealer client could be
9 Yavorsky (2008b) describes how many firms involved with Lehman—
hedge funds, buy-side firms, and other dealers—tried in September
2008 to negotiate offsetting replacement trades that would reduce their
exposure to Lehman. These trades would only take place if Lehman
declared bankruptcy. Unfortunately, "the close-out session resulted in
the replacement of only a relatively limited amount of all the outstand­
ing trades." The practical problems involved the large number of partici­
pants, the large number of outstanding positions, and the difficulties of
agreeing on prices at a time of significant volatility in the market.
C hap ter 8 The Failure Mechanics of D ealer Banks
wired to the dealer's counterparty (or that counterparty's own
clearing bank) before the necessary cash actually appears in the
dealer's clearing account on that day, under the premise that
the dealer will receive sufficient cash from other counterparties
during the day in the course of settling other transactions.
Meanwhile, the dealer holds securities in its clearing account
with a market value that is likely to be more than sufficient to
cover any potential shortfall.10 Abate (2009) estimates that the
intraday peak level of overdrafts typically occurs at about
10 a.m. and "easily exceeds several hundred billion dollars."
When a dealer's cash liquidity comes into doubt, however, a
clearing bank has a "right of offset," a contractual right to dis­
continue making cash payments that would reduce the account
holder's cash balance below zero during the day, after account­
ing for the value of any potential exposures that the clearing
bank has to the account holder. In the case of Lehman's default,
for instance, it has been reported that Lehman's clearing bank,
JPMorgan Chase, invoked this right, refusing to process Lehm­
an's instructions to wire cash needed to settle Lehman's trades
with its counterparties (Dey and Fortson, 2008; Teather, 2008;
Craig and Sidel, 2008). Lehman was unable to meet its obliga­
tions on that day and entered bankruptcy.
8.3 PO LICY RESPO N SES
Policies for the prudential supervision, capital requirements,
and failure resolution of traditional commercial banks have
been developed over many years and are relatively settled. The
financial crisis, however, has brought significant new attention to
policies for reducing the risks posed by large systemically impor­
tant financial institutions, particularly dealer banks.
The regulatory changes currently envisioned for systemically
important financial institutions in both the United States and
Europe include higher capital requirements, new supervi­
sory councils, and special powers to resolve these financial
institutions as they approach insolvency or illiquidity. Banks
sponsoring securitization deals will also be required to hold at
least a minimum level of exposure to the securitized cash flows,
in an attempt to give them the incentive to lower the risk of
10 In the U.S. interbank market, cash payments are settled by FedWire
electronic transfer of federal funds from one bank's account with the
Federal Reserve to another's. As far as the interest earned on its federal
funds and its reserve requirements, what matters to a clearing bank on a
given day is its federal funds balances as of 6:30 p.m. Eastern. The Fed
charges banks a fee of 36 basis points for daylight overdrafts of fed­
eral funds. Clearing banks, in turn, may assess a similar fee to dealer's,
although the clearing bank's overdraft in federal funds would typically
be smaller than the sum of the overdrafts of its client dealers, given
positive and negative dealer balances can be netted.
■ 165
these securitization structures. Capital requirements are likely
to be higher for derivatives that are not guaranteed by a central
clearing counterparty. Information about derivatives positions
will be placed into repositories available to regulators. To this
point, however, proposed regulations are unlikely to result
in the safe resolution of dealer banks that depend on large
amounts of overnight repo financing and have large over-the-
counter derivatives portfolios. Most repos and over-the-counter
derivatives are qualifying financial contracts that are exempt
from automatic stays at bankruptcy (Bliss, 2003; Edwards and
Morrison, 2005). Runs by short-term secured lenders and
over-the-counter derivatives counterparties may continue to
contribute to the failure mechanics of large dealer banks and to
systemic risk.
Perhaps the most important source of systemic risk is the poten­
tial impact of dealer-bank fire sales on market prices and inves­
tor portfolios. In the recent financial crisis, the risk of fire sales
was significantly mitigated by lender-of-last-resort financing
by central banks (Tucker, 2009), and by capital injections into
dealer banks, such as those of the Bank of England and the U.S.
Treasury Department's Troubled Asset Relief Program (TARP).
Some of these facilities are likely to be costly to taxpayers and
to increase moral hazard in the risk taking of large dealer banks
going forward, absent other measures.
Another set of policy steps considers the problems of short-term
tri-party repos, which are a particularly unstable source of financ­
ing in the face of concerns over a dealer's solvency. Because tri­
party clearing banks have an incentive to limit their exposures to
a dealer bank, they are likely to limit the access of a weakened
dealer bank to repo financing and to clearing account functions.
Bernanke (2008; see also 2009) has pointed to the potential
benefits of a tri-party repo "utility," which would have less
discretion in rolling over a dealer's repo positions, meet high
standards, and suffer from fewer conflicting incentives. Another
approach, mentioned by Abate (2009) is central-bank insurance
of tri-party repo transactions. Yet another approach under dis­
cussion is an "emergency bank," to be financed by repo market
participants, that could manage the orderly unwinds of repo
positions of weakened dealers. The emergency bank would have
access to discount-window financing from the central bank and
would insulate systemically critical clearing banks from losses in
the course of the unwinding process.
The threat posed by the flight of over-the-counter derivatives
counterparties can be lowered by central clearing. Sufficiently
extensive and unified clearing can reduce the total exposure of
market participants to any given dealer through the multilateral
netting of positive against negative exposures (Duffie and Zhu,
2009). Obviously, the financial strength of large central clear­
ing counterparties is crucial, as is their implicit government
166 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
backing. Currently, the majority of over-the-counter derivatives
positions are not centrally cleared. There has been modest prog­
ress toward clearing significant quantities of over-the-counter
derivatives that are based on equities, commodities, and for­
eign exchange. Although a large quantity of interest-rate swaps
are cleared, the majority are not. Even the recently established
central clearing counterparties for credit default swaps will not
easily treat a large quantity of positions in credit default swaps
that are not standard enough to be cleared. The challenge of
how to clear a greater share of derivatives and how to deal
with the fact that many derivatives are not standard has only
been partially addressed through legislative proposals that
include higher regulatory capital requirements for uncleared
derivatives.
A further set of proposals addresses the pre-failure resolution of
dealer banks that are suffering grievous financial distress. Dealer
banks could be given regulatory incentives or requirements to
issue forms of debt that, contingent on stipulated distress trig­
gers, convert to equity (Flannery, 2005; Squam Lake Working
Group on Financial Regulation, 2009). Duffie (2009) proposes
that distress-contingent convertible debt be complemented
with regulations favoring mandatory rights offerings of equity
that, similarly, are automatically triggered by leverage or liquid­
ity thresholds. These two new instruments can be designed
to recapitalize a financial institution before a destructive run is
likely to commence, and to reduce a financial institution's incen­
tives for socially excessive risk taking.
The financial crisis has made clear the need to reconsider the
systemic risks posed by the failure of dealer banks and has pro­
vided new insights into the mechanics by which they fail. The
task of building new institutional mechanisms to address these
failure mechanics is timely and urgent.
I am grateful for impetus from Andrei Shleifer and Jeremy
Stein, for research assistance from Ross Darwin, Vojislav
Sesum, and Zhipeng Zhang, and for helpful conversations
with Joseph Abate, Tobias Adrian, James Aitken, John Berry,
Robert Bliss, Lucinda Brickler, Jeremy Bulow, John Coates,
Bill Dudley, David Fanger, Alessio Farhadi, Peter Fisher,
John Goggins, Jacob Goldfield, Jason Granet, Ken Griffin,
Robert E. Hall, Brad Hintz, Henry Hu, Anil Kashyap, Matt
King, Matthew Leising, Paul Klemperer, Joseph Langsam,
Raghu Rajan, Manmohan Singh, Glen Taksler, RickThielke,
Till Schuermann, Hyun Shin, Jeremy Stein, Paul Tucker,
Andrew White, Alex Wolf, Alex Yavorsky, Haoxiang Zhu, and
Tatjana Zidulina. I also thank David Autor, Chad Jones, Ann
Norman, and especially Timothy Taylor for guidance from the
Journal of Economic Perspectives.
References
Abate, Joseph. 2009. "Money Markets: Tri-party Repo
Concerns." Technical Report, Barclays Capital, Research, US
Economics & Rates, Strategy, March 12, 2009.
Bank for International Settlements. 2007. "New Developments
in Clearing and Settlement Arrangements for OTC
Derivatives." Technical Report, Bank of International Settle­
ments, March.
Bank for International Settlements. 2009a. "OTC Derivatives
Market Activity in the First Half of 2009." Technical Report, BIS
Monetary and Economic Department, Basel, November.
Bank for International Settlements. 2009b. "The Role of Valua­
tion and Leverage in Procyclicality," April.
Barr, Alistair. 2007a. "Bear Stearns' Credit Hedge Funds Almost
Wiped Out: Leveraged Fund Worth Nothing; 'Very Little Value'
Left in Larger Fund, Letter Says." MarketWatch, July 18.
Barr, Alistair. 2007b. "Bear to Lend $3.2 Bln to One of its
Hedge Funds— But Bank Doesn't Lend Money to Other, More
Leveraged, Hedge Fund." MarketWatch, June 22.
Bernanke, Ben. 2008. "Reducing Systemic Risk." Speech
presented at the Federal Reserve Bank of Kansas City's Annual
Economic Symposium, Jackson Hole, Wyoming, August 22.
Bernanke, Ben. 2009. "Financial Reform to Address Systemic
Risk." Technical Report, Speech at the Council on Foreign
Relations, March 10.
Bliss, Robert. 2003. "Resolving Large Complex Financial
Organizations." In Research in Financial Services: Private and
Public Policy, Vol. 15: Market Discipline in Banking: Theory
and Evidence, ed. George G. Kaufman, pp. 3-31. Amsterdam:
Elsevier Press.
Bliss, Robert, and George G. Kaufman. 2006. "U.S. Corporate
and Bank Insolvency Regimes: An Economic Comparison and
Evaluation." Working Paper WP-06-01, Federal Reserve Bank of
Chicago.
Bliss, Robert, and Robert Steigerwald. 2006. "Derivatives
Clearing and Settlement: A Comparison of Central Counter­
parties and Alternative Structures." Federal Reserve Bank
of Chicago Economic Perspectives, 30 (4, Fourth Quarter):
pp. 22-29.
Boot, Arnoud, Todd Milbourn, and Anjun Thakor. 1999. "Mega­
mergers and Expanded Scope: Theories of Bank Size and Activ­
ity Diversity." Journal of Banking and Finance, 23(2-4): pp.
195-214.
C hap ter 8 The Failure Mechanics of D ealer Banks
Bulow, Jeremy, and Paul Klemperer. 2009. "Reorganizing the
Banks: Focus on the Liabilities, Not the Assets." VOX, March 21.
http://www.voxeu.org/index.php?q=node/3320.
Burroughs, Bryan. 2008. "Bringing Down Bear Stearns." Vanity
Fair, August.
Cassola, Nuno, Ali Hortacsu, and Jakub Kastl. 2008. "Effects of
the Subprime Market Crisis on the Primary Market for Liquidity."
Unpublished paper.
CNBC. 2008. "Citigroup to Bail Out Internal Hedge Fund." Web
news report, CNBC.com, February 23.
Cohan, William D. 2009. House o f Cards: A Tale of Hubris and
Wretched Excess on Wall Street. New York: Doubleday.
Craig, Susanne, and Robin Sidel. 2008. "J.P. Morgan Made Dual
Cash Demands." Wall Street Journal, October 8.
Dey, lain, and Danny Fortson. 2008. "JP Morgan Brought
Down Lehman Brothers." Technical Report. The Sunday Times,
October 5.
Diamond, Douglas W., and Philip H. Dybvig. 1983. "Bank Runs,
Deposit Insurance, and Liquidity." Journal of Political Economy,
91(3): pp. 401-419.
Duffie, Darrell. 2009. "Contractual Methods for Out-of-Court
Restructuring of Systemically Important Financial Institutions."
Submission Requested by the U.S. Treasury Working Group on
Bank Capital, Graduate School of Business, Stanford University,
November, 2009. http://www.stanford.edu/~duffie/Restruc-
turingDuffie.pdf. Forthcoming in Ending Government Bailouts
as We Know Them, ed. Kenneth Scott, George Shultz, and John
Taylor. Hoover Press.
Duffie, Darrell, and Haoxiang Zhu. 2009. "Does a Central Clear­
ing Counterparty Reduce Counterparty Risk?" http://www
.stanford.edu/~duffie/DuffieZhu.pdf.
Edwards, Franklin, and Edward R. Morrison. 2005. "Derivatives
and the Bankruptcy Code: Why the Special Treatment?" Yale
Journal on Regulation, 22(1): pp. 91-122.
Ewerhart, Christian, and Jens Tapking. 2008. "Repo Markets,
Counterparty Risk, and the 2007/2008 Liquidity Crisis." ECB
Working Paper 909, European Central Bank.
Farrell, Sean. 2008. "Hedge Funds with Billions Tied up at
Lehman Face Months of Uncertainty." The Independent,
October 6.
Financial Services Authority. 2009. "Strengthening Liquidity
Standards." Policy Statement, October, 2009. http://www.fsa
.gov.uk/pubs/policy/ps09_16.pdf.
■ 167
Fisher, Peter. 2008. Comments on "The Role of Liquidity in
Financial Crises," by Franklin Allen and Elena Carletti, Jackson
Hole Conference, August.
Flannery, Mark J. 2005. "No Pain, No Gain? Effecting Market
Discipline via Reverse Convertible Debentures." Chapter 6 in
Capital Adequacy beyond Basel: Banking, Securities, and Insur­
ance, ed. Hal S. Scott. Oxford: Oxford University Press.
Geithner, Timothy. 2008. "Remarks at the Economic Club of
New York," New York City, June 9.
Global Association of Central Counterparties. 2009. "Central
Counterparty Default Management and the Collapse of Lehman
Brothers." Technical Report, CCP12, The Global Association of
Central Counterparties.
Goldman Sachs. 2007. "Goldman Sachs and Various Investors
Including C.V. Starr & Co., Inc., Perry Capital LLC and Eli Broad
Invest $3 Billion in Global Equity Opportunities Fund." Technical
Report, Goldman Sachs Press Release, August 13.
Goldstein, Steve. 2007. "HSBC to Provide $35 billion in Funding
to SIVs—Citigroup Reportedly under Pressure to Move Securi­
ties onto Its Balance Sheet." MarketWatch, November 27.
Gorton, Gary. 2009. "Slapped in the Face by the Invisible Hand:
Banking and the Panic of 2007+." April, 2009. (May 9 version:
http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf.)
Forthcoming in Slapped by the Invisible Hand, by Gary Gorton.
Oxford University Press.
Hills, Bob, David Rule, Sarah Parkinson, and Chris Young. 1999.
"Central Counterparty Clearing Houses and Financial Stability."
Bank of England Financial Stability Review, June, pp. 122-134.
Hintz, Brad, Luke Montgomery, and Vincent Curotto. 2009.
"U.S. Securities Industry: Prime Brokerage, A Rapidly Evolving
Industry." Technical Report, Bernstein Research, March 13.
Hordahl, Peter, and Michael R. King. 2008. "Developments
in Repo Markets During the Financial Turmoil." BIS Quarterly
Review, December, pp. 37-52.
International Swaps and Derivatives Association. 2004. "User's
Guide to the 2004 ISDA Novation Definitions." Technical Report,
ISDA Technical Document, New York.
International Swaps and Derivatives Association. 2009. "ISDA
Margin Survey 2009." Technical Report, ISDA Technical Docu­
ment, New York.
Kanatas, George, and Jianping Qi. 2003. "Integration of Lend­
ing and Underwriting: Implications of Scope Economies." Jour­
nal of Finance, 58(3): pp. 1167-1191.
Kelly, Kate. 2008. "Fear, Rumors Touched Off Fatal Run on Bear
Stearns." Technical Report, WSJ.com, May 28.
168 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Ledrut, Elisabeth, and Christian Upper. 2007. "Changing Post­
trading Arrangements for OTC Derivatives." BIS Quarterly
Review, December, pp. 83-95.
Lehman Bankruptcy Docket. 2008a. "Notice of Debtors' Motion
for an Order Pursuant to Sections 105 and 365 of the Bank­
ruptcy Code to Establish Procedures for the Settlement or
Assumption and Assignment of Prepetition Derivative Contracts
Fed Seeks End to Wall Street Lock on OTC Derivatives." Techni­
cal Report, Docket Number 1498, November 13.
Lehman Bankruptcy Docket. 2008b. "Order Pursuant to
Sections 105 and 365 of the Bankruptcy Code to Establish
Procedures for the Settlement or Assumption and Assignment
of Prepetition Derivative Contracts." Docket Number 2257,
December 16.
Leising, Matthew. 2009. "Fed Seeks End to Wall Street Lock on
OTC Derivatives." Bloomberg.com, May 6.
Mackintosh, James. 2008a. "Lehman Collapse Puts Prime Broker
Model in Question." Financial Times, September 24.
Mackintosh, James. 2008b. "Flight from Morgan Stanley Broker­
age." Financial Times, September 25.
Moyer, Liz. 2007. "Citigroup Goes It Alone To Rescue SIVs."
Forbes.com, December 13.
Securities and Exchange Commission. 2004. "Rule 15c3-3:
Reserve Requirements for Margin Related to Security Futures
Products." Technical Report, 17 CFR Parts 200 and 240 [Release
No. 34-50295; File No. S7-34-02] RIN 3235-AI61. August 31.
Singh, Manmohan. 2009. "Counterparty Risk Post-Lehman Rela­
tive to pre Bear Sterns." May.
Singh, Manmohan, and James Aitken. 2009. "Deleveraging after
Lehman— Evidence from Reduced Rehypothecation." IMF Work­
ing Paper 09/42, International Monetary Fund.
Sorkin, Andrew Ross. 2009. Too Big To Fail: The Inside Story of
How Wall Street and Washington Fought to Save the Financial
System—and Themselves. Viking.
Squam Lake Working Group on Financial Regulation. 2009. "An
Expedited Resolution Mechanism for Distressed Financial Firms:
Regulatory Hybrid Securities." Working Paper, Council on For­
eign Relations, April.
Teather, David. 2008. "Banking Crisis: Lehman Brothers: JP Mor­
gan Accused over Bank's Downfall." The Guardian (London),
October 6.
Tucker, Paul. 2009. "The Repertoire of Official Sector Interven­
tions in the Financial System: Last Resort Lending, Market-
Making, and Capital." Technical Report, Speech Delivered to
the "Bank of Japan 2009 International Conference on Financial
System and Monetary Policy: Implementation," Bank of Japan,
Tokyo, May 27-28.
UBS. 2008. "Shareholder Report on UBS's Writedowns." Techni­
cal Report, UBS, April 18, Zurich.
U.S. Office of the Comptroller of the Currency. 2009. "OCC's
Quarterly Report on Bank Trading and Derivatives Activities:
Second Quarter 2009." Technical Report, US Department of the
Treasury, Washington, DC.
U.S. Treasury Department. 2009. "Resolution Authority for Sys-
temically Significant Financial Companies Act of 2009." Techni­
cal Report, U.S. Treasury Department.
C hap ter 8 The Failure Mechanics of D ealer Banks
University of Cincinnati College of Law. 2009. "Securities Law­
yer's Deskbook." http://taft.law.uc.edu/CCL/ (accessed Decem­
ber 8, 2009).
Yavorsky, Alexander. 2008a. "Credit Default Swaps: Market,
Systemic, and Individual Firm Risks." Moody's Finance and
Securities, Investor Report, Special Comment, Moody's Investor
Services, March.
Yavorsky, Alexander. 2008b. "Credit Default Swaps: Market, Sys­
temic, and Individual Firm Risks in Practice." Moody's Finance
and Securities, Investor Report, Special Comment, Moody's
Investor Services, October.
■ 169
Liquidity Stress
Testing
S te p h e n B a ird 1

Learning Objectives
After completing this reading you should be able to:

Differentiate between various types of liquidity, including Discuss liquidity stress test design issues such as scope,
funding, operational, strategic, contingent, and restricted scenario development, assumptions, outputs, governance,
liquidity. and integration with other risk models.

Estimate contingent liquidity via the liquid asset buffer.

Excerpt is Chapter 3 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen Baird.
A

Stephen Baird is a director in PwC's Chicago office.

171
The global liquidity crisis, which lasted from approximately
August 2007 to the end of 2008, ushered in the broader finan­
cial crisis and highlighted the importance of prudent manage­
ment of liquidity risk. Prior to the crisis, liquidity was readily
available at low cost, and many banks, though apparently well
capitalized, did not have an adequate framework for ensuring
ample liquidity to see them through a prolonged dislocation in
the financial markets. Believing that the funding of contingent
obligations and the inability to roll over existing contractual
obligations were highly unlikely, these institutions did not
conduct stress tests that adequately reflected the severity and
duration of the liquidity crisis that actually occurred during
this period.
The liquidity stress test provides the critical underpinning to
a bank's liquidity risk management framework by determining
IMAGE IS EVERYTHING: THE COLLAPSE OF WASHINGTON MUTUAL
Ignited by a sudden $17 billion run on bank deposits
lasting approximately nine days, WaMu, the thrift divi­
sion of Washington Mutual, Inc., was seized by the Office
of Thrift Supervision on September 25, 2008—to date,
the largest such seizure in U.S. history. Once considered
the banking industry's version of Walmart, WaMu filed for
bankruptcy protection under Chapter 11 one day after the
Office of Thrift Supervision placed its thrift operations into
FDIC receivership, thus becoming the second largest such
bankruptcy filing in U.S. history—surpassed only by that of
Lehman Brothers a week earlier. In a deal brokered chiefly
by the FDIC, JP Morgan Chase & Co. purchased WaMu,
preventing a potentially devastating insurance payout to
WaMu's depositors.
The root of the deluge of retail deposits flowing out of
WaMu's branches can be traced to market perceptions of the
bank's solvency. Two of WaMu's major sources of unsecured
funding—commercial paper and federal funds purchased—
dried up almost completely. This was interpreted by the
rest of the bank's lenders to mean the bank was no longer a
viable counterparty and led to the bank's collapse. Yet, rep­
resentatives of WaMu were quick to note that its operations
did not depend on the availability of short-term financing. In
fact, this position was likely correct. At the time of its demise,
WaMu still had one of the country's largest retail branch
networks, and only a few months before had received an
investment from a private-equity firm, increased its liquidity
172 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
the amount of liquidity that must be held in order to ensure the
institution can meet financial obligations under stressed condi­
tions. A robust liquidity stress test is based on a projection of
cash flows arising from assets, liabilities, and other off-balance
sheet items under a variety of systemic and idiosyncratic sce­
narios that can occur over varying time horizons. The results
of the liquidity stress test provide the foundation for setting
the bank's liquidity risk appetite, establishing appropriate
limits and targets, and developing an effective contingency
funding plan.
In this chapter we will define what is meant by "contingent
liquidity" within the context of liquidity risk management and
the liquidity stress test in particular. We will review the key
components of a liquidity stress test, including (a) the appropri­
ate scope and structure of the liquidity stress test across the
reserves to $50 billion, and shuttered underperforming busi­
ness units. In short, although the bank held a significant
sub-prime exposure, it was well positioned to fund opera­
tions through a competitive buyout process and possibly
achieve long-term recovery albeit with a smaller scale thrift
division. Nonetheless, the crushing blow to WaMu's reputa­
tion resulting from dismal outlook reports left the bank with a
widespread public perception of illiquidity and scant options
outside of bankruptcy.
References:
"WaMu Is Seized, Sold Off to J.P. Morgan, In Largest Failure
in U.S. Banking History" Robin Sidel, David Enrich, Dan
Fitzpatrick. The Wall Street Journal; published September
26, 2008
"Saying Yes, WaMu Built Empire on Shaky Loans" Peter S.
Goodman and Gretchen Morgenson. The New York Times;
published December 28, 2008
"WaMu Slumps as Gimme Credit Cites Liquidity
Concern" Ari Levy. Bloomberg Financial News; published
July 24, 2008
"WaMu: We have $50 billion in liquidity" Aaron Smith. CNN
Money.com; published July 25, 2008.
enterprise, (b) scenario development, and (c) the development
of key assumptions. We will also discuss the broader governance
context of the liquidity stress test, including the governance
around the liquidity stress testing process, how outputs sup­
port the liquidity risk management regime of the organization,
and the controls required within and around the process. Intra­
day liquidity considerations, however, are separately discussed
in Chapter 6.
While the industry has made significant strides in enhanc­
ing liquidity stress testing capabilities since the dark days of
2007-08, banks and their regulators will be working hard to
meet a number of challenges over the next several years in
order to realize the goal of establishing a fully robust liquid­
ity stress testing program. In this chapter we will focus on two
of these emerging trends. First, the industry should improve
the level of integration and consistency between the liquid­
ity stress test, the capital stress test, and, more broadly,
risk measurement and monitoring, performance measure­
ment, and regulatory reporting. Second, banks should invest
in achieving a sustainable technology infrastructure that
ensures liquidity stress testing is performed in an efficient and
controlled manner.
As was seen during the financial crisis, the perception of a
liquidity problem that may arise through an insufficient liquidity
risk management framework can be just as problematic for a
financial institution as an actual inability to meet financial obliga­
tions. The fall of Washington Mutual Bank (WaMu) provides an
instructive example.
9.1 M EASURING CO N TIN G EN T
LIQUIDITY REQ U IREM EN TS
The objective of the liquidity stress test is to measure the
amount of liquidity the institution must maintain in order to
ensure continuing ability to meet financial obligations under
stressed conditions. In order to construct an effective liquidity
stress testing framework, it is important to clearly define what
is meant by "liquidity" for liquidity stress testing purposes.
Within this context, liquidity refers to funding liquidity risk—
the risk that the institution will not have adequate capacity to
fund its obligations without incurring unacceptable economic
losses. Assessing asset liquidity—the risk of incurring losses
due to difficulty converting assets into cash—while not the
objective of the liquidity stress test, must also be carefully con­
sidered in the liquidity stress test since it can also impact the
amount of funding that can be made available from the sale
of assets.
As a source of funding liquidity, businesses, including finan­
cial institutions, utilize liquidity for four purposes: operational,
restricted, contingent, and strategic.
Operational liquidity represents the cash that is needed to fund
the business on a daily basis, and it is required to ensure orderly
clearing of payment transactions. Depending on the nature of
the institution's business, operating cash needs might be quite
volatile and, as a result, a cushion is added to account for the
unpredictability of daily settlements and the excessive system
and management effort that would be required to manage
cash to its theoretical minimum. Operational liquidity must be
maintained to ensure the institution's operations and is therefore
unavailable to meet financial obligations under a liquidity stress
test.
Restricted liquidity represents liquid assets that are available to
be used only for specifically defined purposes. For example, a
bank may be required to collateralize certain wholesale borrow­
ings. Restricted liquidity is unavailable to meet general financial
obligations under a liquidity stress test, but should be applied to
any assumed outflows which they support.
Contingent liquidity represents the liquidity that is available to
meet general financial obligations under a stress scenario. This
liquidity is available in the form of the institution's liquid asset
buffer, which comprises access to financial assets that are of very
high quality and can be easily converted into cash without any
real loss of market value. Measuring required contingent liquid­
ity to cover stressed cash outflows is the principal objective of
the liquidity stress test.
Strategic liquidity represents the cash that is held by the
institution to meet future business needs that may arise
outside the course of normal operations, but it is not pri­
marily aimed at supporting the bank during times of stress.
For example, strategic liquidity may be held to fund future
acquisitions or capital expenditure programs. Strategic
liquidity may be redirected to meet contingent liquidity
requirement needs. As a pragmatic matter, this will likely be
feasible only if such liquidity is present via holdings of highly
liquid assets.
This liquidity taxonomy is illustrated in Figure 9.1.
C h ap ter 9 Liquidity Stress Testing ■ 173
 Available funding
under stress test
Contingent
s Liquid asset buffer composed of a
mixture of liquid investments, liquidity
facility availability, and unrestricted
deposits
Restricted
s Available to meet general s Reserved for specifically defined
financial obligations under purposes arising from normal operations,
a stress test e.g. collateralization requirements

Attributed to underlying outflows under

stress, but not used for general financial
obligations

Strategic
Operational
s Cash used to fund typical business s Reserved for strategic business initiatives
operations and clear payment outside of normal operations, e.g. M&A,
transactions on a daily basis capital improvement projects

v' Levels of cash reserves vary widely by s Not intended to fund daily operations under
business and operating environment a stress scenario, but high quality asset
Not available portion contributes to contingent funding
for drawdown
under stress test

Short-Term Funding Long-Term Funding

(Operational Requirements) (Strategic Planning)
Fiqure 9.1 Liquidity taxonomy.

9.2 O V ER V IEW O F THE M O D EL
If the objective of the liquidity stress test is to measure the
amount of required contingent liquidity, then the institution
must construct a cash flow model that accurately and precisely
measures the following components:
Liquid a s s e t buffer. The liquid asset buffer represents the
contingent liquidity that is currently in place. The liquidity
stress test framework must clearly define the market and
operational characteristics that securities must meet in order
to qualify for inclusion in the liquid asset buffer. In general,
result from the need to prematurely settle non-contractual
maturity obligations as well as the inability to refund con­
tractual maturity obligations that under normal circum­
stances could be rolled over. The institution's framework
should clearly define the types of outflows to be modeled,
which typically fall into the categories of retail deposit
outflows, unsecured wholesale funding outflows, secured
funding runoff, derivative transaction funding, loss of fund­
ing on asset-backed issuances, and drawdown of credit and
liquidity facilities.
S tre sse d in flow s. Stressed inflows are assumed to partially

requirements should ensure that the liquidity-generating
capacity of securities included in the liquid asset buffer
remains intact even in periods of severe idiosyncratic and
market stress. The fundamental characteristics of liquid asset
buffer securities should include low credit and market risk,
ease and certainty of valuation, trading in an active and siz­
able market, and low concentration of buyers and sellers. The
liquid asset buffer should also meet operational requirements
that ensure the liquidity is under the control of the central
treasury area of the entity undergoing the stress test.
S tr e s s e d o u tflo w s. Stressed outflows are those assumed
to occur under stress scenarios. Stressed outflows may
offset the stressed outflows. Inflows may include secured
funding transaction maturities, loan repayments from cus­
tomers, and drawdowns on liquidity facilities available to the
institution. Depending on the assumptions used in a particu­
lar stress scenario, the level of inflows may be reduced or
limited by market conditions.
The liquid asset buffer, net of
S tre sse d liquid a s s e t buffer.
stress outflows and stress inflows, indicates the adequacy
of the current liquid asset buffer given the stress scenario
assumptions.
The components of the liquidity stress test model are depicted
in Figure 9.2.

174 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Normal Liquid Asset Buffer (Less): Stressed Cash Outflow Plus: Stressed Cash Inflows Yields: Stressed Liquid Asset Buffer

Contingent liquidity that is currently
in place. Should comprise a well
diversified portfolio of actively
traded assets with an implicit ease
and certainty of valuation. Asset
quality standards should ensure
sufficient liquidity generation
capacity (investment income /
proceeds from sale) during periods
of high systematic and idiosyncratic
stress.
Mixture of contractual and
contingent cash outflows which
are assumed to occur under stress
scenarios. Examples include
unplanned (premature) non­
contractual obligation settlement
and inability to roll-over sources of
funding, resulting in a short to
long-term liquidity gap. A well
defined stress testing framework
should clearly establish the
categories of outflows to be
modeled.
Cash inflows which are assumed to
partially offset stressed outflows.
Exam ples include secured funding
transaction maturities, loan
repayments from customers and
drawdowns on liquidity facilities
available to the institution.
Depending on the assumptions
used in a particular stress scenario,
the level of inflows may be limited
by market conditions or a regulatory
cap (e.g. not to exceed 75% of
outflows under Basel III LC R .)
Total contingent liquidity having
been reduced by net cash
outflows. The stressed liquid
asset buffer is indicative of the
adequacy of the normal liquid
asset buffer given the stress
scenario assumptions.
Insufficient liquidity under stress
may point towards contractual
maturity mismatch, insufficient
asset quality, or an
overconcentration of certain
sources of funding.

Figure 9.2 Components of the liquidity stress testing model.

9.3 DESIGN O F THE M O D EL
The liquidity stress testing model forms an integral component
of an end-to-end process that begins with risk identification and
event analysis in order to ensure that the roster of scenarios
appropriately captures material liquidity risks (Figure 9.3).
Organizational Scope
The consolidated stress test should be the lynchpin of any
liquidity risk framework. However, an institution may determine
there is a need to conduct stress testing on subsidiary entities
within the organization. The organizational levels at which a
bank may stress liquidity include the parent, subsidiary legal
entities, lines of business, service business units, and shared ser­
vice centers. Each of these cases may be addressed through a
separate liquidity stress test, where necessary. For less material
entities or those entities where risk is assessed to be manage­
able, less complex entity-level liquidity risk reporting might
be sufficient. As a general rule, the institution should consider
the organizational level at which (a) liquidity is commingled,
and (b) liquidity oversight has management accountability.
Combinations of legal entities and operating units having both
of these characteristics will provide the building blocks of the
enterprise-level liquidity stress test:
Liq u id ity tra n sfe r re strictio n s. Liquidity may be trapped in
certain legal entities, potentially creating a distorted view
of the consolidated liquidity position of the institution. For
example, foreign exchange controls may inhibit the conver­
sion of foreign currency in off-shore legal entities. The bank
should assess the impact of such restrictions on enterprise-
level liquidity, considering not only a normal operating
environment but stressed conditions as well. Bank holding
companies, for example, should assume little or no access
to banking subsidiary cash during a crisis due to capital ade­
quacy requirements.
The existence of liquidity transfer restrictions does not nec­
essarily give rise to the need for an additional stress test
where it can be demonstrated that a subsidiary would not
be required to upstream cash to the parent. For example, an
institution may stress the consolidated entity and the holding
company but choose not to test individual banking subsidiar­
ies under the assumption that movement of cash from the
parent to the subsidiary would be unrestricted.

C h ap ter 9 Liquidity Stress Testing ■ 175

 While the liquidity stress test should be performed
C u rre n cy .
in the currency of the entity being tested (the home country
for the consolidated test), careful consideration should be
taken for the liquidity impact of currency conversion require­
ments. For example, less established offshore subsidiaries or
branches sometimes carry a significant currency mismatch,
and the settlement time frame for the home country parent
to swap fund an unanticipated outflow may prove problem­
atic in a crisis.
R e g u la to ry ju risd ictio n . For institutions operating in mul­
tiple foreign jurisdictions under various regulatory oversight
regimes, the need to conduct individual stress tests for
foreign subsidiaries or groups may arise. For example, U.S.
regulations require certain foreign banking organizations to
conduct liquidity stress tests for intermediate holding compa­
nies and branches in order to address concerns that foreign
banks operating in the country would otherwise be over-
reliant on offshore funding.
Planning Horizon
The objective of the liquidity stress test is to ensure that
the institution can maintain adequate contingency fund­
ing through a period of prolonged stress. To meet this goal,
the planning horizon of the liquidity stress test should be at
least twelve months. The bank may choose to project cash
flows beyond twelve months; however, longer-term projec­
tions may be subject to significant forecast error depend­
ing on the time horizon of the baseline balance sheet and
income statement budgeting performed as part of the
strategic planning process. Moreover, the likelihood of the
bank continuing operations indefinitely under stress without
176 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
a recovery or resolution process taking place is unrealistic.
One circumstance in which the bank may choose to forecast
beyond twelve months is the case where a survival horizon is
calculated under the stress test. For banks with ample liquid­
ity, the survival horizon may extend well beyond this period;
some banks have a survival horizon that may extend as far out
as two years, although the extent of the modeled stress will
abate beyond the extreme level of severity assumed in the
very short term.
The frequency of cash flow measurement within the overall time
horizon must also be determined. The decision to estimate
daily, weekly, or monthly cash flows should balance the benefits
of improved precision against the reduced forecasting accu­
racy beyond a certain time frame. Stress models that forecast
daily over a short time frame (e.g., one month) and transition
to weekly or monthly cash flows for the remaining time horizon
are likely to provide the best balance. The need to forecast daily
during the initial stage of the stress test is recommended not
only as a result of the relatively higher predictability of these
cash flows, but also because, as was seen during the financial
crisis, the most critical period of stress for the institution may in
fact occur during those first few days.
9.4 TESTIN G TECH N IQ U ES
There are three general approaches to performing a liquidity
stress test—historical statistical techniques, deterministic
models, and Monte Carlo simulation:
H isto rical statistica l te c h n iq u e s, such as cash flow at risk
(CFaR), model a historical pro forma cash flow based on the
observed cash flow volatility of the institution.
 such as the development of hypothet­
D e te rm in istic m o d e ls,
ical liquidity stress scenarios, model the liquidity impact of a
forward-looking or historical-based scenario that has been
developed by the institution.
is a statistical technique that relies
M o n te C a rlo sim ulation
on simulation modeling and can be used to assess liquidity
risk by stress testing specified variables over a future time
frame.
Stochastic techniques that rely on observations of historical vola­
tility of cash flow variables, whether using historical statistical
models such as CFaR or Monte Carlo simulation techniques that
rely on historical observations of volatility, are viewed less favor­
ably in the wake of the financial crisis. By its nature, liquidity
stress is an extreme "tail event," and deterministic scenarios,
despite their reliance on many assumptions that are derived
through expert judgment, are viewed by regulators and most
financial institutions as the most effective tool for assessing
liquidity risk. An additional challenge of stochastic approaches
is their limited ability to accurately predict the management
countermeasures that would occur during a liquidity crisis event.
The remainder of this chapter will focus on the development of
a deterministic liquidity stress test framework.
9.5 BASELIN E SCEN A RIO
The starting point for building the liquidity stress test is the
baseline balance sheet funding and liquidity plan. As a banking
organization builds out its liquidity stress test framework, it is
sometimes necessary to enhance the structure of the baseline
plan as well to ensure that the base case is consistently struc­
tured and at the same level of detail as the stress scenarios.
It is also advisable to house the baseline analysis in the same
reporting and analysis platform as the liquidity stress test. The
objective is to ensure that the institution can gauge the sever­
ity of each stress scenario by making a valid comparison to the
baseline forecast.
9.6 SCEN A RIO D EV ELO PM EN T
By its very nature, liquidity failure is a high-impact, low-
frequency event. Fortunately, only a handful of large financial
institutions have collapsed due to insufficient liquidity. Unfor­
tunately for this very reason, there is little data upon which to
build reliable, predictive models that can accurately estimate
the minimum level of liquidity an institution can expect to
maintain within a confidence interval. Even in the recent finan­
cial crisis, a combination of government intervention, monetary
stimulus, and customer delevering led to a liquidity buildup
that quickly stuffed the cash coffers of all but the shakiest
banks.
As a result of these limitations and the highly complex, intercon­
nected nature of liquidity behavior, the industry approach to
performing a liquidity stress test is to develop a set of discrete,
deterministic scenarios. While the menu of liquidity stress test
scenarios has become somewhat standardized across the bank­
ing industry since the financial crisis, it is important that each
financial institution carefully consider its unique or idiosyncratic
material risks when building out its scenario framework.
There are two general types of liquidity stress scenarios—historical
scenarios and forward-looking (hypothetical) scenarios.
Historical Scenarios
Historical scenarios are based on actual liquidity failures and
attempt to translate those events to the financial institution
performing the stress test. The failures of WaMu and Northern
Rock in 2008 are common reference events. The advantage of
historical scenarios is that they are empirically based. The disad­
vantage of this approach is that few such failures have actually
occurred; and for the ones that have taken place, very limited
data are available. Additionally, future business conditions may
cause new and unanticipated liquidity events, creating a poten­
tial blind spot for management.
Hypothetical Scenarios
Hypothetical scenarios are based on a forward-looking view in
which the financial institution experiences severe liquidity stress.
Banks typically develop multiple scenarios. Liquidity stress sce­
narios should exhibit the following characteristics:
Some
D istin g u ish b e tw e e n sy ste m ic and id io sy n cra tic risk.
liquidity stress impacts are the result of systemic stress, such
as a reduction in the market liquidity of securities, while
other impacts are the result of bank-only stress, such as a
deposit run. See Figure 9.3 for a detailed description of
these impacts. Banks should develop at least one scenario for
each of the cases of systemic, idiosyncratic, and combined
idiosyncratic and systemic in order to capture these varying
impacts.
D istin g u ish b e tw e e n le v e ls of se v e rity . Assuming graduat­
ing levels of severity, for example, by developing adverse
and severely adverse variations of the idiosyncratic scenario,
enables the institution to broaden its view of liquidity risk and
applicable limits.
C h ap ter 9 Liquidity Stress Testing ■ 177
 The bank must establish a spe­
C le a rly d e fin e th e sc e n a rio s.
cific, detailed description of the business and market events
associated with each scenario in order to provide the foun­
dation for assumption development as well as linking stress
testing to early warning indicators in contingency funding
plans. In developing and documenting each stress scenario,
the bank should ensure the level of detail is sufficient to pro­
vide a comprehensive view into the specific conditions the
institution is experiencing. Scenario descriptions typically
include, at a minimum:
• The general level of stress (e.g., high) of market, eco­
nomic, and credit conditions
• Conditions of wholesale secured and unsecured funding
markets
• Changes in counterparty haircut requirements by collateral
type
• Liquidity impacts on securities in the liquidity buffer and
other assets in the event of sale
• Details of credit grade downgrades
• Deposit runoff assumptions by product and customer
type, and with consideration to other factors such as insur­
ance coverage
• Description of impacts on specific counterparty
relationships
• Rating trigger impacts on derivative margin and collateral
calls
• Impact of regulatory actions or limit breaches in foreign
jurisdictions
• Assumed drawdowns on unfunded credit and liquidity
facilities
• Assumed debt calls and buybacks
C o n s id e r m ore h o listic a p p ro a c h e s to sce n a rio
Standard industry liquidity stress test
d e v e lo p m e n t.
scenarios, including those required by regulators under the
Basel III liquidity coverage ratio (LCR), are highly prescrip­
tive. This philosophy is in sharp contrast to the approach
taken for capital stress testing, where a set of high-level
macroeconomic developments are assumed and then care­
fully assessed to link their impacts to the bank's financial
performance and capital position. In addition to the liquidity-
specific scenarios described here, the institution should also
consider scenarios based on broader economic and business
impacts. Doing so will ensure the bank is considering sys­
temic, interdependent risk behavior rather than simply devel­
oping isolated liquidity assumptions.
In addition to assumption-based hypothetical scenarios, the
bank may also perform a reverse liquidity stress test. The
178 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
objective of a reverse liquidity stress test is to determine
which conditions would need to exist, given the bank's current
liquidity level, to cause its current business plan to become
unviable. To construct such a scenario will require determina­
tion of which factors will have the most significant impact on
liquidity and stressing these assumptions to the institution's
destruction. Developing such a reverse stress test scenario,
while simple in theory, presents a number of problems as there
are a large number of factors which could combine to destroy
the institution. It can also be difficult to develop a destruction
scenario if the bank is highly liquid without making fantastic,
apocalyptic assumptions. As a result, reverse stress testing is
not a universally performed exercise among financial institu­
tions; however, the FRB's SR Letter 12-7 does provide guidance
on reverse stress testing, which is applicable to institutions
above $10 billion in consolidated assets. In this context, the
failure considerations (which most banks qualify as a liquidity
driven event) under recovery and resolution planning might be
viewed as constituting a reverse stress test. Nevertheless, it is
advisable to at least think through a reverse stress test in devel­
oping traditional stress test scenarios as a way of facilitating
an understanding of the priority risks the institution should be
testing (Table 9.1).
9.7 D EV ELO PM EN T O F ASSUM PTIONS *1
Liquidity stress testing is built on hypothetical and historical
scenarios, and as a result is highly dependent on the validity
of assumptions in generating meaningful results. For many key
assumptions there is limited historical or market data to draw
upon in building a fact base. Nevertheless, applying segmen­
tation frameworks that enable differentiation of assumptions
across varying levels of cash flow risk enhances the rigor of the
liquidity stress test.
In addition to developing internal views of stressed liquidity
behavior, the institution should reference the Basel III (including
as implemented in local jurisdictions) liquidity coverage ratio
cash flow rates.
Generally, in developing liquidity stress testing assumptions the
institution should do the following:
1. Qualitatively assess the expected liquidity behavior for each
type of cash flow to determine where there is significant
liquidity risk.
2. Determine the appropriate level of segmentation for each
type of risk based on an assessment of behavioral differ­
ences, bearing in mind any limitations in ongoing data
availability.
Table 9.1 Key Liquidity Stress Impact Factors

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 funding
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
Loss of secured funding Limitation of security types available for 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 portfolio liquidity Increased liquidity haircuts and/or reduced valuations of liquidity portfolio securities
Derivative cash flows Increased derivative margin/collateral calls due to increased market volatility of under­
lying 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

3. Qualitatively assess and order by rank varying levels of
liquidity risk for each segmentation factor, potentially utiliz­
ing a scoring system.
4 . Develop quantitative modeling assumptions based on any
historical data available, such as experiences during the
financial crisis, or available from other sources such as peer
benchmarking.
5. Develop matrices of relative modeling assumptions based
on scored risk levels and baseline historical data.
6 . Adjust assumption matrices as appropriate for each stress
scenario, for example, reflecting differences in relative
overall severity or assumptions concerning idiosyncratic or
systemic risk.
The following assumptions can have an outsized impact on the
results of the stress test, and should be considered carefully in
developing the model:
In vestm e n t p o rtfo lio h aircuts. The ability to obtain liquid­
ity through pledging, funding through a repo transaction,
or outright sale of investment portfolio securities will have
a critical impact on available liquidity under stress. For sys­
temic stress scenarios, it is assumed that haircuts will widen
on securities as was observed during the crisis. The model
should include varying haircut assumptions for each security
type where liquidity characteristics differ, for example, dif­
ferentiating between agency mortgage-backed securities and
non-agency mortgage-backed securities. The model should
also include expected haircut differences between secured
financing channels used by the institution, for example,
Federal Home Loan Bank funding, and repo facilities.
Developing a scoring system that orders by rank the relative
liquidity along these various segmentation dimensions can be
a useful framework for this purpose. The institution can then
assign specific haircuts to each type of security and funding
channel based on the assessed liquidity risk. The starting
point for developing liquidity haircuts is a review of current
market conditions (assuming such conditions are normal),
and comparing these advance rates to what the bank expe­
rienced during the financial crisis. If the bank does not have
such data available, it will need to be obtained through peer
comparisons where possible.
D e p o sit o u tflo w s. Deposit runoff is, for most institutions, the
most significant threat to liquidity and the most important
behavioral dynamic to model. For the typical, heavily deposit-
funded bank, liquidity stress test models built on simplistic
assumptions concerning deposit behavior will most likely
yield meaningless results, even if other aspects of the model
have been calibrated rigorously.
Unfortunately, there is a scarcity of historical data to rely
upon in developing deposit runoff assumptions. While
the runs that occurred during the crisis, particularly those
at WaMu and Northern Rock, provide useful reference

C h ap ter 9 Liquidity Stress Testing ■ 179

Table 9.2 Deposit Behavioral Characteristics
Typical Behavioral Assessment Factors
Consumer Small Business
• Relationship tenure • Relationship tenure
• Checking product usage • Value-added product usage
• ATM usage frequency • Credit usage
• Rate paid • Branch usage frequency
• Internet usage • FDIC coverage
• FDIC coverage • Rate paid
• Direct control vs. escrow
points, the institution should build a set of detailed deposit
runoff assumptions based on a behavioral segmentation
framework that captures differences in stressed deposit
behavior.
Table 9.2 summarizes behavioral differences typically
observed in deposit portfolios. The institution should care­
fully analyze the historical behavior of its deposit portfolio—
preferably at the account rather than portfolio level—to
develop an appropriate internal segmentation framework.
Empirical analysis is unlikely to yield a perfect experiment
indicative of behavior during a hypothetical crisis. However,
such an analysis is suggestive of customer "stickiness" and
provides a more rigorous foundation than high-level, qualita­
tive assumptions.
U n se cu re d w h o le sa le fu n d in g . Availability of unsecured
wholesale funding is generally assumed to be heavily
reduced in a stress scenario, particularly under idiosyncratic
stress. The bank should review each funding channel to dif­
ferentiate by key liquidity factors, most significantly overnight
versus term funding. There is likely to be little historical data
available assuming the institution has not experienced a
significant stress event. Banks typically apply highly conserva­
tive assumptions when reflecting on the drastic impact that a
stress event is likely to have on wholesale funding availability,
particularly term funding.
Collateral requirements should
C o lla te ra l re q u ire m e n ts.
be expected to increase during a stress scenario as a result
of both valuation impacts on existing collateral as well as
increased collateral levels required as a result of changes in
derivative positions. How the institution develops assump­
tions for collateral call levels (as opposed to collateral valu­
ation impacts, which should align to unsecured wholesale
funding models) will depend on the level of detail required.
The institution may choose to review its historical collateral
call levels, particularly during times of stress, and select the
most significant liquidity requirement experienced during
180 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Commercial and Institutional
• Relationship tenure
• Credit usage
• Treasury and trade usage
• Balance level
• Net borrowing position
• Industry segment
• Company size
• Rate paid
a historical period. A more detailed approach would be to
model each position independently.
The model should address each
O th e r c o n tin g e n t lia b ilitie s.
material source of contingent liquidity outflow, including
drawdowns of customer credit lines, liquidity facilities, letters
of credit, trade financing arrangements, securitization facility
runoff, and other contractual arrangements. Where possible,
the institution should review the behavior of such contingent
liabilities during the financial crisis. If historical data is not
available, conservative assumptions are appropriate.
Non-contractual commitments must also be incorporated
into the model. Particularly for lower stress scenarios, the
institution will still seek to maintain reputational strength and
avoid damage to business franchise value. Achieving these
objectives may require voluntary financing transactions such
as completion of underwriting pipeline deals and repurchase
of securities issued in order to protect counterparties from
mark-to-market losses. Quantitative assumptions for these
requirements can be developed using the projected level of
activity as appropriate.
B u sin ess dial b ack. The liquidity stress test should incorporate
a set of realistic assumptions concerning the institution's abil­
ity to reduce liquidity-draining business activities such as new
loan origination. These assumptions should be developed
through discussions with business unit management, who will
have a view into the level of reduced funding activity that can
occur without causing significant reputational problems.
9.8 OUTPUTS O F THE M O D EL
The outcome of liquidity stress testing, along with the other
components of the institution's liquidity risk measurement
framework, provide the foundation for assessing tactical and
structural liquidity relative to internally established limits and
regulatory expectations. In particular, the liquidity stress test
forms an integral part of an institution's liquidity risk escalation
process. The bank's liquidity limit structure, and in particular the
contingency funding plan, should be tied directly to the results
of the liquidity stress test. These linkages may exist through, for
example, survival horizon metric minimums, minimum available
liquidity limits, and stressed liquidity metric limits.
The liquidity stress test should enable the production of a regu­
lar reporting package that contains the following for each of the
entities being tested:
Key assumptions include
S tre ss te stin g a ssu m p tio n s.
(1 ) overall stress level represented by the scenario; (2 ) indica­
tion of whether the scenario is systemic, idiosyncratic, or both
systemic and idiosyncratic; (3) documentation of the overall
macroeconomic, market, and company-specific events lead­
ing to the stress scenario; and (4) description of the cash flow
impacts of the scenario.
Liq u id ity p osition m e trics. The principal measurement out­
come of the liquidity stress test is the level of available liquid­
ity relative to net cash outflows under each scenario. The
exact form of this metric varies across institutions but may
be expressed as a percentage of net outflows or as a dollar
value relative to a policy minimum. Some institutions distin­
guish between tactical and structural liquidity in measuring
the results of the liquidity stress test. The Basel III LCR, for
example, provides a thirty day view into available liquidity
under stress. To measure the longer-term or structural liquid­
ity position, the institution may calculate a survival horizon
relative to a limit. For example, the bank's policy may be to
maintain available liquidity to support twelve months of net
outflow under a specific stress scenario.
P ro sp e ctiv e liquidity position m etrics. In addition to measur­
ing the current liquidity position, the bank should measure
the prospective liquidity profile of the bank over the stress
horizon. Key indicators of liquidity risk include prospective
available liquidity, ratios indicative of wholesale funding
dependence (e.g., net non-core funding dependence), and
metrics indicative of potential overconcentration in specific
funding channels (e.g., percentage of funding from brokered
deposits). When monitoring prospective liquidity, it is impor­
tant to highlight any specific stress points along the horizon
where survival would require potentially problematic debt issu­
ances, intercompany funding transactions, or capital actions.
The institution may choose to establish limits for prospective
liquidity in addition to current liquidity, for example, maintain­
ing a certain survival horizon throughout the stress test.
In addition to capturing
C a p ita l and p e rfo rm a n ce m etrics.
the liquidity impact of the stress test, it is also important to
measure the balance sheet more holistically. For example,
assessing the economic impact of the investment portfolio
by measuring yield net of a regulatory or economic capital
charge enables the institution to assess the tradeoff between
low-yielding, low-haircut instruments and higher performance,
less liquid ones. Monitoring key capital metrics for each entity
ensures that the model captures the impact of any capital
actions required to support liquidity during the stress period.
The frequency with which the liquidity stress test is performed
will vary and typically depends upon the cadence of manage­
ment oversight and operational and technological capabilities
of the institution. At a minimum, the liquidity stress test should
be performed quarterly in order to support review by the asset
liability management committee. More advanced banking
organizations have made significant investments in building the
ability to perform liquidity stress tests more frequently, in some
cases even daily.
9.9 G O V ER N A N C E AND CO N TRO LS *•
As an integral part of the institution's liquidity risk governance
framework, the liquidity stress test should be the subject of, while
at the same time supporting, effective oversight in order to help
ensure the liquidity risk profile is aligned to the bank's risk appe­
tite and capacity. The specific roles should consist of the following:
The ALCO, consistent
A sset-liab ility co m m itte e (A L C O ).
with its board, management risk committee, and executive
management delegated oversight of managing liquidity risk,
typically has overall responsibility for the liquidity stress test­
ing framework. Specifically, the ALCO should be responsible
for the following:
• Ensuring the establishment, review, and approval of a
liquidity stress testing policy. The liquidity stress testing
policy should detail the scenarios to be run, key assump­
tions, roles and responsibilities, reporting requirements,
and limits. The specific structure of liquidity stress testing
documentation may be tailored to the policy structure
of the bank. Many institutions include this policy as an
appendix or supporting standard to the overall liquidity
risk management policy or as a component of the con­
tingency funding plan. The liquidity stress testing policy
should be renewed at least annually.
• Suggesting and approving liquidity risk scenarios,
including major changes to liquidity scenarios and/or
assumptions.
• Setting liquidity risk policy limits dependent on stress
test outcomes and escalating exceptions. For certain
limit tiers, escalation may be required to the board of
directors.
C h ap ter 9 Liquidity Stress Testing ■ 181
 Treasury. The treasury unit, as the first line of defense,
typically has ownership of the liquidity stress test modeling
process. Treasury should be responsible for the following:
• Maintenance of liquidity stress testing procedures.
• Recommending stress test scenarios.
• Reviewing and monitoring the liquidity characteristics
of the institution's assets and liabilities and making rec­
ommendations to the ALCO concerning stress testing
assumptions. Treasury should work with other functions
within the organization, in particular business line manage­
ment, in developing assumptions for customer assets and
liabilities. A formal requirement should be established in
the liquidity stress testing policy that management reviews
the key analytical assumptions of the liquidity stress test at
least quarterly.
• Producing stress test-based liquidity risk reporting.
It is recommended that the liquidity stress test baseline
balance sheet data (i.e., the current positions and contractual
maturities) be fed from, or at least reconciled to, reporting
prepared by a group independent of treasury, such as
financial control, independent risk management, or middle
office.
Within large, complex banking organizations, it is expected
that multiple treasury units will perform liquidity stress tests
for their respective entities. In such cases the corporate trea­
sury group should ensure that the global liquidity stress test­
ing policy establishes a consistent framework of scenarios,
assumptions, and model design across the enterprise.
Risk management. The independent risk management func­
tion, as the second line of defense, is responsible for provid­
ing independent oversight of liquidity stress testing along
with the other components of the liquidity risk management
program. Specifically, risk management is responsible for the
following:
• Administering the liquidity risk stress testing policy
• Reviewing and providing effective challenge of the sce­
nario design and assumptions
• Ensuring the institution's approach to liquidity stress test­
ing is in line with acceptable industry practices and regula­
tory rules and guidance
• Reviewing and approving the liquidity stress test-based
limits
• Monitoring of liquidity stress test-based limits
• Ensuring the institution's ALCO, executive management,
and board are kept well-informed of the bank's liquidity
risk profile as indicated by the stress testing results
182 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Where multiple risk units within the institution are oversee­
ing liquidity stress testing, the independent risk management
function should be responsible for coordinating globally with
regional and business unit risk management teams to ensure
enterprise-wide consistency.
Internal au d it. Internal audit, as the third line of defense,
should periodically review the liquidity stress testing frame­
work, procedures, and controls to ensure compliance with
policy, regulatory, and control requirements.
M o d el risk m a n a g e m e n t: Model risk management is respon­
sible for providing independent validation and changing
management governance of the liquidity stress testing model
in line with the institution's model risk management policy.
Practices vary among institutions in defining and evaluat­
ing models for oversight. It is assumed, however, that the
liquidity stress testing model will be assessed as highly criti­
cal given its foundational role in monitoring the bank's risk
profile.
9.10 LIQUIDITY OPTIMIZATION
The primary goal of the liquidity stress test is to determine the
appropriate size of the liquidity buffer. However, the liquidity
stress test should also be referenced in developing the composi­
tion of the buffer, with the objective of maximizing the efficiency
of the liquidity portfolio. Given a target level of contingent
liquidity required to support risk limits and regulatory require­
ments, Treasury will be able to choose between portfolio alter­
natives that vary in terms of both yield and capital requirements.
This choice gives rise to an optimization opportunity:
Liq u id ity v e rsu s y ie ld : Typically, higher yielding instruments
will have less favorable liquidity characteristics and/or add
duration to the investment portfolio. Maximizing the yield
and/or duration of the portfolio (even under the usual strict
investment policy constraints) is likely to be suboptimal for
the institution's return on asset performance as a whole. This
yield maximizing portfolio will be inefficient due to the addi­
tional balance level required to offset stress test haircuts and
the mismatch between the portfolio's inflows and the stress
test outflows. For example, taking the simplified stress test­
ing example represented by the Basel III LCR, maximizing
the size of the Level 2A portfolio (e.g., by investing in agency
mortgage-backed securities) that require a 15% haircut, may
reduce overall return on assets relative to investing slightly
lower yielding treasury securities that require no haircut.
Conversely, maximizing the liquidity profile of the portfolio
at the expense of yield may be equally inefficient. Armed
 with a robust liquidity stress testing model, treasury should
avoid constructing a needlessly conservative liquidity
portfolio when the pattern of stressed net outflows dem­
onstrates that the institution can comfortably stretch the
duration and risk profile of its investments.
Depending upon the institution's eco­
Liq u id ity vs. cap ital.
nomic and regulatory capital framework, a similar trade-off
exists for incorporating the capital impact of various port­
folio alternatives. Continuing with the example of Level 2A
agency mortgage-backed securities, maximizing the invest­
ment allocation of these instruments may be suboptimal
given the additional regulatory and potentially economic
capital requirements associated with these instruments. For
banks whose capital position is such that any additional asset
amount gives rise to an additional equity capital requirement
under leverage ratio limits, the additional haircut required for
higher-risk instruments will also be problematic.
9.11 FUNDING OPTIMIZATION
An important insight provided by the liquidity stress test model
is the impact of varying funding sources with differing liquidity
characteristics. In fact, a key objective of the focus on enhancing
liquidity stress testing since the financial crisis has been to cre­
ate an incentive for financial institutions to favor "sticky" funding
sources such as retail branch deposits at the expense of "hot"
money sourced from wholesale channels. By explicitly model­
ing the liquidity impact of these funding alternatives, treasury
can and should develop a target funding profile that balances
liquidity and cost. For example, the superior liquidity profile of
commercial deposits linked to treasury management services
should serve to bolster the business case for investing in target
industry segments with more intensive working capital require­
ments. Building this linkage requires a funds transfer pricing
(FTP) framework that accurately incorporates the stressed liquid­
ity profile of various business segments across the enterprise.
9.12 ESTABLISHING A SUSTAINABLE
INFRASTRUCTURE
The strongest liquidity stress testing analytical framework will
have little value without a data management infrastructure to
support it. In order to support efficient and controlled ongo­
ing stress testing and reporting, the institution should maintain
an information technology infrastructure that performs auto­
mated data collection, aggregation, capturing of market data,
report generation, and analytics. The challenge for many large,
complex financial institutions has been that developing such
an infrastructure for liquidity stress data has required signifi­
cant modifications to existing data warehouse capabilities built
largely on general ledger and transactional customer data. In
building an infrastructure that supports liquidity stress testing,
the institution should ensure that several critical requirements
are met. These include:
Position d a ta co llectio n and a g g re g a tio n . A data manage­
ment model must be established to ensure that required
liquidity position data are captured in an automated fashion.
The specific architecture employed by an institution will vary,
but could include the use of standardized templates or data
hub structures. Required liquidity attributes may need to be
associated to each position to enable automated develop­
ment of model inputs. The position data will also need to
conform to the required organizational granularity. For large,
internationally active banking organizations, this is likely
to require data across numerous legal entity, business line,
and jurisdictional dimensions. In addition to capture current
positions, the institution should retain historic data in the
data hub for historical analysis-based model calibration. The
objective is to ensure that liquidity data is housed in a single
location and forms a single source of truth.
R e g u la to ry re p o rt g e n e ra tio n . Building on this automated
position capture should be the ability to generate regulatory
reports (e.g., the Basel III LCR) with a minimum of manual
intervention. Solutions may include functional replicas of offi­
cial regulatory reports—or customized proprietary versions if
official templates are not available—that are populated with
associated validations and regulatory adjustments, requiring
minimal user manipulation. Such solutions may be developed
as proprietary applications or included within the reporting
functionality of third party treasury platforms.
A n a ly tics. The liquidity stress test model should contain the
features and functions that management would expect in
any robust analysis tool. These would include, for example,
the ability to perform sensitivity analysis on stress test
assumptions, the ability to save scenarios, and the ability
to easily generate various legal entity views. In addition to
such flexible forecasting functionality, leading practice is
to include analytic functionality that, for example, assesses
the economic capital impact of various liquidity portfolio
allocations.
Key risk indicators and performance
Liq u id ity d a sh b o a rd .
drivers should be tracked on a predefined basis and dis­
tributed to risk managers. Liquidity stress test results may
be included in an existing risk dashboard or circulated
separately.
C h ap ter 9 Liquidity Stress Testing ■ 183
9.13 INTEGRATION O F LIQUIDITY with performing the capital stress test, the institution should
perform a liquidity impact analysis to determine whether
STRESS TESTING WITH RELATED RISK additional capital impacts may occur through investment
M O DELS portfolio and required funding actions that would cause fur­
ther deterioration in capital adequacy.
Liquidity stress testing should not be performed in a silo with­
Liq u id ity stre ss te stin g and a sse t liability m a n a g e m e n t.
out consideration of other related risk frameworks, such as
Interest rate risk models are designed to assess the interest
asset liability management (for interest rate risk), capital stress
expense and economic value of equity impacts of severe
testing, and recovery and resolution planning. These models
movements in interest rates. Such a stress event could have
may employ related assumptions concerning the balance sheet
a significant impact on capital but is less likely to have a
behavior of certain accounts, and developing these assump­
direct impact on the bank's short-term liquidity profile. As a
tions independently is likely to lead to an inconsistent overall
result, a liquidity impact analysis is typically not run concur­
risk management framework. More importantly, it is imperative
rently with interest rate risk stress testing analogous to what
that a banking organization consider the correlations between
must be performed for capital stress testing. Nevertheless,
risk types that are likely to surface in a systemic or idiosyncratic
a consistent behavioral framework should be applied to
stress scenario. For example, in a capital-stressed environment,
both the interest rate and liquidity stress testing models.
an institution may be required to take a capital action requiring
For example, if the liquidity stress test model assumes that
the raising of liquidity at the holding company level. If raising
certain operational deposits do not run off in a stress event,
such liquidity requires incurring losses on investment portfolio
the interest rate risk model should segment these deposits
liquidation (all the more likely in a stressed environment), addi­
and assume that they would have duration at least as long as
tional capital pressures may occur.
non-operational deposits.
In theory, the institution should maintain a holistic risk model
When it comes to the liquidity stress model, however, it is
that assesses the impact on liquidity, capital, and balance
important to consider interest rate impacts. In particular, the
sheet structure under a common set of scenarios. In prac­
liquidity stress test scenario framework, liquidity risk dash­
tice, such an approach can be problematic due not only to
boards, and liquidity risk early warning indicators should not
the modeling complexity involved, but also as a result of the
neglect to include the possibility of an interest rate shock
need to develop unique stress scenarios for each risk type.
and the potential impact such an event would have on inde­
For example, a bank may stress capital based on a recession­
terminate liabilities. For example, in an environment where
ary scenario that adversely affects credit performance but is
rates are historically low and there is significant risk of a yield
also associated with falling interest rates (as expected during
curve steepening (i.e., the current environment), the institu­
a recession) and a less severe impact on liquidity than what
tion must carefully consider the impact of deposit disinter­
would be typically assumed under an idiosyncratic "run on the
mediation due to interest rate increases. A significant yield
bank" liquidity stress test scenario. Nevertheless, the bank
curve steepening could present significant liquidity risk to the
should carefully consider the interdependencies and connec­
institution, even in the absence of any safety and soundness
tion points between the liquidity stress model and other risk
concerns, as depositors seek the higher yields available in
models:
longer-duration investments.
Liq u id ity stre ss te stin g and cap ital stre ss te stin g . Linking
Liq u id ity stre ss te stin g and fu n d s tra n sfe r p ricin g . The FTP
capital and liquidity stress testing requires, first, ensuring that
framework, while not a risk model, is a strategically impor­
the liquidity stress test incorporates any required capital infu­
tant tool for driving business decision making. One of the
sions of subsidiary entities. For each liquidity stress test sce­
key objectives of any FTP framework is proper pricing of
nario, capital impact assumptions must be developed based
liquidity, whether provided by the treasury center for lend­
on the overall market and idiosyncratic conditions assumed
ing purposes or credited to liability-generating activities.
to occur under the scenario. The level of detail in developing
The FTP framework should leverage and be consistent with
these assumptions may vary from a high-level capital infusion
the contingent liquidity requirement for assets and liabilities
assumption for affected subsidiaries to detailed credit loss
measured by the liquidity stress test model. For example, if
and pre-provision net revenue modeling.
it is determined that a 25% cash buffer is required to support
Second, the capital stress testing framework should include a wholesale operational deposit (to borrow a Basel III LCR
a liquidity stress evaluation to assess the impact of any assumption), the cost of carrying this buffer should be passed
required liquidity impacts on capital adequacy. In conjunction through within the FTP framework.

184 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
CO N CLU SIO N
The liquidity stress test is a core component of the bank's
liquidity risk framework, and following the financial crisis has
become an increased area of scrutiny and expectation among
regulators and other stakeholders. While nearly all financial
institutions of significant size have a basic liquidity stress
testing process in place, there are typically a number of areas
of potential improvement. As banks continue to refine and
improve their liquidity stress capabilities, they should focus on
four areas:
• En su rin g th e a p p ro p ria te sc o p e and stru ctu re of th e liq u id ­
While stress testing the consolidated entity is
ity stre ss te st.
a common practice, it is important to carefully review juris­
diction, legal entity, charter, and foreign exchange liquidity
restrictions to ensure testing is performed with each appro­
priate view.
• B uilding th e m o d el on ro b u st a ssu m p tio n s. While there
is unlikely to be a perfect historical experiment upon which
to base stress scenario assumptions, the bank should
nevertheless make a diligent attempt to build the most
robust set of assumptions possible. Increasing the level of
granularity—such as by enhancing the level of segmentation
for deposit behavioural analysis—typically yields beneficial
results.
• Im proving in teg ra tio n w ith re la te d risk and p e rfo rm a n ce
Longer term, the industry will continue to evolve
m o d e ls.
toward unifying what is currently a set of relatively isolated
frameworks in addressing liquidity risk, capital, asset liability
management, and performance measurement. Developing
better linkage between stress testing and performance man­
agement and across risk categories will create the necessity
to holistically assess risk-based performance results in busi­
ness and treasury banking activities.
• Creating a sustainable liquidity risk
A u to m a tin g th e p ro c e ss.
infrastructure is a necessary foundation for improved analyt­
ics and more frequent monitoring. For most institutions, this
will require establishing and maintaining a tailored data hub,
an automated data model, and robust analytics and reporting
capabilities.
C h ap ter 9 Liquidity Stress Testing ■ 185
 Learning Objectives
After completing this reading you should be able to:

Identify best practices for the reporting of a bank's Explain the process of reporting a liquidity stress test and
liquidity position. interpret a liquidity stress test report.

Compare and interpret different types of liquidity

risk reports.

Excerpt is Chapter 14 ofThe Principles of Banking, by Moorad Choudhry.

187
Elsewhere I have highlighted the nature of liquidity risk
exposure measurement. We press on further with a look at
benchmark liquidity risk reporting, and stress testing report­
ing output. We look at a range of quantitative and qualitative
liquidity reports, as part of our approach to a general under­
standing of liquidity risk management at the aggregate over­
view level.
We begin with an illustration using examples of baseline liquidity
reports. This is followed with a description of additional liquid­
ity reports, together with a summary of the reporting frequency
required by UK regulated banks. This regulatory reporting
requirement is similar in most other jurisdictions. The second
part of the chapter looks at the presentation of liquidity stress
testing results.
A number of the reports shown here are available as template
spreadsheets on the Wiley website supplementary material.
10.1 LIQUIDITY RISK REPORTING
A bank will produce a number of liquidity reports in the normal
course of business, on a daily, weekly, monthly and quarterly
basis. It is important that the format of liquidity Ml is both trans­
parent and accessible. We illustrate a sample of reports that
provide a benchmark framework for reporting.
Deposit Tracker Report
The deposit tracker is a simple report of the current size of
deposits, together with a forecast of what the level of deposits
are expected to be going forward. This report is tracked weekly
and monthly because it provides an idea of the LTD ratio in the
immediate short term. The LTD is a key management liquidity
ratio.
Table 10.1 A shows the first part of a typical deposit
tracker report for a medium-sized commercial bank, as at
month-end May 2009. We see that the report provides the
following:
• the month-end actuals for deposits by customer type;
• the change from each month-end
• the aggregate customer assets and hence, the LTD ratio;
• a forecast of the position for the month-end for each month
to the end of the year.
188 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
We see that this bank is required to meet a Board-approved LTD
ratio limit of 85%, which it is just exceeding as at the date of this
report, but the forecast for year-end is within this.
Table 10.1 B is the second part of the deposit tracker, it shows
how much liabilities will need to increase, or assets reduce, all
else being equal, for the bank to meet a particular LTD ratio.
Figure 10.1 is a graphical presentation of the deposit tracker
report.
Figure 10.2A from the report shows the customer deposits
by account type and tenor, while Figure 10.2B shows the
deposits' maturity profile. This illustration assists the Treasury
department to gauge the trend of the deposit balances over
time. For example, from Figure 10.2A it is clear that a large
percentage of the retail bank deposits are current accounts
and rolling deposits, with very little fixed-term deposits. For
regulatory purposes, these funds will be treated as short-term
liabilities and will not assist the bank's regulatory liquidity
metrics (which emphasises long-term funds), even though the
local regulator may allow the bank to treat overnight balances
as longer term if they can be shown to be acting as such in
"behavioural" terms. In this case, it is worthwhile for the bank
to undertake a marketing exercise to determine if customers
may be interested in moving their deposits into fixed-term
or notice accounts. Any increase in the size of the latter will
improve the firm's liquidity metrics.
The forecast element of this report is based essentially on
objective judgement. The historical trend up to the current
date will assist in making the forecast; otherwise, it is a case
of making as best an estimate as possible, with inputs from
the relationship managers who look after the various cus­
tomer accounts.
Daily Liquidity Report
The daily liquidity report is a straightforward spreadsheet
detailing the bank's liquid and marketable assets, together
with liabilities, up to 1-year maturity and beyond. It provides an
end-of-day of the bank's liquidity position for the Treasury and
Finance departments. Each branch and subsidiary will complete
one, although a bank that has only a branch structure (and no
subsidiaries) may aggregate the report.
We provide an example of a daily liquidity report for a com­
mercial bank at Figure 10.3. This uses inputs from the bank's
Table 10.1 A Deposit Tracker Report, Month-End Actuals and Year-End Forecast

Deposit Tracker Month End Actuals Forecasts

31/12/2008 31/01/2009 28/02/2009 31/03/2009 30/04/2009 28/05/2009 30/06/2009 31/07/2009 30/08/2009 30/09/2009 31/10/2009 30/11/2009 31/12/2009

Eligible Correspon­ 482,236 431,166 485,302 507,193 536,907 493,930 515,753 520,753 520,753 520,753 525,753 530,753 535,753
dent Banks
Corporate Client 449,871 375,849 248,677 263,267 243,710 280,248 273,893 273,893 273,893 273,893 273,893 273,893 273,893
Deposits
Private Bank Client 14,168 23,334 18,990 102,174 102,582 99,119 99,123 99,123 99,123 124,123 124,123 124,123 124,123
Deposits
Local Authority 196,624 195,814 192,100 226,622 267,001 325,016 333,287 343,287 348,287 373,287 393,287 413,287 433,287
Deposits
Retail Bank 1,234,799 1,318,219 1,323,738 1,264,323 1,293,918 1,258,133 1,264,025 1,264,025 1,264,025 1,264,025 1,264,025 1,264,025 1,264,025
Deposits
Eligible Private 24,864 37,456 38,358 37,196 37,388 35,512 35,529 35,529 35,529 35,529 35,529 35,529 35,529
Bank Correspon­
dent Banks
Treasury Sales 5,775 5,198 4,477 3,846 822 770 763 763 763 763 763 763 763
Total Customer 2,408,337 2,387,036 2,311,642 2,404,621 2,482,328 2,492,728 2,522,373 2,537,373 2,542,373 2,592,373 2,617,373 2,642,373 2,667,373
Deposits:
M/M +/- -21,301 -75,394 92,979 77,707 10,400 29,645 15,000 5,000 50,000 25,000 25,000 25,000
W/W + /-
Mend +/—
Drawdown-Month 76,374 8,526 4,479 5,298 2,911 3,136 5,570
ahead
Repayment-From 37,888 11,920 4,429 2,326 25,800 7,965 20,863
loans schedules
Forecast Monthly 38,486 -3,394 50 2,972 -22,889 -4,829 -15,293
loan +/—
Total Customer 2,305,766 2,266,004 2,223,145 2,166,076 2,194,016 2,145,648 2,184,134 2,180,740 2,180,790 2,183,762 2,160,873 2,156,044 2,140,751
Loans:
Loan-to-deposit % 95.74 94.93 96.17 90.08 88.39 86.08 86.59 85.94 85.78 84.24 82.56 81.59 80.26
«o
o

Table 10.1B Deposit Tracker, LTD Ratio Required Cash Flow Changes

Forecasts

LTD
Required: ratio 31/01/2009 28/02/2009 31/03/2009 30/04/2009 28/05/2009 30/06/2009 31/07/2009 30/08/2009 30/09/2009 31/10/2009 30/11/2009 31/12/2009

Liabilities 85 278,851 303,823 143,704 98,867 31,564 47,196 28,203 23,262 -23,241 -75,169 -105,851 -148,842
increase

84 310,588 334,959 174,041 129,596 61,615 77,786 58,746 53,805 7,344 -44,905 -75,654 -118,860

83 343,089 366,846 205,109 161,065 92,390 109,113 90,025 85,085 38,666 -13,911 -44,730 -88,155
82 376,384 399,510 236,935 193,301 123,916 141,205 122,066 117,127 70,752 17,838 -13,051 -56,701

81 410,500 432,981 269,547 226,334 156,220 174,088 154,899 149,960 103,630 50,372 19,409 -24,470

80 445,469 467,289 302,974 260,192 189,332 207,794 188,552 183,614 137,330 83,718 52,682 8,566

Assets 85 -237,023 -258,249 -122,148 -84,037 -26,829 -40,117 -23,973 -19,773 19,755 63,894 89,973 126,516
reduce

84 -260,894 -281,366 -146,194 -108,860 -51,756 -65,340 -49,347 -45,196 -6,169 37,720 63,550 99,842

83 -284,764 -304,482 -170,241 -133,684 -76,684 -90,564 -74,720 -70,620 -32,093 11,547 37,126 73,168

82 -308,634 -327,599 -194,287 -158,507 -101,611 -115,788 -100,094 -96,044 -58,016 -14,627 10,702 46,495

81 -332,505 -350,715 -218,333 -183,330 -126,538 -141,012 -125,468 -121,468 -83,940 -40,801 -15,722 19,821

80 -356,375 -373,831 -242,379 -208,154 -151,466 -166,235 -150,842 -146,891 -109,864 -66,975 -42,145 -6,853
Fiqure 10.1 Deposit tracker, graphical illustration.

balance sheet accounting system to provide a summary of and non-eligible bank CDs. The value of securities deemed
liquid assets, liabilities by tenor, and a cumulative liquidity instantly liquid will be input to the liquidity ratio calculation
report. Figure 10.3 is the summary of liquid securities; in this report. Table 10.2A is the summary of assets and liabilities,
case these consist of government bonds, central bank eligible and Table 10.2B is the cumulative liquidity report and liquidity

Customer deposits / Accounts by maturity

300 1200

250 - - 1000

£* 200 - - 800
LU QZ
CD LU
U )
•
C

- 600
fU 150 -
c •
C

_Q
ru
c
<u
+J _Q
to
o 100 - 400 +-*
Q_
-

CD
O CXL
u
50 - - 200

0 -& 0
Current Rolling Up to 1 12 months
accounts deposits week 1 month 3 months 6 months 12 months +
Correspondent banks 22.74 0 44.13 273.68 183.40 26.00 0.00 0.00
i=i Corporate banking 78.89 51.94 55.78 25.32 61.08 7.27 0.17 0.00
Local authority deposits 0 0 29.60 74.24 127.63 71.64 29.18 1.00

Private banking 13.76 95.35 0.00 0.00 0.00 0.00 0.00 0.00
-B- Retail banking 112.98 1036.85 0.59 7.49 28.73 69.35 9.65 2.14

Fiqure 10.2A Deposit tracker, deposit type and tenor.

C hap ter 10 Liquidity Risk Reporting and Stress Testing ■ 191

 Customer deposits / Accounts maturity profile
600.00 1,400.00

1200.00
500.00 -
-

- 1000.00
Qd 400.00 -
LU
U ) - 800.00 LU
•
C
U )
c 300.00 - •
c

_Q
03
c
CD - 600.00 03
+-» _Q
03
o 03
200.00
C£
CL -
(D
v_
O - 400.00
U

100.00
200.00
-

0.00 - 0.00
Up to 1
----------------------

week 1 month 3 months 6 months 12 months 12 months +

Retail banking 1,267.78 117.36 109.87 81.14 11.79 2.14

+ Correspondent banks 549.95 483.08 209.4 26.00 0.00 0.00
Corporate 280.45 93.84 68.52 7.44 0.17 0.00
-A- Local authority deposits 333.29 303.69 229.45 101.82 30.18 1.00
-X- Private banking 109.11 0.00 0.00 0.00 0.00 0.00

Figure 10.2B Deposits maturity profile.

risk factor calculation. The "counterbalancing capacity" in
Table 10.2B is the sum of available securities to cover for sud
den cash outflows.
This spreadsheet is available on the Wiley website supplemen­
tary material accompanying this book.
Funding Maturity Gap ("Mismatch")
Report
The funding gap report shows the maturity gap (also known
as the maturity mismatch) per time bucket, for all assets and
liabilities, with an adjustment for liquid securities. It includes
the cumulative liquidity cash flow of the previous report just
described, and indeed the two reports can be combined. An
extract is shown at Table 10.3. Figure 10.4 shows the maturity
mismatch in graphical form. The key indicates the cash flow for
each type of product.
The same report is used to generate the cash flow survival
horizon report. This is shown at Figure 10.5. We observe that
the bank in this example has a survival horizon of only seven
days under normal circumstances; when the cash flow value
of liquid securities and other adjustments is included, we see
that the survival period is extended to 27 days. This is still
below the Basel III requirement, and so on the strength of
this report the bank will need to take action to address the
iquidity shortage.
The full report spreadsheets, with breakdown by product type
and incorporating cell formulae, are available on the Wiley
website.
Funding Concentration Report
Funding source concentration reports are key Ml for senior
Treasury and relationship managers. A central principle of
liquidity management is funding diversity, and its empha­
sis that a bank should not become over-reliant on a single
source, or sector, of funds. This includes reliance on intra­
group funds.

192 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 SECURITIES AND CDs

00s
In p u t d a ta

Marketable Securities CDs

Bank CDs: non-ECB eligible, liquid at maturity date 231,645

(breakdown below)
Bank CDs: ECB eligible, liquid same day 0

ECB eligible securities, liquid in 1 week tender 649,967

Non-ECB eligible securities, can be sold over 4 weeks 277,589
Government securities 9,640
TOTAL MARKETABLE SECURITIES AND CDs 937,196 231,645
Non-marketable
Non-ECB eligible CD summary
Average remaining tenor Amount
1 day
2 days
1 week
2 weeks 6,645
1 month 25,000
2 months 50,000
3 months 35,000
6 months 115,000
12 months

Figure 10.3 List of liquid securities: input to daily liquidity report.

Table 10.4 is an example of a 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 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.
In the illustration shown, the largest depositor ("CBS") exceeds
the internal single-source concentration limit of 1 0 % by a consid­
erable margin. Assuming that this is a close customer relation­
ship, the bank will need to increase its liabilities base to bring
the share down to limit, or otherwise risk damaging the relation­
ship by asking the depositor to remove some of the funds.
stress points for a bank's funding requirement. In a stress situa­
tion a bank can expect un-utilised liquidity and funding lines to
be drawn down, as customers experience funding difficulties of
their own. The existence of undrawn commitments can exacer­
bate funding shortages at exactly the wrong time, which is why
liquidity metrics include such undrawn commitments. It is also a
reason to report them separately.
Figure 10.6 A is an example of an undrawn commitments report,
showing trend over time, while Figure 10.6 B shows the trend
for both drawn and undrawn committed facilities. These are
aggregate-level reports, the bank will also produce detailed
breakdowns per customer.

Undrawn Commitment Report Liability Profile

Off-balance sheet products such as liquidity lines, revolving This is a simple breakdown of the share of each type of liability
credit facilities, letters of credit and guarantees are potential at the bank. An example is shown at Figure 10.7. In this case,

C hap ter 10 Liquidity Risk Reporting and Stress Testing ■ 193

 Table 10.2A Asset and Liability Cash Flows

194
Input Data

■
A SSETS 000s 1 D ay 2 D ays 1 W eek 2 W eeks 1 M onth 2 M onths 3 M onths 6 M onths <1 Year > 1 Year Total

Non-marketable 0
Securities & CDs
Retail call a/c 6,754 0 0 0 0 0 0 0 0 0 6,754

Retail time deposit 432 3,533 0 4 4 4,529 9 1,619 420 23,749 34,299

Inter-Group call 4,725 0 0 0 0 0 0 0 0 0 4,725

Inter-Group time 19,199 89,848 281,434 90,150 135,378 73,895 60,768 21,379 5,912 244 778,207

Other bank call 56,568 0 0 0 0 0 0 0 0 0 56,568

Other bank time 5,465 148,347 188,620 7,833 89,500 30,020 0 25,319 128 83,985 579,217

Corporate call 30,658 0 0 0 0 0 0 0 0 0 30,658

Corporate time 13,936 112,975 35,335 53,432 10,923 159,894 133,718 63,182 116,551 1,365,637 2,065,583
Government bonds 161,011 0 19,361 35 335 303 9 868 678 84,857 267,457

Total Assets 298,748 354,703 524,750 151,454 236,140 268,641 194,504 112,367 123,689 1,558,472 3,823,468

Average remaining 44.59 Months

duration of assets

Input Data

Liab ilities 000s 1 D ay 2 D ays 1 W eek 2 W eeks 1 M onth 2 M onths 3 M onths 6 M onths <1 Year > 1 Year Total

Without any stickiness

assumptions

Retail call 97,482 0 0 0 0 0 0 0 0 0 97,482

Retail time 19,780 18,250 120,492 65,241 123,345 113,741 157,361 126,162 50,841 1,993 797,206

Inter-Group call 50,996 0 0 0 0 0 0 0 0 0 50,996

Inter-Group time 72,276 136,744 351,130 233,319 60,987 161,120 43,881 101,896 24,294 0 1,185,647
Other bank call 235,097 0 0 0 0 0 0 0 0 0 235,097
Other bank time 16,088 116,319 135,796 21,210 121,181 85,287 192,512 64,901 0 0 753,294
Corporate call 60,085 0 0 0 0 0 0 0 0 0 60,085
Corporate time 17,937 94,226 173,805 152,144 94,976 111,413 47,748 18,394 11,475 0 722,118
Government 3,689 6,005 58,163 109,046 37,671 204,339 54,477 31,341 5,902 1,122 511,755
Total Liab ilities 573,430 371,544 839,386 580,960 438,160 675,900 495,979 342,694 92,512 3,115 4,413,680

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Undrawn commitments 273,242

Average remaining 7.72 Months

duration of liabilities
 Table 1 0 .2 B Cum ulative Liquidity Report

Country: London
Currency: EUR
Date: 25-Nov-10
Cumulative Liquidity Report
1 Day 2 Day 1 Week 2 Week 1 Month 2 Months 3 Months 6 Months 1 Year
Cumulative net cash balance (111,734) (104,480) (301,843) (642,230) (738,261) (1,040,588) (1,884,251) (2,122,457) (2,099,158)
Other forecast inflows
Other forecast outflows
Cumulative cash gap (111,734) (104,480) (301,843) (642,230) (738,261) (1,040,588) (1,884,251) (2,122,457) (2,099,158)
Counterbalancing capacity 8,676 8,676 797,674 804,186 828,686 877,686 979,996 1,092,696 1,092,696
Liquidity gap (103,058) (95,804) 495,831 161,957 90,426 (162,902) (904,256) (1,029,761) (1,006,462)
Limit
Variance (103,058) (95,804) 495,831 161,957 90,426 (162,902) (904,256) (1,029,761) (1,006,462)

Liquidity Metrics
Limit
1-week Ratio 11.13% 0.00% OK
1-month Ratio 2.03% -5% OK
Liquidity Risk Factor 3.85

Liquidity Risk Factor Months

Average remaining term of assets 44.5900 Excluding marketable securities

Adjusted for marketable securities 34.8776
Average remaining term of liabilities 7.7200 With no call stickiness
Excluding call deposits 8.0046
Average tenor of call deposits 37.55
Combined average remaining term of liabilities 9.0593
LRF 3.8499

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 195

«o
o

Table 10.3 Extract from M aturity G ap Report

Data as of 2 June 2010. All figures in EUR thousands unless otherwise noted.
Liquidity Management - Maturity Mismatch
No behavioural or stress adjustments applied
Inflows Sight Two - Eight Nine One - Three Three - Six Six One - Three Three - Five Five Years and Total
Days Days - One Months Months Months - One Years Years on
Month Year
TOTAL INFLOWS (908,203,354) (188,005,661) (705,398,674) (376,131,077) (86,328,844) (97,212,696) (481,473,198) (444,603,252) (734,632,172) (4,021,988,928)
Outflows Sight Two - Eight Nine Days - One - Three Three - Six Six Months - One - Three Three - Five Five Years and Total
Days One Month Months Months One Year Years Years on
TOTAL OUTFLOWS 893,940,981 397,283,377 1,379,620,964 1,251,323,695 328,027,956 105,751,557 3,219,569 0 0 4,359,168,099
Behavioural OK
Adjustments/Stress
Net Mismatch per (14,262,374) 209,277,716 674,222,290 875,192,618 241,699,112 8,538,861 (478,253,629) (444,603,252) (734,632,172) 337,179,171
Bucket
Adjustments Sight Sight - 8 Days Sight - 1 Month Sight - Three Sight - Six Sight - One Sight - Three Sight - Five Sight - Five Total
Months Months Year Years Years Years
TOTAL ADJUSTMENTS (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (1,256,876,281) (11,311,886,530)

Cumulative Mismatch Sight Sight - 8 Days Sight - 1 Month Sight - Three Sight - Six Sight - One Sight - Three Sight - Five Sight - Five
Months Months Year Years Years Years
(1,271,138,655) (1,061,860,938) (387,638,649) 487,553,969 729,253,082 737,791,943 259,538,314 (185,064,938) (919,697,110)
Liquidity Ratio 29.16% 24.36% 8.89% -11.18% -16.73% -16.93% -5.95% 4.25% 21.10%

Behavioural 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Adjustments/Stress
Variance
Internal Limit 0.00% 3.00% -3.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

FSA Limit 0.00% -5.00%

Notes:
"Outflow" are LIABILITIES.
"Inflow" are ASSETS.
 10,000,000,000
□ 30 - Fiscal Liabilities
□ 29 - Cash and Equivalents
□ 28 - Capital
8,000.000,000 □ 27 - Retail -Time Deposit
□ 26 • Retail • Cutrent Account
a 23 - Inter*Group - Time Deposit

, , ,(
□ 24 - Inter-Group - Current Account
6 000 0 0 0 □ 23 - Inter-Bank • Repo
□ 22 • Inter-Bank • Time Deposit
□ 21 - Inter-Bank • Current Account
□ 20 • Government • Time Deposit
4,000,000,000-1 □ 19 -Goverroent- Current Account

2,000,000,000 -I
(2,000 ,000,000)-!
(4,000,000.000)-!
Two- Nine Days One -
Bight -O ne Three
Sight Days Month Months
(6,000,000,000)
I □ 18-Corporate-Time Deposit
□ 17 - Corporate - Current Account
■ 1 6 -Fiscal Assets
■ 13-Fixed Assets
■ 14 - Provision on Loan
■ 13-Cash and Equivalents
□ 12 • Retail - Time Loan
□ 11- Retail - Overdraft
B 10 - Inter-Grovp • Time Loan
■ 09 - Inter-Group - Overdraft
□ 08 - Inter*Bank - Bonds. FRNs and CDs
B 07 - Inter-Bank • Repo
□ 06 - Inter-Bank - Time Loan
B 05 - Inter-Bank - Overdraft
□ 04 - Government - Time Loan
Three - Six One - □ 03 - Government - Overdraft
Six M onths- Three T hree- Five Years ■ 02 - Corporate • Time Loan
Months One Year Years Five Yean and on Total
S 01 - Corporate - Overdraft

Figure 10.4 Graphical representation, maturity gap report.

1 Inflows i I Outflows ---- Cumulative cash flo w ....... Adjusted cumulative cash flow
Fiaure 10.5 Cash flow survival horizon.

the total liabilities of the bank are made up of the following • Repo (high-quality securities);
categories: • Asset-backed securities;
• Customers: individuals; • Unsecured: other wholesale;
• Customers: large enterprises; • Repo (other assets);
• Repo (highly liquid securities); • Conditional liabilities;

C hap ter 10 Liquidity Risk Reporting and Stress Testing ■ 197

 Table 10.4 Funding Concentration Report

198
LARGE DEPOSITOR CONCENTRATION REPORT SUMMARY - 31 AUG 10

■
GROUP TREASURY Large Depositors by Country as a Percentage of Total Funding*

Country Total Large Deposits '000s % of External Country Funding % of External Group Funding

A 1,652,551 44.3% 5.0%

B 1,193,328 27.0% 3.6%
C 1,061,180 33.6% 3.2%
D 818,658 10.4% 2.5%
E 119,664 4.7% 0.4%
F 50,195 3.7% 0 2
. %
G 40,000 4.0% 0 .1 %
Total 4,935,577 15.0%
* Large depositors lend Bank pic more than $50m.

Large Depositors as a Percentage of Country and Total Funding

Deposit Percentage of Group

Customer Amount 000s Percentage of Countries External Funding External Funding **

Bank pic A B C D E F G

CBS 844,101 16.5% 1 .4% 0 .8 % 2.5%

CBL 588,777 7.4% 3.3% 1 8 . %
Customer 2 448,000 14.2% 1.4%
ACO 341,150 9.1% 1 0 . %
Bank Med 307,609 0 .1 % 7.1% 0.5% 0.9%
Sovereign 300,000 8 .0 % 0.9%
Monetary
Agency 1
CBJ 227,730 1.9% 2 .8 % 1 2 8
. % 0.7%
CBA 190,706 3.2% 0.9% 0 .6 %
Sovereign 171,195 1 1 . % 0.9% 3.7% 0.5%

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Monetary
Agency 2
Banque Maghreb 145,000 4.6% 0.4%
 Table 10.4 C ontinued

Large Depositors as a Percentage of Country and Total Funding

Deposit Percentage of Group

Customer Amount 000s Percentage of Countries External Funding External Funding **

Bank pic A B C D E F G

Customer 1 142,516 4.5% 0.4%

Customer 3 133,080 1.7% 0.4%
AMF 122,850 3.3% 0.4%
Customer 4 102,600 1.3% 0.3%
R Bank 1 0 0 ,0 0 0 2.7% 0.3%
Petro Company 94,421 3.0% 0.3%
ABC 92,819 2.3% 0 .1 % 0.3%
ALF 88,311 2 .8 % 0.3%
Retail depositor 80,000 2.5% 0 .2 %
Customer 5 68,116 0.9% 0 .2 %
Principal Bank 62,933 2 .0 % 0 .2 %
Sicon Construction 60,139 2.4% 0 .2 %
The Public Ware­ 59,526 2.3% 0 .2 %
housing Co
GIB 54,000 1 .4% 0 .2 %
SCB 50,000 0.3% 4.0% 0 .2 %
SIB 50,000 1 .3% 0 .2 %
CBUAE 50,000 1 .3% 0 .2 %
Total 4,975,577 27.0% 33.6% 44.3% 10.4% 4.0% 12.8% 3.7% 4.7% 15.0%
CBS is Bank pic's biggest depositor (16.5% of funding). This exceeds the Group's 10% max. depositor funding limit.

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 199

 Undrawn commitment trend and the share of each is shown in the chart. Other
types of funding sources by product type may
include one or more of the following:

• Covered Bonds;
• Client free cash;
• Structured deposit products;
• Unsecured: credit institution;
• Unsecured: governments and central banks;
• Unsecured: non-bank financial;
• Customers: SME;
Total Head Office -------Total subsidiary • Group;
• Net derivatives margin;
Fiqure 10.6A Undrawn commitment report, subsidiary.
• Capital: undated and dated;
• Primary issuance.
Drawn and Undrawn commitment trends
The report format can be set to the user's desired
choice.

Wholesale Pricing and Volume

A bank's liquidity position is not illustrated solely
by its cash flow liquidity metrics. An indica­
tion of liquidity strength can also be gleaned
from looking at a bank's funding costs, and the
composition of its funding by product. The first,
especially, is valuable market intelligence and
Total un-drawns I [Total Head Office undrawns ===== Aggregate limit
the bank regulator will also be compiling this
Fiaure 10.6B Undrawn commitment report, head office. information. The regulatory authority can obtain

■ Customers: Individuals
□ Repo: Highly liquid securities
□ Repo: High-quality securities
■ Asset-backed securities
□ Unsecured wholesale
■ Repo: Other assets
□ Customers: Large enterprises
□ Conditional liabilities

Fiqure 10.7 Liability profile.

200 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Firm Specific Yield Curve (EUR)
250

Cash deposits
Primary issuance
Covered Bonds
* - ABCP & ABS

0 H--------- 1--------- 1--------- 1--------- 1--------- 1------

1 m-3 m 3 m-6 m 6 m-1 y 1 y-2 y 2 y-5 y 5y

Fiqure 10.8 Firm-specific funding yield curve.

an early warning of a particular bank experiencing funding
stress if it observes that its funding yield curve is rising mate­
rially above that of its peer group. For individual bank senior
management, it is difficult to obtain this information about
other banks; however, it should be possible to get an idea of
the peer group average 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.
Figure 10.8 is an example of a firm-specific yield curve for a
UK bank. Figure 10.9 shows the breakdown of the same bank's
wholesale funding by volume and product type.
Summary and Qualitative Reports
Liquidity report Ml for senior management should be presented
as a 1-page summary of the key liquidity metrics. This can be
distributed on a monthly basis or as directed by ALCO, although
the distribution frequency may be increased during a stress
period. Keeping the report to one side of A4 will increase the
chance that the report will actually be read and noted at senior
management level, which is why these reports are an important
part of liquidity Ml. An example of a monthly summary report is
presented at Figure 10.10.

□ Cash deposits
■ Primary issuance
□ Covered Bonds
□ ABCP & ABS

Fiqure 10.9 Wholesale funding breakdown by product and tenor bucket.

C hap ter 10 Liquidity Risk Reporting and Stress Testing ■ 201

 MONTHLY LIQUIDITY SNAPSHOT
CUM ULATIVE LIQUIDITY REPO RT ($ '000)

Cumulative Liquidity Report

1 Day 2 Day 1 Week 2 W eek 1 M onth 2 M onths 3 M o n th s 6 M onths 1 Year

Cumulative Net Cash Balance 10 10 -1 2 6 0 •2 2 6 0 • 1.180 -14 01 • 1.150 -850 -850
Other Forecast Inflows
Other Forecast Outflows
Cumulative Cash Gap •0 80 -1 2 6 0 -1 2 6 0 • 1.180 •1401 • 1.150 -850 •850
Counterbalanciag Capacity 110 110 615 640 748 741 1238 1238 1231
Liquidity Gap 260 260 625 -620 •432 -660 u 388 388

Limit

V ariance 260 260 •625 •620 •432 -660 88 388 388

* Cash gap turns negative between 2-day and 1-week

* Liquidity gap turns negative between 2-day and 1-week

LIQUIDITY RATIOS - THREE MONTH VIEW

* Ratios are above the limit

Current month Previous month Change

LIQUIDITY RISK FACTOR 22.2 25.1

▼
a

LOAN-TO-DEPOSIT RATIO 96% 93%

▲
•

NET INTER-GROUP LENDING 0228) (1,552) w

Fiaure 10.10 Monthly liquidity snapshot for senior management.

The content is self-explanatory. An example for a bank with a obligation as a minimum requirement, and supplement it with
group structure is shown at Figure 10.11. additional Ml as desired.

For banking groups that operate across country jurisdictions and
multiple subsidiaries, a qualitative report should be completed for
Head Office Group Treasury, on a monthly basis. This will assist the
group to better understand the liquidity position in each country.
Frequency of Reporting
In general, the main liquidity reports are required by the regu­
lator, who stipulates their frequency. ALCO should view this
In the UK, quantitative liquidity reporting is an integral part
of the regulatory regime. The full requirement applies to
individual liquidity adequacy standards (HAS) firms. Some
smaller institutions and foreign branches are not ILAS firms,
and where reporting requirements are waived or modified,
the regulatory authority will agree the format and frequency
of iliquidity reporting on a case-by-case basis. Table 10.5 is a
summary of the reporting requirements for UK standard ILAS
firms.

202 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 GROUP TREASURY QUALITATIVE REPORTING

Monthly Liquidity Highlights

Template for Branches and Subsidiaries to Summarise Main Liquidity Changes for the Last Month

To be Provided a Fixed Specified Date Each Week

Points to consider:

1. Explain significant changes in your 1-week and 1-month liquidity ratios

2. Explain any changes to your cash and liquidity gap in your Cumulative Liquidity model
3. Explain significant changes to the Liquidity Risk Factor
4. Explain growth or shrinkage of asset books
5. Detail any changes to inter-group borrowing/lending position; detail the counterparties for any
large-size deals
6 . Any increase/decrease in corporate deposits, detail large dated transactions with an estimated
confidence level of roll-over
7. Any increase/decrease in retail deposits
8. Average daily opening cash position
This list is not exhaustive and any other relevant points are welcome.

Figure 10.11 Group treasury qualitative reporting, regular liquidity highlights.

Table 10.5 UK Liquidity Reporting Requirements: Standard ILAS Firms

Report Description Frequency Submission Deadlines

FSA047: Daily Flows
FSA048: Enhanced
mismatch report
FSA050: Liquidity Buffer
qualifying securities
FSA051: Funding
concentration
FSA052: Wholesale
liabilities
FSA053: Retail, SME and
large enterprises corporate
funding
FSA054: Currency analysis
Off-balance sheet report
Source: FSA.
Daily cash flows out to 3 months; BAU: Weekly firm- specific BAU: end-of-day Monday
analyses survival period and/or market-wide liquidity
Stress: End of day following
stress: Daily
business day
ILAS risk drivers and contractual As above As above
cash flows across full maturity
spectrum
Granular analysis of firm's market­ Monthly 15 business days after
able asset holdings month-end
Firm's borrowings of unsecured Monthly 15 business days after
wholesale funds (excludes primary month-end
issuance), by counterparty class
Daily transaction prices and Weekly End-of-day Tuesday
transacted volumes for wholesale
unsecured liabilities
Firm's retail and corporate fund­ Quarterly 15 business days after
ing profile and the stickiness of month-end
retail deposits
Analysis of foreign exchange (FX) Quarterly 15 business days after
exposures on firm's balance sheet month-end
Aggregate undrawn committed Monthly 15 business days after
facilities month-end

C hap ter 10 Liquidity Risk Reporting and Stress Testing ■ 203

STRESS TEST REPORTS
The purpose of liquidity stress testing is to ascertain the extent
of funding difficulties for the bank in the event of idiosyncratic or
market-wide stress. Elsewhere we described the different types
of scenario events that the UK PSA prescribes for UK-regulated
banks to undertake. Stress test output results should help senior
management to understand the liquidity position of the bank,
enabling them to take mitigating action if deemed necessary.
The primary stress test output is the cash flow survival report.
This was shown earlier in the chapter; at Figure 10.12 we illus­
trate an example of a report under BAU conditions and one
after the mitigating actions have been taken (such as liquidating
securities, and accessing contingency funding sources).
The second chart shows the stressed cumulative cash flow
forecast taking into account the immediate sale or repo of mar­
ketable securities. In this example, the standard FSA-specified
stresses have been applied: wholesale funding, retail liquidity,
intra-day liquidity (3- and 5-day stresses), cross-currency liquid­
ity, intra-group liquidity, off-balance sheet liquidity, market­
able assets, non-marketable assets, and funding concentration.
Observed behavioural forecasting (OBF), which refers to the
treatment of liabilities for "stickiness", has been applied in
the following way: non-interest bearing liabilities (1 0 0 % every
3 days), current accounts (-5.66% every 36 days), retail time
deposits (-0.41% every 344 days), capital (100% every 3 days),
cash & equivalents (100% every 3 days), fiscal liabilities (100%
every 3 days), repo liabilities (in this example there are no
repos), other time deposits (-0.03% every 47 days) and foreign
exchange (100% every 30 days). No OBF has been applied to
corporate deposits, government time deposits, intra-group time
deposits and inter-bank time deposits.
In this example, the survival period has been extended from 49
days to 93 days after taking into account the impact of the stress.
For senior management, a 1-slide summary of this test result is
illustrated at Figure 10.13.
A line-by-line stress test result report should be produced on
a quarterly basis, or as required by the regulator. We provide
an example at Table 10.6. This shows the results of individual
shocks on the liquidity ratio, and the probability of each result
occurring. The following categories are included:
• reduction in liquid assets;
• decrease in liabilities;
• FX mismatch;
• combined shocks.
This report would be produced as part of routine stress testing,
undertaken either by Treasury or Risk Management.*1
Example 10.1 Treatm ent of Cash Flows
A common question in liquidity reporting concerns the treat­
ment of specific types of cash flow. For example, consider the
following:
1. Treatment of non-maturity items in liquidity/interest rate
sensitivity analysis; for instance, demand deposits.
2. Treatment of off-balance sheet items in liquidity gap analysis:
i. derivatives (options: equity, floors, caps and collars);
ii. undrawn commitments.
In fact the treatment often differs for regulatory return purposes
and what is in place in many banks' actual liquidity reporting
models. Callable and demand deposits are treated as 1-day

2,000,000,000 End of 2-week stress period End of 3-month stress period •Inflows Outflows Cumulative cash flow
1.500.000. 000
. .
1 000 000.000
500,000,000 Day 93

Q vct»U* UC OWDvcP a t>o o uo o o OO O D O O o aB> o O C a

p pa
-500,000,000 P
v< v< *P<
C\
*<£ vat< o*< *<
p
vc
p
vc VC
P
VC
u &
v;£J v: vc VC vc

- 1,000,000,000 OO OO ii a tS £ SO 3 s OO
8 W
SO SO
CO
►-
o
—
•-
o
CA
*-
—
-- VO
JO
to
to CO
to
CO
CA o Cj •u
OO w
Ln LA
Ov 2 2
-1,500,000,000
- 2 ,000 ,000,000
- 2 ^ 00 ,000,000

Fiaure 10.12A and B Stress test results: cash flow survival horizon.

204 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 LIQUIDITY RISK (STRESS TESTING) WEEKLY SUMMARY 23 February 2010

Collation Grid
Assets 26/02/10-26/02/10 01/03/10-01/03/10 02/03/10-02/03/10 03/03/10-03/03/10 04/03/10-04/03/10 05/03/10-05/03/10 08/03/10-08/03/10 09/03/10-09/04/10 09/04/10-07/05/10 10/05/10-09/06/10 10/06/10-09/07/10 12/07/10-11/08/10 12/08/10-10/09/10
DEPOSIT 0 -241,607,851 -40,054,610 0 0 0 0 0 0 0 0 0 0
FOREIGN EXCHANGE -44,965,540 -137,991,183 -57,139,991 -53,663,305 -58,564,187 -9,179,822 -9,053,677 -8,699,928 -9,564,882 -8,699,926 -8,699,928 -8,699,928 -8,699,928
LOAN -3,399,632,793 -3,393,8689,825 -2,673,744,068 -2,670,030,075 -2,652,419,071 -2,488,454,257 -2,449,789,080 -1,910,019,970 -1,793,858,833 -1,679,325,195 -1,642,531,170 -1,564,709,832 -1,544,267,305
SECURITIES -1,284,200,226 -1,284,200,226 -1,284,200,226 -1,264,200,228 -1,284,200,226 -1,284,200,226 -1,284,200,226 -1,176,860,413 -1,068,883,169 -1,010,663,169 -956,385,475 -932,385,475 -816,120,475
UNDER INVESTIGATION 0 0 0 0 0 0 0 0 0 0 0 0 0
Total Assets -4,728,801,560 -5,057,489,085 -4,055,138,895 -4,008,093,608 -3,995,183,484 -3,778,884,305 -3,743,042,983 -3,095,580,310 -2,670,306,684 -2,698,908,291 -2,607,616,573 -2,505,795,234 -2,371,087,708

Liabilities 26/02/10-26/02/10 01/03/10-01/03/10 02/03/10-02/03/10 03/03/10-03/03/10 04/03/10-04/03/10 05/03/10-05/03/10 08/03/10-08/03/10 09/03/10-09/03/10 09/04/10-07/05/10 10/05/10-09/06/10 10/06/10-09/07/10 12/07/10-11/08/10 12/07/10-10/07/10
DEPOSIT 4,110,991,383 4,352,599,234 3,950,075,302 3,866,816,947 3,828,122,384 3,723,005,860 3,705,910,202 1,502,417,595 850,054,068 418,752,249 336,523,349 231,403,692 187,572,850
FOREIGN EXCHANGE 45,942,962 135,799,261 57,335,715 54,355,437 60,278,274 9,513,048 9,386,774 9,125,155 10,059,444 9,125,168 9,125,168 9,125,168 9,125,168
LOAN 0 313,297 -700.000 -700,000 -700,000 -700,000 -700,000 -700,000 -500,000 -500,000 -500,000 -500,000 -500,000
UNDER INVESTIGATION 0 0 0 0 0 0 0 0 0 0 17 17 17
Total Liabilities 4,156,934,345 4,488,711,792 4,006,711,017 3,920,472,434 3,887,700,657 3,731,818,908 3,714,596,976 1,510,842,763 899,613,510 427,377,418 345,248,534 240,029,078 196,499,065

Cashflow 0 3,089,921 520,349,416 -39,193,296 -19,861,653 59,437,430 19,599,390 -1,556,291,540 -385,955,527 -300,837,700 0,162,835 -3,398,115 91,176,514
Cumulative Cashflow 0 3,089,921 523,439,337 484,246,041 464,334,355 523,821,818 543,421,208 -1,012,870,332 -1,398,625,959 -1,599,663,659 -1,690,500,824 -1,693,888,942 -1,602,722,428

Cumulative Cashflow Forecast and Stress Tests

T he C u m u lativ e C a sh flow su rv iv al h o rizo n is 42 d a y s. O n c e O b se rv e d B eh av io u ral F o re c a s tin g (OBF) is a p p lie d a lo n g w ith th e s t r e s s e s s e t o u t by th e FSA, th e F o re c a s te d C u m u lativ e
C a sh flow su rv iv al h o rizo n is b e y o n d th a t of th e 6 m o n th s b ein g a n a ly s e d . O n ce re le v a n t h a irc u ts a re a p p lie d to th e M arketable A s s e ts a s p a rt of th e FSA s t r e s s te s tin g , th e ir valu e
r e d u c e s by €150m m to €1.13bn
Cumulative Cashflow Forecast - Unstressed Cumulative Cashflow Forecast - Stresses &
OBF applied
Cashflow Forecast Cashflow Forecast

i 2f4l«,eM -rg,-• — -• — • - • *9 • ♦ *

s
iM
l,-UU 5C-
Ia
i
%
•^ , . ..i . . : $ v v . ’/ - 1 : y

P S U M )-

i i•

L m
• T T l .'

rifT
:

• G r a p h s s h o w d a ily c a s h flo w m o v e m e n ts o v e r a 6 m o n th p e rio d fro m 23 rd F e b 2 0 1 0 • S h o w s th e P o s t - F S A s t r e s s e d C u m u la tiv e C a s h flo w F o r e c a s t ta k in g Into a c c o u n t th e im m e d ia te sa le /re p o of

• T h e C a s h f lo w i s a rriv e d at a fte r fa c to rin g in sa le /re p o o f m a rk e ta b le s e c u r it ie s (b o n d s , F R N s , C D s ) . “O v e rn ig h t” d ata M a rk eta b le s e c u r it ie s
Is u n a d ju s te d . • T h e fo llo w in g F S A s t r e s s e d h a v e b e e n a p p lie d : W h o le s a le F u n d in g , R e ta il L iq u id ity , In tra d a y liq u id ity - 3 & 5 d ay
• T h e C u m u la tiv e c a s h f lo w is b a s e d on c o n tra c tu a l c a s h f lo w s a n d n o a d ju s tm e n t h a s b e e n m a d e fo r a s s e t/ lia b ility s t r e s s e s , C r a s s C u r r e n c y L iq u id ity , In tra -G ro u p L iq u id ity , O ff B a la n c e S h e e t Liq u id ity , M a rk e ta b le A s s e t s , N on-
b e h a v io u r o r “ s t ic k in e s s ”. M a rk eta b le A s s e t s , F u n d in g C o n c e n tra tio n .

• D ata fe e d in g g ra p h u s e s s a m e b a s e lin e d ata a s s e e n in B L A S T . A d d itio n a l d e a ls h a v e b e e n a d d e d to t h is d a ta fo r F X • O B F ( s t ic k in e s s ) a p p lie d : N on L ia b ilit ie s (1 0 0 % e v e r y 3 d a y s ), C u rr e n t A c c o u n t s ( - 5 .6 6 % e v e ry 36 d a y s ), R e ta il T im e

s w a p p o s it io n s .
T h e “c u m u la tiv e c a s h f lo w " s u r v iv a l h o riz o n is 42 d a y s .
Marketable Securities
Haircut Value
Marketable Securities stressed
d e p o s it s ( - 0 .4 1 % e v e r y 3 4 4 d a y s ), C a p ita l (1 0 0 % e v e ry 3 d a y s ), C a s h & E q u iv a le n t s (1 0 0 % e v e ry 3 d a y s ) , F is c a l
L ia b ilit ie s (1 0 0 % e v e r y 3 d a y s ), R e p o L ia b ilit ie s (c u rre n tly n o r e p o s ), O th e r tim e d e p o s it s ( - 0 .0 3 % e v e r y 47 d a y s ), F X
(1 0 0 % e v e r y 30 d a y s )
€1,279,200,226
• O B F not a p p lie d : C o r p D e p o s it s , G o v t tim e d e p o s it s , In tra g ro u p tim e d e p o s it s , In te rb a n k tim e d e p o s it s , O th e r
€ 1 5 0 ,1 1 6 ,4 2 3 L ia b ilit ie s
• F o r e c a s t e d C u m u la tiv e C a s h flo w s u r v iv a l h o riz o n is b e y o n d th at o f th e 6 m o n th s b e in g a n a ly s e d fo r t h is re p o rt
€ 1 ,1 2 9 ,0 8 3 ,8 0 3 o n c e O B F a n d th e F S A s t r e s s e s h a v e b e e n a p p lie d .

Figure 10.13 Senior management summary report, 1-slide PowerPoint.

money for regulatory purposes, although certain regulatory Bank liquidity models commonly apply the following treatment:
authorities will allow a "behavioural" adjustment of retail depos­ a• Derivatives are included to the extent that collateral is pay­
••

its where it can be shown that these remain fairly stable over I
able or receivable under an ISDA/CSA agreement; coupons
time. For example, 50% of such deposits may be allowed to be
receivable or payable will also be included on their pay dates.
treated as longer term funds. Generally, however, such funds do
• Commitments: all committed but undrawn lending is
not improve a bank's liquidity metrics, because they are viewed
included as an outflow of cash (at sight) and included in
as 1 -day funds by regulators.
liquidity calculations.
For off-balance sheet items, the UK FSA treatment is as follows:
In general, a conservative approach to treatment of expected
• Derivatives values/notionals are not included in the liquidity cash outflows, whether as derivative collateral or undrawn com­
ratio calculation; however, coupons receivable or payable will mitments, is recommended business bestpractice.
be included on their pay dates.
• Commitments: 10% (specified by FSA) committed but
undrawn lending is included as an outflow of cash (at sight)
and included in the ratio calculations.

C hap ter 10 Liquidity Risk Reporting and Stress Testing ■ 205

206
Table 10.6 Liquidity Management: Individual Stress Test Results Report
Stress Tests - Individual Shocks Sight - 8 Day Sight - 1 Month Probability Impact

Reduction in Liquid Assets

Change in repo criteria Light Rating category 1 notch downgrade 8.46% 1.35% 50% 30
Moderate Rating category 2 notch downgrade 2.34% 0 .1 2 % 2 0 % 70
Severe Rating category 3 notch downgrade -15.2% -18.2% 1 % 90
Mark-to-market reduction Light 8.46% 1.35% 60% 2 0

in value of assets
Moderate 2.34% 0 .1 2 % 40% 30
Severe -15.2% -18.2% 5% 70
Increased haircut on assets Light 8.46% 1.35% 70% 25
Moderate 2.34% 0 .1 2 % 30% 45
Severe -15.2% -18.2% 8 % 80
Unavailability of repo Severe Treat all marketable securities as illiquid (i.e., -15.2% -18.2% 5% 1 0 0

facilities allocate to final legal maturity time buckets)

Decrease in Liabilities

Withdrawal of customer Light Reduce customer deposits by 5%, replace with 8.46% 1.35% 70% 2 0

deposits o/night funding

Moderate Reduce customer deposits by 10%, replace with 2.34% 0 .1 2 % 15% 30
o/night funding
Severe Reduce customer deposits by 15%, replace with -15.2% -18.2% 5% 40
o/night funding
Withdrawal of corporate Light Reduce Local Authority deposits by 25%, other 8.46% 1.35% 5% 2 0

deposits deposits by 1 0 %, replace with overnight funding

Moderate Reduce Local Authority deposits by 50%, other 2.34% 0 .1 2 % 2 % 70
Corporate Banking deposits by 35%, replace
with overnight funding
Severe Reduce Local Authority deposits by 100%, other -15.2% -18.2% 1 % 1 0 0

Corporate Banking deposits by 70%, replace

with overnight funding

■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Withdrawal of intragroup Light Reduce net group liability to EUR500 mm, 8.46% 1.35% 1 0 0 % 5
deposits replace with overnight funding
 Table 10.6 C ontinued

Stress Tests - Individual Shocks Sight - 8 Day Sight - 1 Month Probability Impact

Moderate Reduce net group liability to EUR250 mm, 2.34% 0 .1 2 % 70% 2 0

replace with overnight funding

Severe Reduce net group liability to nil, replace with -15.2% -18.2% 30% 50
overnight funding
Withdrawal of inter-bank Light Reduce deposits from "relationship banks" 8.46% 1.35% 80% 2 0

deposits (correspondent banks) by 5%, other inter-bank

deposits by 25%, replace with o/night funding
Moderate Reduce deposits from "relationship banks" (cor­ 2.34% 0 .1 2 % 30% 60
respondent banks) by 25%, other inter-bank
deposits by 50%, replace with o/night funding
Severe Reduce deposits from "relationship banks" (cor­ -15.2% -18.2% 1 0 % 90
respondent banks) by 50%, other inter-bank
deposits by 1 0 0 %, replace with o/night funding
FX Markets

FX rate changes Light Stress GBP and USD FX rates by 15% 8.46% 1.35% 90% 2 0

Moderate Stress GBP and USD FX rates by 15% 2.34% 0 ,1 2 % 40% 40

Severe Stress GBP and USD FX rates by 25% -15.2% -18.2% 2 0 % 90
Withdraw of FX swap Light Withdrawal of less liquid swap markets 8.46% 1.35% 30% 15
markets
Moderate Withdraws of swap markets (excl. USD, EUR, 2.34% 0 .1 2 % 7% 40
GBR)
Severe Withdrawal of all swap markets -15.2% -18.2% 2 % 50
Stress Tests-Combined Shocks Sight - 8 day Sight - 1 month Probability Impact
Slow-bum liquidity crunch Detailed description of balance sheet shocks -25.5% -26.7% 2 % 85
Severe reputational Detailed description of balance sheetshocks -42.4% -51.2% 0.50% 1 0 0

damage

Chapter 10 Liquidity Risk Reporting and Stress Testing ■ 207

Contingency
Funding Planning
Chi Lai and Richard Tuosto 1

Learning Objectives
After completing this reading you should be able to:

Discuss the relationship between contingency funding
plan and liquidity stress testing.
Evaluate the key design considerations of a sound contin­
gency 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).

Excerpt is Chapter 7 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen Baird.

1 _
Chi Lai is a director in PwC's New York office, and Richard Tuosto is a manager in PwC's New York office.

209
11.1 ACTIO N S IN A LIQUIDITY CRISIS
A contingency funding plan (CFP) serves as a logical connection
to its companion, the liquidity stress testing framework, by link­
ing the stress test results and other related information as inputs
to the CFP governance, menu of contingent liquidity actions,
and decision framework.
Contingent liquidity events can be categorized by their level
of estimated adverse impact and probability. Institutions man­
age one end of the spectrum—the low-impact, high-probability
events—as part of their business-as-usual (BAU) funding and
liquidity risk management activities but use CFPs to address
the other end of the spectrum associated with high-impact
low-probability events. CFPs provide a structured approach for
developing and implementing the institution's financial and oper­
ational strategies for effectively managing such contingent liquid­
ity events during periods of severe market and financial stress.
This chapter provides a brief overview of the CFP's evolution
and recent changes, design framework and key considerations,
and implementation considerations.
11.2 EVOLVIN G CAPABILITIES
AN D EN H A N CEM EN TS
Formalized CFPs have gained greater traction and importance
over the past decade as market disruptions have become more
common and concerns for the survival of institutions in crisis
have drawn sharpened attention. Progress has been made in
formalizing and standardizing CFPs; however, there remain
notable differences among institutions with respect to the level
of coverage and detail. In general, smaller institutions have
typically included their CFPs as part of their broader business
continuity plans, while larger institutions have established more
formalized CFPs. Larger, more complex firms may also have
several CFPs to address the specific challenges and options for
different subsidiaries and legal entities.
The European Banking Commission's 2008 report, "EU Bank's
Liquidity Stress Testing and Contingency Funding Plans," which
highlighted the practices of 84 surveyed institutions, noted rec­
ommendations on areas for enhancements, and provided guid­
ance to supervisors and central banks on areas of focus for their
evaluation of the institutions' CFPs. Since that time, supervisors
have released additional guidance pertaining to CFP design
and implementation requirements. More recently, the Federal
Reserve, in its "Enhanced Prudential Standards for Bank Hold­
ing Companies and Foreign Banking Organizations" guidance,
required that banking organizations operating in the U.S. with
$50 billion or more in assets establish and maintain a CFP to
210 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
set out the company's strategies for addressing liquidity needs
during liquidity stress events.
As part of this guidance, supervisors have indicated that CFPs
should have defined policies and procedures that address the
governance, roles and responsibilities, liquidity measures and
triggers, menu of contingent actions, and communication pro­
tocols. Further, an institution's CFP, or collective set of CFPs,
should be tailored to the specific business and risk profiles of
the institution, covering the different set of businesses, subsid­
iaries, legal entities, products/asset classes, and geographic and
foreign exchange (FX) coverage in which the institution oper­
ates. Finally, institutions should also regularly test their CFPs to
ensure operational effectiveness.
In addition to the specific guidance on CFPs, other supervisory
guidance on capital management, liquidity risk management,
and recovery and resolution planning have impacted how insti­
tutions design their CFPs. In particular, the Federal Reserve's
Comprehensive Liquidity Assessment and Review (CLAR) and
the daily liquidity regulatory reporting requirements have link­
ages to the CFPs' governance and liquidity measures. Addi­
tionally, CFPs are often referenced as part of and aligned to
an institution's recovery and resolution planning activities, as
liquidity risk is often one of the key drivers of the potential
institution's failure and a critical resource needed to effectively
support the execution of the institutions' resolution strategies'.
In this capacity, the CFP serves as an important bridge between
the institution's BAU liquidity risk management practices and the
recovery and resolution planning activities, where specific parts
of the institution must be resolved.
11.3 DESIGN CON SIDERATION S
While no universal CFP exists that can cover all types of institu­
tions and situations, there are several CFP key design consider­
ations that firms should be mindful of in designing or refreshing
their CFPs. These considerations include the following:
I. Aligned to business and risk profiles
II. Integrated with broader risk management frameworks
III. Operational and actionable, but flexible playbook
IV. Inclusive of appropriate stakeholder groups
V. Supported by a communication plan
I. Align to Business and Risk Profiles
CFPs should be considered in the context of the institu­
tion's specific business and risk profiles, including the scope
of business activities, products/asset classes, geographic and
FX coverage, and legal entity structures. Institutions should
ensure consistency by aligning their risk appetite statement to
the CFP framework, through quantifiable early warning indica­
tors, limits, and escalation levels.
A CFP should be refreshed accordingly as the institution's
business and risk profile changes over time; both internally as
corporate and business strategies change, new products and
services are introduced, as well as externally, as the macro-
economic and market environments evolve. In addition to the
periodic updates to the CFP, leading institutions are taking a
more proactive stance on the development of the CFP by incor­
porating it as part of, or in parallel with, their strategic planning
exercises, thereby positioning the CFP to be more forward-
looking and flexible.
II. Integrate with Broader Risk
Management Frameworks
The CFP is not a stand-alone tool, but rather, an integrated part
of the institution's liquidity risk management and firm-wide risk
management frame-works, including enterprise risk manage­
ment (ERM), capital management, and business continuity and
crisis management. This integration of the CFP to other compo­
nents of the ERM disciplines increases the CFP's effectiveness
and consistency by enabling it to leverage and reference estab­
lished controls and processes.
The CFP should be explicitly linked to the liquidity risk mea­
surement framework and the liquidity stress test, in particular
through its limit structure and escalation levels. For example, the
liquidity risk measures used in the institution's BAU risk manage­
ment activities serve as a foundation from which the CFP defines
its early warning indicators (EWIs). Additionally, linkages to
the business continuity and crisis management frameworks will
reinforce key operational and communication protocols during
times of crisis.
III. Operational, Actionable,
but Flexible Playbook
As a playbook, the effectiveness of the CFP lies in its opera­
tional readiness. In a crisis, the ability to convene management
and start to develop contingent strategies and a plan of action
would likely prove highly challenging without prior planning. As
such, it is important for the CFP to include a menu of possible
contingency actions that management can undertake in differ­
ent stress scenarios and at graduated levels of severity. These
graduated stress levels should be aligned to EWIs, triggers, and
contingency actions. Through this process, the institution will
have a structured roadmap, outlining potential liquidity risks and
associated management actions that can be calibrated for differ­
ent stages of the liquidity crisis.
By virtue of the fact that the CFP cannot anticipate all possible
situations that may lead to a liquidity crisis, effective CFPs strike a
balance between specifying recommended contingency actions
while enabling management sufficient flexibility and discretion to
make informed decisions as the crisis evolves over time.
IV. Inclusive of Appropriate
Stakeholder Groups
Developing operational readiness in a CFP requires a thorough
understanding of both strategic and tactical aspects of the
institution. This assessment begins with scenario design, contin­
gency planning, and communication strategies, and continues
through execution, where timely coordination and communica­
tion are critical to ensuring that internal and external stakehold­
ers remain confident in the institution's financial strength.
For these reasons, the involvement of appropriate stakeholder
groups, including various management committees (e.g., asset-
liability committee (ALCO), risk and capital committee, invest­
ment committee), business units, finance, corporate treasury,
risk, operations and technology, is needed to capture the
appropriate elements of the CFP as part of the design and to
ensure successful coordination from an execution standpoint.
In practice, involvement of the various stakeholder groups pro­
vides a strong forum in which potential issues or challenges can
be openly discussed and addressed.
V. Supported by a Communication Plan
As in any crisis, the coordinated and timely communication of
information to stakeholders is critical—a key lesson that resur­
faced in the recent financial crisis. In addition to the need for the
institution to be internally coordinated, external communication
to clients, analysts, counterparties, and regulators with timely and
accurate information is critical as it helps to reinforce confidence
in the institution and mitigate potential risk that rumors and fears
do not further precipitate and adversely impact the institution.
11.4 FRA M EW O RK AND BUILDING
BLO CKS
With these key design considerations in mind, institutions
can develop their CFPs using an integrated framework that
addresses the people, process, data, and reporting dimensions,
keeping in mind that the CFP framework should be tailored to
its business and risk profiles, including the scope and scale of its
C hap ter 11 Contingency Funding Planning ■ 211
business activities, products/asset classes, geographic and FX
coverage, subsidiaries, and/or legal entities.
Key components of a CFP framework include the following:
1. Governance and oversight
2. Scenarios and liquidity gap analysis
3. Contingent actions
4. Monitoring and escalation
5. Data and reporting
Governance and Oversight
An effective CFP requires both well-defined roles and responsi­
bilities and a strong communication strategy that ensures timely
coordination and communication among internal and external
stakeholders. Both the organizational roles and communications
plan need to be supported by well-defined policies and proce­
dures, and reinforced through CFP periodic testing and simula­
tion exercises.
Stakeholder Involvement, Roles,
and Responsibilities
A well-designed CFP requires representation from a variety of
stakeholder groups across the institution. Front office and busi­
ness groups can provide insights into how their businesses per­
form under different business environments and stress scenarios;
corporate finance, treasury and risk management groups can
provide perspectives on how funding and liquidity risk profiles
are managed, both in BAU and in crisis situations, and the tools
afforded as the liquidity crisis escalates; and operations can
describe the collateral and cash management processes and
how they manage the inflows and outflows of liquidity.
While the specific CFP roles and responsibilities of different groups
may vary across different institutions, there are several groups that
play a pivotal role in the CFP design and implementation, including
corporate treasury, the liquidity crisis team, management com­
mittee, and board of directors. The following descriptions should
serve as a starting point for institutions in defining specific CFP
roles and responsibilities. Institutions should be mindful that these
roles should be tailored to address institution-specific organiza­
tional structure, capabilities, and coverage/responsibilities:
Corporate treasury. As part of its BAU activities, corporate
treasury monitors the ongoing business, risk, funding, and
liquidity profile of the institution. The treasurer, in consulta­
tion with the CFO and others, may invoke the CFP and con­
vene the liquidity crisis team (LCT) based on a review of the
markets, industry, institution-specific conditions, and liquidity
stress testing results.
212 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Liquidity crisis team. The LCT serves as the central point
of contact and is responsible for the continuous monitoring
of the institution's liquidity profile. The LCT will also provide
recommendations on CFP actions, working closely with cor­
porate treasury and the management committee. In perform­
ing this function, the LCT helps ensure effective coordination
and communication across the organization as well as with
external stakeholders. The LCT should be composed of
senior members of the institution's business and supporting
functions, including C-level executives, and heads of business
segments, geographies, and legal entities. Generally, the LCT
is responsible for designing the CFP and submitting it to the
senior management group for review and approval.
Management committee. During a crisis, the senior manage­
ment of an institution provides oversight of the LCT and con­
sults with the board of directors, monitoring the institution's
liquidity risk profile and reviewing specific recommendations
for and coordination of CFP actions.
Board of directors. The board of directors should be
actively engaged, in coordination with the management
committee and LCT teams, during the crisis and serve as
an advisor and counsel to them. A strong understanding
of the contents of the CFP will enable board members
to be actively engaged with the management committee
in evaluating CFP actions being considered, particularly
if the institution's liquidity position continues to worsen,
and strategic actions, such as large asset and/or subsidiary
sales, need to be taken.
For institutions that have complex business models that
include multiple business segments, geographies, and/or
legal entities, it is important that the overall organizational
structure be well defined at the parent level and the operat­
ing subsidiaries. This helps ensure a proper chain of com­
mand where decisions are well coordinated and aligned
across the institution as a whole.
Communication and Coordination
CFPs should include a communications strategy and plan to
ensure proper notification, coordination, issue reporting and
escalation. The different groups across the institution must work
in concert, relying on each other to ensure information is avail­
able on a timely basis to support management decision-making.
Additionally, an effective communication strategy and plan pro­
motes confidence. Confidence is critical, as demonstrated time
and again in financial services industry, most recently during the
financial crisis of 2007-08.
In any crisis situation, clear and timely communication helps the
institution demonstrate a sense of control and confidence that
management understands the challenges ahead and has a plan of
action. This is important to both internal and external stakehold­
ers, including employees, clients, counterparties, shareholders, rat­
ings agencies, and regulators, as the loss of confidence can quickly
spiral downward when rumors start to take over news headlines—
whether such headlines are grounded on reality or not.
Communications with respect to messaging and content should
be centrally managed. Everyone should be working off the same
page. However, the bidirectional communication and coordina­
tion with the stakeholders should reside with those executive
and management teams that have existing working relation­
ships. For example:
• Business units—clients, counterparties
• Corporate treasury—regulators and supervisors, rating
agencies, clearing banks
• Investor relations—investors, analyst community, public media
• Legal and compliance—regulators and supervisors
These coordination points may differ across institutions,
depending on their size, complexity, and organization structure.
Additionally, institutions may already have existing communi­
cation plans, as part of their BAU and/or business continuity
activities. As such, institutions should look to leverage existing
practices as part of their CFP design and make appropriate
enhancements, where appropriate.
Policies and Procedures
Institutions should document their CFPs and ensure alignment
with other risk management, business continuity, and recov­
ery planning-related policies and procedures. Documentation
should include all aspects of the CFP, including the governance
structure, processes, data, and reporting activities. An illustra­
tive example of a CFP policy outline is as follows:
• Introduction
• Overview and purpose of the CFP
• Related policies including CFPs across business segments,
geographies and legal entities, resolution and recovery
planning, and business continuity policies
• Governance
• Roles and responsibilities
• Review and approval
• Periodic review
• Stress testing and scenarios overview (likely covered in detail
in separate document)
• Methodology
• Scenario design
• Inputs, outputs, and calculations
• Key assumptions
• Data control
• Model validation
• Monitoring and escalation
• Regular monitoring and risk management
• Liquidity gap analysis
• Contingent actions
• Reporting
• Reporting frequency
• Briefing decks and reports
The CFP policy should be consistently applied, whether it is a sin­
gle CFP or multiple CFPs, and should be reviewed and updated
periodically to ensure continued alignment to the institutions
current and forecasted business activities and risks exposures.
Testing and Readiness Assessment
On a periodic basis, institutions should evaluate their CFP oper­
ational readiness and test targeted elements of their CFPs to
ensure relevance and execution effectiveness in times of stress,
particularly given changing market dynamics and the institution's
business and risk profiles. While certain contingent activities,
such as business divestitures, large asset sales, and use of Fed­
eral Reserve borrowing, may be impractical or unavailable for
testing, there are some market activities such as debt issuances,
brokered deposits issuances, and limited securities sale of the
investment portfolio to generate additional liquidity that may be
appropriate to test.
Additionally, institutions should evaluate the CFP's opera­
tional effectiveness: Such activities should include the CFP's
governance, escalation process, communication, coordi­
nation, and reporting. Leading institutions that perform
frequent exercises that best simulate the potential liquidity
crisis environment will improve the CFP's operational effec­
tiveness and response times, aspects that are critical during a
crisis. Further, the test simulations may also identify potential
gaps and/or improvement opportunities that would otherwise
be undetected if the CFP were left purely as a theoretical
design exercise.
Scenarios and Liquidity Gap Analysis
Institutions should align their CFP stress scenarios to those in its
liquidity stress testing framework, as well as to other frameworks
such as the recovery and resolution plans. The liquidity stress
testing scenarios will cover both systemic (general market) and
C hap ter 11 Contingency Funding Planning ■ 213
idiosyncratic (institution-specific) risks and address both mar­
ket (asset) liquidity and funding liquidity, over short-term and
prolonged stress periods. The liquidity stress testing framework
should ensure that effects of these stresses on the institution's
liquidity profile is appropriately measured and monitored. The
CFP in turn should provide a tactical mechanism for escalating
a developing crisis to management's attention and ensuring
actionable responses are available.
In addition to incorporating the outcomes of the institution's
liquidity stress testing, the CFP itself may contain additional
liquidity-related stress scenarios. These additional scenarios,
while outside the institution's broader liquidity risk monitor­
ing and limit structure (as contained within the liquidity stress
test), ensure effective contingency plans are in place in the
event of certain events that could potentially impact liquid­
ity. For example, the CFP might include scenarios in which its
intraday debit cap with Fedwire is exceeded, specific coun­
terparties fail, or Federal Home Loan Bank funding becomes
unavailable.
Contingent Actions
Based on the liquidity gap analysis, institutions can develop
contingent actions/capital recovery actions, including a spec­
trum of business scoping activities, pricing initiatives, disposi­
tion actions, and potential expense control actions, that will
help strengthen the institution's liquidity position. In general,
the applicability and appropriateness of such contingent
actions should be considered in the context of the nature and
severity (amount) of capital shortfall, associated timing and
pattern of the expected capital shortfall, estimated capital
relief from the contingent action, and the institution's ability to
execute internal or external/market activities associated with
such contingent actions.
Examples of contingent actions include, but not are limited to
the following:
• Maintaining lines of credit that allow borrowing without
major restrictions on use and reasonable rates
• Increasing underwriting standards and dialing back lending
• Adjusting pricing strategies to increase premiums paid on
deposit products in order to entice investors to place depos­
its with the institution
• Changing investment strategy to roll off reinvestment of
securities at maturity
• Shifting allocation from short-term funding to longer-term
funding sources
• Increasing issuance of brokered CDs or direct to consumer
deposits
214 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
• Securitizing retail assets (e.g., mortgages, credit card receiv­
ables, loans, auto leases)
• Pledging of assets through the Federal Reserve discount
window
• Selling liquid assets/investments
• Drawing down on securitization conduits
• Issuing subordinated debt
• Reducing asset growth through reduced balance transfers
• Issuing at-call loans (which can be recalled to provide cash
when needed)
• Selling consumer loans and/or credit card receivables
• Selling business or business units
• Raising equity funds through asset sales or issuance
• Reducing capital distributions
• Curtailing discretionary spending and expenses
The availability and potential impact of these contingent actions
is dependent on the systemic and/or idiosyncratic nature and
severity of the stress events. For example, a general freeze-up
or withdrawal of credit in the financial markets could prevent
access to existing lines of credit for rolling over short-term obli­
gations. Lenders may restrict or outright refuse to extend credit
based on perceptions of the institution's financial strength and
exposures to risks. Asset liquidity may decrease precipitously,
leaving the institution challenged to fund certain business activi­
ties and commitments.
In general, a number of market factors can impact the institu­
tion's ability to take contingent actions including, but not limited
to the following:
• Shutdown of securitization markets
• Restricted access to repo funding due to solvency issues,
credit downgrades, or reputation damage
• Ratings downgrade and subsequent increase in collateral/
margin requirements
• Predatory margin and collateral practices by counterparties
• Increased cash deposit requirements with custodian banks
• Increased cost-of-funding (i.e., debt yields)
• Deposit runoff
• Collapse of interbank market and wholesale funding
concentration
• Counterparties not willing to roll over funding
Management should try to anticipate these challenges as well as
the implications they may have on its liquidity responses. Where
possible, the CFP should document mitigating actions that man­
agement would consider taking to address such challenges.
Market Signals and Reputational Impact These measures can be organized as market and business mea­
sures (external and internal) and liquidity health measures (inter­
In the early stages when an institution experiences liquidity
nal), and represent factors that affect—directly or indirectly—the
stress, it may elect to curtail certain businesses activities, tighten
institution's liquidity position. Collectively, these measures form
its credit and lending standards, and/or limit its exposure to
a set of key risk indicators or Early Warning Indicators (EWIs)
higher risk counterparties to strengthen its liquidity profile and
that provide advance signaling of potential liquidity problems
resources. While these responses will provide some measure of
on the horizon, enabling management to evaluate and take
improved liquidity, such actions may send inadvertent signals to
measured steps as the crisis escalates.
the market and thereby impact the external perception of the
institution's financial strength and reputation, adversely limiting
Early Warning Indicators
the availability and/or effectiveness of future contingent actions
as the crisis evolves. Market and business measures reflect the market environment
and institution-specific business strategy and activities. These
For example, borrowers who believe that the institution has
indicators, such as significant changes in levels and volatility
spurned their business will likely look to other lenders. Coun­
of the equity markets, severe drop in institution's stock price,
terparties, such as hedge funds, which rely on credit from prime
and dramatic changes in the business' revenues from a certain
brokers or trading counterparties, could cease their relation­
geographic area, can prompt management to evaluate how
ship with the institution and seek other trading partners or
changing market conditions and institution's business strat­
intermediaries. Certain debt holders that have strong business
egy may be adversely impacted and thereby proactively take
relationships with the institution could "force" a debt buyback,
actions in advance of oncoming market disruptions.
and the institution in agreeing to such buyback will likely reduce
its liquidity; however, refusing to do so could raise questions Liquidity health measures serve as indicators of the institution's
regarding the institution's viability. liquidity base and strength. While the market and business
risk measures should be evaluated within a broader context,
A change in the market's perception of an institution's viability
the liquidity health measures, such as short-term funding as
could have rapid and severe impacts on its liquidity. For this
a proportion of total funding, deposits-to-loan for depository
reason, certain actions could cause more harm than benefit
businesses, and the firm's credit rating, are more targeted in
depending on the severity of the stress and the institution's
that deterioration in these metrics reflect a direct and adverse
financial strength, as already noted.
impact on the institution's current and/or projected liquidity
At various stages of liquidity stress, management must consider profile and strength.
the signals that its actions convey to the markets, its lenders,
Both types of measures are important for informing manage­
clients, and counterparties. Depending on the specific timing,
ment of the potential effects of different liquidity stress sce­
certain contingent actions, while they may provide short-term
narios. Internal and external EWIs should be selected in concert
liquidity, may ultimately leave the institution worse off, depend­
so that the institution can identify emerging liquidity risks and
ing on the reactions of its external stakeholders. For example,
the nature of these risks as idiosyncratic, systemic, or some
attempts to access a sovereign lending facility or other emer­
combination of the two. The combination of EWIs and escala­
gency source of funds may lead counterparties and lenders to
tion levels enable the institution to anticipate and manage the
immediately withdraw existing credit out of concern that the
liquidity crisis as it unfolds over time.
institution will fail. The sale of certain businesses or a suspen­
sion of activities, such as reverse repo or other customer funding
operations, could be perceived as signs of distress. These con­ Market and Business Factors
tingent actions may be necessary during the later stages of the Institutions will need to define EWIs using external and internal
crisis; however, at earlier stages, perceived signals of weakness information in order to monitor trends in the market as well
may actually precipitate a liquidity crunch for the institution. as among the institution's peer group. Such information can
include a combination of macroeconomic measures, industry
measures, and institution-specific measures.
Monitoring and Escalation
Macro-environment factors may not directly correspond to indi­
The CFP should leverage the institution's liquidity risk monitor­ vidual liquidity challenges that an institution may face; however,
ing and measurement framework. This framework should include they can provide insight into general market distress and a sys­
a portfolio of measures to monitor both the current liquidity temic withdrawal of liquidity, similar to the freezing of the repo
profile and the anticipated effects of potential liquidity events. markets during the financial crisis. Macro-environment measures

C hap ter 11 Contingency Funding Planning ■ 215

should focus on risks that are specific to the financial system
and its general liquidity. Examples may include repo spreads,
asset haircut trends, and movements in credit default swap
(CDS) spreads.
Industry factors include trends in the profitability of the financial
sector, recent rating agency action, banking industry capital
adequacy, S&P financial institution sector movement, and other
factors. Competitor analysis can also be applied to evaluate the
trends in the industry to detect potential performance problems
in an institution's peer group.
Institution-specific measures help management to assess the
market's perception of the institution's financial strength and the
likelihood of a liquidity crisis through external information. Inter­
nal measures provide greater insight into the operations of the
institution and their potential impact on its liquidity position.
Examples of EWIs encompassing market and business factors
include:
• Significant and unexpected drop in stock market indices
• Downgrade of U.S. Treasury or other sovereign debt rates
• Spike in market volatility (e.g., VIX)
• Unexpected catastrophic events (e.g., September 11, 2001,
earthquakes)
• Rapid asset growth funded by potentially volatile liabilities
• Real or perceived negative publicity
• A decline in asset quality
• A decline in earnings performance or projections
• Downgrades or announcements of potential downgrades of
the institution's credit rating by rating agencies
• Cancellation of loan commitments and/or not renewing
maturing loans
• Wider secondary spreads on the institution's senior and sub­
ordinated debt, rising CDS spreads and increased trading of
the bank's debt
• Increased collateral requirements or demand collateral
for accepting credit exposure to the institution from
counterparties
• Counterparties and brokers unwilling to deal in unsecured or
longer-term transactions
• Requests from depositors for early withdrawal of their funds,
or the bank has to repurchase its paper in the market
• Calls by debt holders for the institution to buy back its debt
or CD issuance
• Volatility in foreign exchange markets, particularly in the
currencies in which the institutions has exposure to and/or
requires as part of its liquidity risk management
216 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Such EWIs are generally most useful before or at the onset
of the liquidity crisis, and during the early stages of the CFP
escalation levels; however, their usefulness and applicability are
aligned to the specific stress scenario and the institution's spe­
cific business and risk profiles.
Liquidity Heath Measures
While the review of macro-economic and industry measures
provide advance signaling of a potential pending liquidity crisis,
institutions should also monitor a suite of liquidity health ratios
to help quantify the impact of the liquidity risks and to support
decision making on CFP actions being considered. These met­
rics will typically be detailed in the institution's liquidity risk man­
agement policy and referenced by the CFP. Key liquidity health
measures include, but are not limited to, the following:
• Projected net funding requirements to current unused
funding capacity. Measures the funding and borrowing
needed to finance the institution's increased lending activities
and banking activities, and provides an approach to assess
the institution's future lending obligations in proportion to
the total funds available at the institution.
• Non-core funding to long-term assets. Measures the
proportion of longterm funding needs that are supported
by less stable sources of funding. A higher non-core fund­
ing dependency ratio is indicative of a high dependence on
volatile funding sources that, during times of financial stress,
may have limited availability or may only be available at a
much higher cost.
• Overnight borrowings to total assets. Measures the reli­
ance on overnight funding to fund the institution's assets
as the use of this volatile source of funding can expose the
institution to increased liquidity risk.
• Short-term liabilities to total assets. Measures the funding
levels that will need to be rolled over within a predetermined
short-term time period (e.g., under 30 days, 60 days, 90 days)
to support the institution's assets.
• Funding sources concentration. The concentration of fund­
ing sources for an institution is an important measure for
understanding which counterparties are most likely to cease
providing liquidity during a stress event. Liquidity provid­
ers that comprise a substantial proportion of an institution's
funding needs could cause serious harm to liquidity during
times of stress, should they decide that their exposure to the
institution is too large and decrease that exposure. Managing
concentration and establishing a variety of liquidity providers
will likely lessen the impact of the loss of any single provider
and give the institution additional sources of liquidity to tap
in the case of a shortfall.
• Funding maturity profile. In addition to managing the con­
centration of funding sources, institutions should also evalu­
ate the concentration of maturities for their funding. Large
concentrations in funding maturities can threaten an institu­
tion's liquidity position, particularly when a concentration in
maturity is accompanied by a reliance on short-term fund­
ing. Institutions should assess the maturity horizon of their
funding sources in tandem with the concentration of funding
sources and with significant consideration to the institution's
reliance on short-term funding.
• Used capacity to total borrowing capacity. Measures the
borrowing capacity available to the institution, based on the
used capacity relative to the total borrowing capacity, where
the used capacity represents the amount of funding currently
being utilized across all funding channels (core funding, inter­
bank markets, and funds generated by institutional sales).
• Liquid assets to volatile liabilities. Measures the basic
surplus or cushion that liquid assets provide over required
funding needs and can be used to monitor the level of liquid
assets available to offset volatile funding.
• Unpledged eligible collateral to total assets. Measures the
institution's ability to sell assets or use assets as collateral
to obtain funding to meet future requirements. The ability
to quickly identify and understand the liquidity of unencum­
bered assets will help it optimize its management of the
collateral, particularly during periods of market stress.
• Loans to commitments. Measures the exposure to credit
facilities that may be required at some point in the future. As
these commitments are drawn down, utilization increases,
prompting further need for funding to meet the obligations.
For institutions with more advanced liquidity risk management
capabilities, these liquidity health measures will also include
daily liquidity position reporting, the Basel III Liquidity Coverage
Ratio (LCR) and the Net Stable Funding Ratio (NSFR) measures.
These liquidity health measures should be monitored continu­
ously over the course of the crisis; however, their importance
is related to their associated limits. As these liquidity health
measures start to reach predefined limits, management should
start to evaluate what contingent actions are appropriate. Simi­
lar to the market and business measures, the usefulness and
applicability of liquidity health measures are dependent on the
institution's scope and complexity of business activities.
Escalation Levels
In designing their CFPs, institutions establish a series of esca­
lation levels properly aligned to the scenarios, contingency
actions, and liquidity measures, including EWIs and health mea­
sures. While there are no specific guidelines in the number of
escalation levels required in CFPs, three to five escalation levels
are common industry practice. For illustrative purposes, here are
descriptions of the different escalation levels, using three levels:
• Level 1. This is the initial escalation level and represents ele­
vated monitoring over market conditions and the impact to
the institution's business segments and performance. Level 1
could be triggered by stress test results indicating a greater
decline in liquidity than the institution's risk appetite targets
and/or a shift in the market's perception of the institution.
The convening of the LCT prompts closer coordination and
communications among the various stakeholders internally
and a communication plan is executed to keep external stake­
holder properly informed and aware of the institution-specific
issues and challenges, and actions being contemplated.
Monitoring should remain focused on forward-looking mea­
sures of the institution's liquidity health and the general market
perception. Business activities that are expected to impact the
business and risk profile of the institution will likely be closely
monitored with increased frequency and scrutiny.
• Level 2. At this escalation level, the institution has experi­
enced noticeable markets and/or idiosyncratic events that are
adversely impacting its business and liquidity risk profile. The
institution should monitor indicators of its current liquidity
position and any causes of deterioration more closely, with a
focus on how the institution's peers and counterparties react
to the changing market dynamics.
As the crisis continues to worsen, management's attention
is on recovery while sustaining business and financial perfor­
mance; however, the focus is more attuned to the immediate
and short-term horizon. The LCT and management commit­
tee activities are taken to actively enhance the institution's
liquidity position, likely curtailing business activities, and lim­
iting the extension of additional and new credit facilities.
In addition, the institution may take steps to improve its
liquidity through strategic sales of less liquid portfolio invest­
ments and assets, in addition to evaluating the feasibility of
significant CFP contingent actions, such as larger asset sales,
business divestitures, and discontinuing certain business
activities, given the evolving market conditions.
• Level 3. At the later stages of the crisis, the institution would
have taken dramatic steps to stabilize its liquidity position,
potentially including significant curtailing of liquidity intensive
business activities or disposition/sales of businesses.
At this point, the institution's focus is primarily on
survival. In this situation, the market environment, state of
the institution, and potential CFP actions show similarities to
the circumstances contemplated as part of the institution's
recovery and resolution planning activities.
C hap ter 11 Contingency Funding Planning ■ 217
Events that trigger the status of the escalation level should be
analyzed to understand the cause of the trigger event(s) and
the association to capital adequacy; findings should be summa­
rized and communicated, along with specific recommendations.
The movement from one escalation level to another—whether
up or down—should be explicitly considered and approved by
the LCT. While the CFP provides a structured outline for the
expected levels and trend of EWIs and liquidity risk measures,
the importance of management's expert judgment and ability to
put together the mosaic of the different challenges and decide
on a proper course of action should not be understated.
At each escalation level, notification, review and approval
requirements should be defined to ensure appropriate com­
munications and reporting, in alignment and concert with the
defined CFP governance structure, roles and responsibilities. For
example, the Level 1 escalation level, which represents height­
ened management monitoring, may require only notification
and periodic update to senior management, CFO, CRO, etc.;
contingent actions taken at this level may require ALCO and/or
the Treasurer. At the Level 2 or 3 escalation levels, where contin­
gency actions typically involve more severe actions, notification
as well as approvals for certain contingent actions will inevitably
involve senior management and/or the Board.
Additional information on EWIs can be found in Chapter 3—
Early Warning Indicators.
Data and Reporting
When ensuring that the institution's liquidity risk monitoring
and measuring framework adequately supports the objec­
tives of the CFP, one should consider the frequency with which
various measurements utilized to monitor and manage liquid­
ity risk are generated, assessed, and reported. While daily
reporting of the liquidity profile to the treasury function and
the funding desks is prevalent at many institutions, there are
a number of institutions that could benefit from increasing
the frequency of liquidity management reporting, especially
to other areas of the institution (such as senior management
group, ALCO and other risk committees, and the board). This
broader reporting of liquidity management should have the
contextual information and qualitative guidance to support
senior management in its approach to understanding the insti­
tution's liquidity profile.
Reports should convey the methods used to determine liquidity
coverage for upcoming liabilities and funding needs and elabo­
rate on the level of coverage predicted by these measures. In
addition, institutions should ensure that existing reports capture
intraday liquidity positions, track exposure to contingent liabili­
ties, and monitor capacity usage in funding sources.
Consideration should be given to the dissemination of liquidity
risk reports within the institutions, how these reports are used
by management and the board in making decisions, and the
appropriateness of the information contained within the reports,
given their audience.
11.5 ADDITION AL CON SIDERATION S
Different Types of Institutions
As noted earlier, the scope and depth of the CFP will be
dependent on the type of institution. Depository institutions
will primarily focus on their deposit base and potential runoff,
while institutions that rely more on wholesale funding will look
to lines of credit and funding markets. Insurance companies
primarily derive their funding from the liabilities of their poli­
cies and have historically focused on cash flow matching more
than banking institutions. These unique characteristics should
be reflected in the CFP's design, monitoring tools, and menu of
contingent actions.
Institutions must also recognize the risks inherent in their busi­
ness practices. Lending institutions that specialize in revolv­
ers and other open commitment loans should incorporate
the potential liquidity drain from obligors drawing down on
unfunded commitments. Prime brokers and broker dealers can
experience a decline in the funding coverage of their assets as
clients withdraw their accounts from the institution. Counterpar­
ties may also make collateral calls, where they previously did
not, on positions that have moved in their favor or refuse to post
collateral. Institutions that rely on wholesale funding may also
experience higher margin requirements and collateral haircuts
as their creditworthiness comes under question.
Organizational Structure of the CFPs
An effective CFP properly addresses the institution's suite
of businesses, geographies, and legal entities. However, it is
unlikely that a single CFP document can properly cover all
these elements in a clear and concise manner. More practically,
institutions have developed a portfolio of CFPs. This portfolio
of CFPs consists of individual CFPs that address business-
specific segment, products/asset classes, geographic and FX
coverage, and legal entities. In aggregate, the portfolio of CFPs
provides a comprehensive view and coverage of the institution's
business activities.
Depending on the nature and scope of the institution, separate
CFPs may be necessary to address regulatory requirements. For
example, ring-fenced entities that are supervised by a different

218 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
regulator than that of the institution's regulator at the holding
company have separate CFPs. Some industry participants have
taken the opportunity to align CFP coverage to also include
legal entities classifications associated with their recovery and
resolution planning strategies. Other institutions that have large
FX business and coverage may develop a currency CFP that ana­
lyzes the currency exposures across its legal entities.
Liquidity and Capital
The advancement of capital and liquidity practices, guided both
by enhanced expectations from supervisors as well as internally-
driven initiatives, has been notable; however, there is still work
to be done. Historically, capital and liquidity management
practices have been highly siloed; however, most recently, insti­
tutions have started to bring a more integrated approach and
view to these areas. This integrated approach will help bring a
common set of EWIs, a more comprehensive view of the impact
of liquidity specific stress test results, and proposed response
actions on capital positions and vice versa. Further, it should
strengthen the alignment of the integrated liquidity and capital
stress testing and contingency plans to other enterprise-wide
applications, including recovery and resolution plans, capital
management, enterprise risk management, and other related
capabilities of the institution.
CO N CLU SIO N
While institutions have made measureable progress in their
CFPs, there are nevertheless opportunities for improvement.
Regulatory focus will likely remain elevated in the area of liquid­
ity risk management, and expectations will likely only increase.
Consequently, institutions need to demonstrate their CFPs are
well designed, aligned with the institution's target business and
risk profiles, and are actionable. As such, institutions should
review their CFPs to ensure that the key elements that consti­
tute an effective CFP include the following attributes:
• Strong management involvement and participation from the
enterprise
• Alignment to other capital and risk management frameworks
• Evaluation of a wide range of possible scenarios
• Clearly documented management action plan
• Communication plan with coordination to internal and exter­
nal stake-holders
Institutions should be mindful that the CFP is a playbook—and
as such, it requires updating on a regular basis. Strong CFPs
will not only provide a menu of options during a time of crisis,
but also enhance the overall strategic, business, and risk man­
agement capabilities of the institution, ultimately helping to
establish further credibility and confidence from the institution's
external stakeholders.
References
European Central Bank. 2008. "EU Bank's Liquidity Stress Test­
ing and Contingency Funding Plans," European Central Bank
SR 10-6. "Interagency Policy Statement on Funding and Liquid­
ity Risk Management," 2010. OCC, FRB, FDIC, OTS, NCUA
Basel Committee on Banking Supervision, 2008. "Principles
for Sound Liquidity Risk Management and Supervision, Bank
for International Settlement— Basel Committee on Banking
Supervision"
Office of the Comptroller of the Currency. 2012. Comptroller's
Handbook, "Safety and Soundness—Liquidity," June 2012,
Office of the Comptroller of the Currency
R. Bryant. "Contingency Funding Plan: Banking Busywork or
Essential Management Tool?" Federal Reserve Bank of Atlanta
C hap ter 11 Contingency Funding Planning ■ 219
 Learning Objectives
After completing this reading you should be able to:

Differentiate between the various transaction and Explain challenges faced by banks that offer deposit
non-transaction deposit types. accounts, including deposit insurance, disclosures,
overdraft protection, and basic (lifeline) banking.
Compare different methods used to determine the pricing
of deposits and calculate the price of a deposit account
using cost-plus, marginal cost, and conditional pricing
formulas.

Excerpt is Chapter 12 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

221
K E Y TOPICS IN THIS CH APTER
• Types of Deposit Accounts Offered
• The Changing Mix of Deposits and Deposit Costs
• Pricing Deposit Services
• Conditional Deposit Pricing
• Rules for Deposit Insurance Coverage
• Disclosure of Deposit Terms
• Lifeline Banking
12.1 INTRODUCTION
Barney Kilgore, one of the most famous presidents in the history
of Dow Jones & Company and publisher of T h e Wall S tre e t
Jo u rn a l, once cautioned his staff: "Don't write banking stories
for bankers. Write for the bank's customers. There are a hell of
a lot more depositors than bankers." Kilgore was a wise man,
indeed. For every banker in this world there are thousands upon
thousands of depositors. Deposit accounts are the number one
source of funds at most banks.
Deposits are a key element in defining what a banking firm
really does and what critical roles it really plays in the economy.
The ability of management and staff to attract transaction
(checkable) and savings deposits from businesses and consum­
ers is an important measure of a depository institution's accep­
tance by the public. Moreover, deposits provide much of the
raw material for making loans and, thus, may represent the ulti­
mate source of profits and growth for a depository institution.
Important indicators of management's effectiveness are whether
or not funds deposited by the public have been raised at the
lowest possible cost and whether sufficient deposits are avail­
able to fund all those loans and projects management wishes to
pursue. 1
This last point highlights two key issues every depository
institution must deal with in managing the public's deposits:
(1) Where can funds be raised at lowest possible cost? and
(2) How can management ensure that the institution always
has enough deposits to support lending and other services
the public demands? Neither question is easy to answer,
especially in today's competitive marketplace. Both the cost
and amount of deposits that depository institutions sell to
the public are heavily influenced by the pricing schedules
1Portions of this chapter are based on an article by Peter S. Rose in The
Canadian Banker [3] and are used with permission of the publisher.
222 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
and competitive maneuverings of other financial institutions
offering similar services, such as share accounts in money
market mutual funds and credit unions, cash management
accounts offered by brokerage firms and insurance companies,
and interest-bearing investment accounts offered by many
securities firms.
So challenging has it become today to attract significant new
deposits that many financial firms have created a new executive
position— c h ie f d e p o s it o ffice r. Innovation in the form of new
types of deposits, new service delivery methods (increasingly
electronic in design), and new pricing schemes is accelerating
today. Financial-service managers who fail to stay abreast of
changes in their competitors' deposit pricing and marketing
programs stand to lose both customers and profits. In this chap­
ter we explore the types of deposits that depository institutions
sell to the public. We also examine how deposits are priced,
the methods for determining their cost to the offering institu­
tion, and the impact of government regulation on the deposit
function.
12.2 TYPES O F DEPOSITS O F F E R E D
BY D EPO SITO RY INSTITUTIONS
The number and range of deposit services offered by deposi­
tory institutions are impressive indeed and often confusing for
customers. Like a Baskin-Robbins ice cream store, deposit plans
designed to attract customer funds today come in 31 flavors
and more, each plan having features intended to closely match
business and household needs for saving money and making
payments for goods and services.
Transaction (Payments or Demand)
Deposits
One of the oldest services offered by depository institutions
has centered on making p a y m e n ts on behalf of customers. This
transaction, or d em a n d , deposit service requires financial-
service providers to honor immediately any withdrawals made
either in person by the customer or by a third party designated
by the customer to be the recipient of funds withdrawn. Trans­
action deposits include reg u la r n o n in te re st-b e a rin g d e m a n d
d e p o s its that do not earn an explicit interest payment but pro­
vide the customer with payment services, safekeeping of funds,
and recordkeeping for any transactions carried out by check,
card, or via an electronic network, and in te re st-b e a rin g d e m a n d
d e p o s its that provide all of the foregoing services and pay inter­
est to the depositor as well.

Factoid
In 2003 for the first time in the history of the United States
payments made by checks written against transaction
deposit accounts were smaller in number than electronic
payments, due principally to the explosive growth of debit
cards and computer terminals which promise to expand
sharply in the new century.
Noninterest-Bearing Transaction (Demand)
Deposits
Interest payments have been prohibited on regular check­
ing accounts in the United States since passage of the Glass-
Steagall Act of 1933. Congress feared at the time that paying
interest on immediately withdrawable deposits endangered
bank safety—a proposition that researchers have subsequently
found to have little support. However, demand (transaction)
deposits are among the most volatile and least predictable of
a depository institution's sources of funds, with the shortest
potential maturity, because they can be withdrawn without prior
notice. Most noninterest-bearing demand deposits are held by
business firms. In 2009 the U.S. Congress passed the Wall Street
Reform and Consumer Protection Act, allowing banks offering
demand deposits to corporations to pay interest on these
accounts.
Interest-Bearing Transaction Deposits
Many consumers today have moved their funds into other
types of transaction deposits that pay at least some interest
return. Beginning in New England during the 1970s, hybrid
checking-savings deposits began to appear in the form of
negotiable order of withdrawal (NOW) accounts. NOWs are
interest-bearing savings deposits that give the offering deposi­
tory institution the right to insist on prior notice before the cus­
tomer withdraws funds. Because this notice requirement is rarely
exercised, the NOW can be used just like a checking (transac­
tion) account to pay for purchases of goods and services. NOWs
were permitted nationwide beginning in 1981 as a result of pas­
sage of the Depository Institutions Deregulation Act of 1980.
However, they could be held only by individuals and nonprofit
institutions. When NOWs became legal nationwide, the U.S.
Congress also sanctioned the offering of automatic transfers
(ATS), which permit the customer to preauthorize a depository
institution to move funds from a savings account to a transaction
account in order to cover overdrafts. The net effect was to pay
interest on transaction balances roughly equal to the interest
earned on a savings account.
C hap ter 12
Two other important interest-bearing transaction accounts were
created in the United States in 1982 with passage of the Garn-St
Germain Depository Institutions Act. Banks and thrift institutions
could offer deposits competitive with the share accounts offered
by money market funds that carried higher, unregulated interest
rates and are normally backed by a pool of high-quality securi­
ties. The result was the appearance of money market deposit
accounts (MMDAs) and Super NOWs (SNOWs), offering flexible
money market interest rates but accessible via check or preau­
thorized draft to pay for goods and services.
MMDAs are short-maturity deposits that may have a term of
only a few days, weeks, or months, and the offering institution
can pay any interest rate competitive enough to attract and
hold the customer's deposit. Up to six preauthorized drafts per
month are allowed, but only three withdrawals may be made by
writing checks. There is no limit to the personal withdrawals the
customer may make (though service providers reserve the right
to set maximum amounts and frequencies for personal with­
drawals). Unlike NOWs, MMDAs can be held by businesses as
well as individuals.
Super NOWs were authorized at about the same time as
MMDAs, but could be held only by individuals and nonprofit
institutions. The number of checks the depositor may write is
not limited by regulation. However, offering institutions post
lower yields on SNOWs than on MMDAs because the former
can be drafted more frequently by customers. Incidentally, fed­
eral regulatory authorities classify MMDAs today not as trans­
action (payments) deposits, but as savings deposits. They are
included in this section on transaction accounts because they
carry limited check-writing privileges.
Mobile Apps—Impact on Transaction Deposits
and Potential Customers
Finally, the hottest item in the transaction deposit field today
appears to be the mobile check deposit. Designed principally
for customers on the move, carrying camera-equipped smart
phones (such as iPhone or BlackBerry), users take pictures of the
front and back of endorsed checks, upload this information into
their deposit account, regardless of their location, and receive
instant confirmation of the posted deposit. Protection can be
provided by such security measures as two-factor login authen­
tication; recent deposits may be visible where the participating
depository institution allows this visibility, and photo clarity may
be corrected and improved.
This mobile-deposit innovation has centered initially in the
industry's leaders, such as JP Morgan Chase, USAA, and Bank
of America. However, this service will likely soon be offered by
a host of smaller depository institutions, both banks and credit
Managing and Pricing Deposit Services ■ 223
unions, advertising the capability to make deposits from homes,
businesses, shopping centers, and thousands of other, more
convenient locations. K e y q u e stio n s fo r th e fu tu re:
• With mobile-phone digital services who will want to write
checks?
• What will be the use of building or operating branch offices
and automated teller machines (ATMs)?
• With phone delivery what is the compelling reason to actually
visit a depository institution?
• What opportunities for attracting new deposits and new
sources of revenue does mobile-phone banking present to
the industry?
• How many more phone users, compared to deposit holders,
are there as prospective customers around the globe?
Increasingly electronic payment services (such as PayPal) are
capturing the consumer's money in place of banks and other
depository institutions. Banking's share of "swipe fees" at store
registers generally have declined as electronic transactions have
taken over.
Nontransaction (Savings or Thrift)
Deposits
Savings or thrift deposits are designed to attract funds from
customers who wish to set aside money in anticipation of future
expenditures or for financial emergencies. These deposits nor­
mally pay significantly higher interest rates than transaction
deposits do. While their interest cost is higher, thrift deposits
are generally less costly to process and manage on the part of
offering institutions.
Just as depository institutions for decades offered only one
basic transaction deposit—the regular checking account—so it
was with savings plans. Passbook savings deposits were sold
to household customers in small denominations (frequently
a passbook deposit could be opened for as little as $5), and
withdrawal privileges were unlimited. While legally a depository
institution could insist on receiving prior notice of a planned
withdrawal from a passbook savings deposit, few institutions
insisted on this technicality because of the low interest rate
paid on these accounts and because passbook deposits tend
to be stable anyway, with little sensitivity to changes in interest
rates. Individuals, nonprofit organizations, and governments can
hold savings deposits, as can business firms, but in the United
States businesses could not place more than $150,000 in such a
deposit.
Some institutions offer sta te m e n t sa vin g s d e p o s its , evidenced
only by computer entry. The customer can get monthly printouts
224 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
or electronic statements, showing deposits, withdrawals, interest
earned, and the balance in the account. Many depository institu­
tions, however, still offer the more traditional passbook savings
deposit, where the customer is given a booklet or electronic
message, showing the account's balance, interest earnings,
deposits, and withdrawals, as well as the many rules that bind
depository institution and depositor.
For many years, wealthier individuals and businesses have been
offered time deposits, which carry fixed maturity dates (often
covering 30, 60, 90,180 or 360 days and 1 through 5 years or
more) with fixed and sometimes fluctuating interest rates. More
recently, time deposits have been issued with interest rates
adjusted periodically (such as every 90 days, known as a le g or
roll p e rio d ). Time deposits must carry a minimum maturity of
seven days and normally cannot be withdrawn before that.
Time deposits come in a wide variety of types and terms. How­
ever, the most popular of all time deposits are C D s— ce rtifica te s
o f d e p o s it. C D s may be issued in n e g o tia b le form—the
$ 1 0 0 , 0 0 0 -plus instruments purchased principally by corpora­
tions and wealthy individuals that may be bought and sold any
number of times prior to reaching their maturity—or in nonne-
g o tia b le form—smaller denomination accounts that cannot be
traded prior to maturity and are usually acquired by individuals.
Innovation has entered the CD marketplace recently with the
development of b u m p -u p C D s (allowing a depositor to switch to
a higher interest rate if market interest rates rise); ste p -u p C D s
(permitting periodic upward adjustments in promised interest
rates); liq u id C D s (allowing the depositor to withdraw some of
his or her funds without a withdrawal penalty); and in d e x C D s
(linking returns on these certificates to stock market perfor­
mance, such as returns on the Standard and Poor's 500 stock
index).
Retirement Savings Deposits
In 1981, with passage of the Economic Recovery Tax Act,
the U.S. Congress opened the door to yet another deposit
instrument— re tire m e n t sa vin g s a cco u n ts. Wage earners and
salaried individuals were granted the right to make limited con­
tributions each year, tax free, to an individual re tire m e n t a cco u n t
(IRA), offered by depository institutions, brokerage firms, insur­
ance companies, and mutual funds, or by employers with quali­
fied pension or profit-sharing plans. There was ample precedent
for the creation of IRAs; in 1962, Congress had authorized finan­
cial institutions to sell K e o g h plan retirement accounts, available
to self-employed persons.
In 1997 the Congress, in an effort to encourage more saving for
retirement, purchases of new homes, and childrens' education,
modified the rules for IRA accounts, allowing individuals with
higher incomes to make annual tax-deductible contributions to
their retirement accounts and families to set up new education
savings accounts that could grow tax-free until needed to cover
college tuition and other qualified educational expenses. At
the same time the Tax Relief Act of 1997 created the Roth IRA,
which allows individuals to make non-tax-deductible contribu­
tions to a savings fund that can grow tax free but pay no tax on
their investment earnings when withdrawn.
Concern by Congress over the fact that few workers still
appeared to be saving for retirement led to passage of the Pen­
sion Protection Act of 2006. This law makes it easier for employ­
ers to automatically enroll their employees in retirement plans
through payroll deductions. In some cases workplace retirement
plans periodically reallocate a worker's payroll savings into dif­
ferent retirement assets as circumstances change, even if the
worker herself doesn't do so (known as a "default option").
These employer-engineered decisions regarding employees'
retirement accounts are subject to the proviso that the manager
running the retirement plan act not recklessly but as a "prudent
person" would.
Today depository institutions in the United States hold about a
quarter of all IRA and Keogh retirement accounts outstanding,
ranking second only to mutual funds. The great appeal for the
managers of depository institutions is the high degree of stabil­
ity of IRA and Keogh deposits—financial managers can generally
rely on having these funds around for several years. Moreover,
many IRAs and Keoghs carry fixed interest rates—an advantage
if market interest rates are rising—allowing depository institu­
tions to earn higher returns on their loans and investments that
more than cover the interest costs associated with IRAs and
Keoghs. (These retirement accounts were made more attractive
to the public recently when the U.S. Congress voted to increase
FDIC insurance coverage to $250,000 for qualified deposits.)
Overall, however, Keogh and IRA retirement accounts repre­
sented less than 5 percent of the total deposits of U.S. FDIC-
insured banks.
12.3 INTEREST RATES O F F E R E D ON
D IFFER EN T TYPES O F DEPOSITS
Each of the different types of deposits we have discussed typi­
cally carries a different rate of interest. In general, the longer the
maturity of a deposit, the greater the yield that must be offered
to depositors because of the time value of money and the
frequent upward slope of the yield curve. For example, NOW
accounts and savings deposits are subject to immediate with­
drawal by the customer; accordingly, their offer rate to custom­
ers is among the lowest of all deposits. In contrast, negotiable
C hap ter 12
CDs and deposits of a year or longer to maturity often carry the
highest interest rates that depositories offer.
The size and perceived risk exposure of offering institutions
also play an important role in shaping deposit interest rates. For
example, banks in New York and London, due to their greater
size and strength, typically are able to offer deposits at the low­
est average interest rates, while deposit rates posted by other
institutions are generally scaled upward from that level. Other
key factors are the marketing philosophy and goals of the offer­
ing institution. Depository institutions that choose to compete
for deposits aggressively will post higher offer rates to bid
deposits away from their competitors.
Factoid
Virtual (Web-centered) banks generally offer higher deposit
interest rates than do traditional brick-and-mortar banks. Why?
Answer: This is probably due to the somewhat greater
perceived risk of the Web-based banks and their frequent
lack of a complete menu of services.
Filmtoid
What Christmastime ritual finds James Stewart playing the
manager of a small-town thrift with funding problems so
severe that core depositors are lined up to withdraw all their
money?
Answer: It's a Wonderful Life.
The Composition of Deposits
The largest of all depository institutions are commercial banks,
whose $9.3 trillion in deposits in 2010 exceeded the deposits
held by all nonbank depository institutions (including thrifts and
credit unions) by a ratio of more than four to one. By examining
recent trends in bank deposits we can get a pretty good idea of
recent changes in the mix of deposits at all types of depository
institutions in recent years.
In recent years, banks have been most able to sell time and
savings deposits—interest-bearing thrift accounts—to the
public. As Table 12.1 shows, time and savings deposits repre­
sented more than four-fifths of the total deposits held by all
U.S.-insured commercial banks by 2010. Not surprisingly, then,
interest-bearing deposits and nontransaction deposits, both
of which include time and savings deposits, have captured
the majority share of all deposit accounts. In contrast, regular
demand deposits, which generally pay little or no interest and
Managing and Pricing Deposit Services ■ 225
Table 12.1 The Changing Com position of Deposits in the United States

Percentages for All U.S. FDIC-lnsured Banks

Deposit Type or Category 1983 1987 1993 1998 2001 2007 2010*

Noninterest-bearing deposits 37.9% 20.5% 2 0 .8 % 19.5% 19.9% 16.4% 18.2%

Interest-bearing deposits 62.1 79.5 79.2 80.5 80.1 83.6 81.8
Total deposits 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 %

Transaction deposits 31.9% 32.3% 33.4% 24.3% 2 1 .2 % 12.5% 12.3

Nontransaction deposits 6 8 .1 67.7 6 6 .6 75.7 78.8 87.5 87.7
Total domestic office deposits . %
1 0 0 0 1 0 0 .0 % 1 0 0 0. % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 %

Demand deposits 25.4% 22.9% 2 0 .2 % 18.9% 19.0% 8 .8 % 8.7

Savings deposits** 30.2 36.2 41.2 43.5 48.0 55.1 64.3
Time deposits 44.4 40.9 38.6 37.6 33.0 36.1 27.0
Total domestic office deposits 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 % 1 0 0 .0 %

*Figures based on data for September 30, 2010.

**The savings deposit figures include money market deposit accounts (MMDAs).
Source: Federal Deposit Insurance Corporation.

make up the majority of transaction and noninterest-bearing more stable, less-expensive deposit base. In 2010, according to
deposits, have declined significantly to less than 1 0 percent of the FDIC, core deposits (principally small savings and checkable
total deposits inside the United States. accounts) represented 80 percent of total deposits at the small­
est (under $100 million in assets) U.S. banks compared to about
Indeed, as Gerdes et al. [1 ] observed, the volume of checks
70 percent at the largest ($1 billion in assets plus) U.S. banking
paid in the United States fell from close to 50 billion in 1995
firms. However, the combination of inflation, government dereg­
to only about 40 billion most recently due mainly to the rise of
ulation, stiff competition, and better-educated customers has
electronic payments media, including credit and debit cards,
resulted in a dramatic shift in the mix of deposits that depository
Web-based payments systems, and electronic wire transfers.
institutions are able to sell, including a decline in core accounts.
However, most authorities argue that checks written against
demand (transaction) deposits will continue to be important in Operating costs for institutions offering deposit services have
the American payments system, though in parts of Europe (par­ soared in recent years. For example, interest payments on
ticularly in Finland, Germany, and the Netherlands) electronic deposits (both foreign and domestic) for all insured U.S. com­
payments are rapidly moving upward. mercial banks amounted to about $10 billion in 1970, but had
jumped to more than $200 billion in 2010. At the same time
Bankers, if left to decide for themselves about the best mix of
new, higher-yielding deposits proved to be more interest sensi­
deposits, would generally prefer a high proportion of transac­
tive than older, less-expensive deposits, thus putting pressure
tion deposits (including regular checking or demand accounts)
on management to pay competitive interest rates on their
and low-yielding time and savings deposits. These accounts
deposits. Depository institutions that didn't keep up with market
are among the least expensive of all sources of funds and often
interest rates had to be prepared for extra liquidity demands—
include a substantial percentage of core deposits—a stable
substantial deposit withdrawals and fluctuating deposit levels.
base of deposited funds that is not highly sensitive to market
Faced with substantial interest cost pressures, many financial
interest rates (i.e., bears a low interest-rate elasticity) and
managers have pushed hard to reduce their institution's nonin­
tends to remain with a depository institution. While many core
terest expenses (e.g., by automating their operations and reduc­
deposits (such as small savings accounts) can be withdrawn
ing the number of employees on the payroll).
immediately, they have an effective maturity often spanning
years. Thus, the availability of a large block of core deposits
increases the duration of a depository institution's liabilities
The Ownership of Deposits
and makes that institution less vulnerable to swings in interest
rates. The presence of substantial amounts of core deposits in The dominant holder of bank deposits inside the United States
smaller banks helps explain why large banks in recent years have is the private sector—individuals, partnerships, and corpora­
acquired so many smaller banking firms—to gain access to a tions (IPC)—accounting for three-quarters of all U.S. deposits.

226 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The next largest deposit owner is state and local governments
(about 4 percent of the total), representing the funds accumu­
lated by counties, cities, and other local units of government.
These deposits are often highly volatile, rising sharply when tax
collections roll in or bonds are sold, and falling precipitously
when local government payrolls must be met or construction
begins on a new public building. Many depository institutions
accept state and local deposits as a service to their commu­
nities even though these deposits frequently are not highly
profitable.
Factoid
The more rapid the turnover of population in a given market
area, the more intensive tends to be competition among
depository institutions in the sale of deposit services and the
more favorable loan and deposit interest rates tend to be,
unless the relocation of depositors doesn't require a change
of depository institution.
Banks also hold comparatively small amounts of U.S. govern­
ment deposits. In fact, the U.S. Treasury keeps most of its oper­
ating funds in domestic banking institutions in Treasury tax an d
loan (TT& L) a cco u n ts. When taxes are collected from the public
E-BANKING AND E-COMMERCE
CH ECK CLEARING FOR THE 21ST CENTURY
ACT (CHECK 21)
Paper checks are being processed much faster these days
and more businesses and consumers are going electronic. In
past years depositors used to count on "float" time between
the moment they wrote a check and the time funds were
actually removed from their checking account. With float
the check writer could often beat the check back to his bank
and deposit more money just in time. Today, however, funds
often get moved out of one account into another the same
day. Increasingly financial firms are capturing the float that
used to benefit depositors.
At the heart of the newly emerging check system is a process
known as e le c tro n ic c h e ck co n v e rsio n , which takes informa­
tion from the check you have written and electronically deb­
its your account, often on the spot. Your check is not sent
through the normal clearing process used in the past. Indeed,
some merchants will stamp "void" on your check and give it
right back to you once they have electronically transferred
the data it contains. Moreover, more depository institutions
are neither returning checks to their deposit customers nor
sending original checks to other depository institutions.
C hap ter 12
or Treasury securities are sold to investors, the government
usually directs these funds into TT&L deposits first, in order to
minimize the impact of government operations on the financial
system. The Treasury then makes periodic withdrawals (directing
the money into its accounts at the Federal Reserve banks) when
it needs to make expenditures. Today the Treasury pays fees to
depository institutions to help lower the cost of handling gov­
ernment deposits and receives interest on many of the balances
held with depository institutions.
Another deposit category of substantial size is deposits held by
foreign governments, businesses, and individuals, many of which
are received in offshore offices. Foreign-owned deposits rose
rapidly during the 1960s and 1970s, climbing to nearly one-fifth
of total U.S. bank deposits in 1980, reflecting the rapid growth
in world trade and investments by U.S. businesses abroad.
However, foreign-owned deposits then declined as a propor­
tion of U.S. bank funds as domestic interest rates proved to be
significantly cheaper. Moreover, international crises, the tragedy
of 9/11, and recent economic fluctuations encouraged American
banks to scale down their overseas expansion plans. However,
as the 2 1 st century unfolded, foreign deposits began to grow
again due to the availability of higher-yielding foreign invest­
ments, the continued expansion of several foreign economies
(especially in Asia), and a deep business recession in Europe and
the United States.
In 2004, the Check 21 Act became law, permitting depository
institutions to electronically transfer c h e c k im a g es instead
of checks themselves, replacing originals with su b stitu te
ch e ck s. These are photographed copies of the front and
back of the original check that can be processed as though
they were originals. The front will say: "This is a legal copy of
your check. You can use it in the same way you would use the
original check." Thus, substitute checks provide proof that
you paid a bill just as would be the case if you had the origi­
nal check.
Check 21 carries a number of benefits for both depositors
and depository institutions. It protects depositors against
loss from substitute checks. The depositor can contact his
or her deposit institution to request a refund when the use
of substitute checks has led to an error that cost the deposi­
tor money. Check 21 also benefits depository institutions
by sharply reducing the cost of check clearing, especially in
doing away with the necessity of shipping bundles of checks
around the country. However, from the customer's point of
view more bounced checks and overdraft charges are likely.
(For further information about Check 21 and the rights and
obligations of depositors and institutions, see, especially,
www.federalreserve.gov/check2 1 .)
Managing and Pricing Deposit Services ■ 227
The final major deposit ownership category is deposits of other
banks, which include c o rre s p o n d e n t d e p o s its , representing
funds that depository institutions hold with each other to pay for
correspondent services. For example, large metropolitan banks
provide data processing and computerized recordkeeping,
investment counseling, participations in loans, and the clearing
and collection of checks and other drafts for smaller urban and
outlying depository institutions. An institution that holds depos­
its received from other depositories will record them as a liability
on its balance sheet under the label d e p o s its d u e to b a n ks a n d
o th e r d e p o s ito ry in stitu tion s. The institution that owns such
deposits will record them as assets under the label d e p o s its d u e
from b a n ks a n d o th e r d e p o s ito ry in stitu tion s.
The Cost of Different Deposit Accounts
Other factors held constant, the managers of depository insti­
tutions would prefer to raise funds by selling those types of
deposits that cost the least amount of money or, when revenues
generated by the use of deposited funds are considered, gen­
erate the greatest net revenue after expenses. If a depository
institution can raise all of its funds from sales of the cheapest
deposits and then turn around and purchase the highest-
yielding assets, it will maximize its spread and, possibly, its net
REAL BANKS, REAL DECISIONS
WHO OFFERS THE HIGHEST DEPOSIT
INTEREST RATES, AND WHY?
Customers interested in purchasing the highest-yielding
interest-bearing deposits and the managers of depository
institutions interested in discovering what deposit interest
yields their competitors are offering can consult newspapers
or go online to key websites—for example, www.banx.com
or www.Bankrate.com.
Among the key types of deposit rate information available
are these:
• The average yields (APY) offered on CDs purchased
through security brokers who search the marketplace
every day for the highest yields available on large deposits
(usually close to $ 1 0 0 , 0 0 0 in size).
• A list of those depository institutions offering the highest
yields (APYs) on retail deposits (typically $500 to $25,000
minimum denomination) and jumbo CDs (usually carrying
an opening balance of about $ 1 0 0 , 0 0 0 or even larger).
Among the depository institutions offering the highest
deposit yields are usually leading credit card and household
lenders, such as Discover Bank, Ally Bank (formerly GMAC
Bank), and E* Trade Bank.
228 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
income. But what are the cheapest deposits? And which depos­
its generate the highest net revenues?
Research based upon cost-accounting techniques suggests that
c h e ck a b le (demand or transaction) d e p o s its —including regular
checking accounts, special checkbook deposits (which often
pay no interest), and interest-bearing checking accounts—are
typically among the lowest-cost deposits that depositories
sell. While check processing and account maintenance are
major expense items, the absence of interest payments on
many demand (transaction) deposit accounts help keep their
cost down relative to other sources of funds. Moreover, check­
processing costs should move substantially lower in the period
ahead as c h e ck im aging becomes more widely used. Paper
checks are rapidly being supplanted by electronic images, per­
mitting greater storage capacity and faster retrieval, cutting
costs and improving service.
Especially popular in the new century have been a u to m a tic bill­
p a yin g se rv ic e s, including online bill payment services offered
by depository institutions and direct electronic debits that
you authorize out of your bank account and are carried out by
a credit card company or other merchant to whom you owe
money. Increasingly it is becoming possible to pay almost every
bill without cutting a check or visiting a list of websites. Funds
Why are the foregoing institutions generally among the
leaders in offering deposit interest rates? One reason is they
expect to earn relatively high returns on their consumer and
credit card loans, giving them an ample margin over deposit
costs.
In the case of Internet-based banking institutions these
unique electronic firms must attract the public away from
more traditional institutions and often provide few services,
so they must offer exceptional deposit rates to attract the
funds they need. Moreover, virtual banks typically have
relatively low fixed (overhead) costs, allowing these firms to
bid higher for the public's deposits.
On the negative side, however, many virtual banks have not
been as successful in attracting customers as have traditional
depository institutions in recent years. Indeed, the most
successful firms at attracting customer deposits recently have
been m ultichannel d e p o s ito ry in stitu tio n s —offering both
traditional and online services through the same institution—
indicating that many customers are more likely to use online
services of financial firms that also are accessible in person
through traditional branch offices and automated teller
machines.
are simply automatically "yanked out" of your account on the
same day each month.
In fact, so significant has been the recent decline in paper check
volume that the Federal Reserve System announced recently
that it was reducing the number of check processing regions in
the United States. This trend has gotten a favorable reception
from financial institutions hoping to reduce operating costs.
However, check writing has generated substantial fee income for
most offering institutions—a key source of revenue that will have
to be replaced with new revenue sources as the global financial
system goes more and more electronic.
Thrift deposits—particularly money market accounts, time
deposits, and savings accounts—generally rank second to
demand deposits as the least costly deposits. Savings depos­
its are relatively cheap because of the low interest rate they
tend to carry—one of the lowest annual interest yields (APY)
offered—and, in many cases, the absence of monthly statements
for depositors. However, many passbook savings accounts
have substantial deposit and withdrawal activity as some savers
attempt to use them as checking (transaction) accounts.
While demand (checking or transaction) deposits have about
the same gross expenses per dollar of deposit as time (thrift)
deposits do, the higher service fees levied against transaction
account customers help to lower the net cost of checkable
deposits (after service revenues are netted out) below the net
cost of most time (thrift) accounts. This factor plus new govern­
ment regulations help explain why depository institutions today
are more aggressively pricing their checkable deposits, asking
depositors to pay a bigger share of the activity costs they cre­
ate when they write checks and transfer funds electronically.
When we give each type of deposit credit for the earnings it
generates through the making of loans and investments, check­
able (demand) deposits appear to be substantially more profit­
able than time deposits for the average depository institution.
Moreover, interest expense per dollar of time deposits averages
about triple the interest expense associated with each dollar of
demand (transaction) deposits.
Business transaction accounts, generally speaking, are consid­
erably more profitable than personal checking accounts. One
reason is the lower interest expense generally associated with
commercial deposits. Moreover, the average size of a personal
transaction account normally is less than one-third the average
size of a commercial account, so a depository institution receives
substantially more investable funds from commercial demand
deposits. However, competition posed by foreign financial-
service firms for commercial transaction accounts has become
so intense that profit margins on these accounts often are razor
thin in today's market.
C hap ter 12
While the managers of depository institutions would prefer to
sell only the cheapest deposits to the public, it is predominantly
public preference that determines which types of deposits will
be created. Depository institutions that do not wish to conform
to customer preferences will simply be outbid for deposits by
those who do. At the same time, recent deregulation of the
financial markets has made it possible for more kinds of financial
service firms to respond to the public's deposit preferences.
C O N C EP T C H E C K
12.1. What are the major types of deposit plans that
depository institutions offer today?
12.2. What are core deposits, and why are they so impor­
tant today?
12.3. How has the composition of deposits changed in
recent years?
12.4. What are the consequences for the management
and performance of depository institutions resulting
from recent changes in deposit composition?
12.5. Which deposits are the least costly for depository
institutions? The most costly?
12.4 PRICING DEPOSIT-RELATED
SERV ICES
We have examined the different types of deposit plans offered
today and how the composition of deposits has been chang­
ing over time. An equally important issue remains: How should
depository institutions price their deposit services in order to
attract new funds and make a profit?
In pricing deposit services, management is caught on the horns
of an old dilemma. It needs to pay a high enough interest return
to attract and hold customer funds, but must avoid paying an
interest rate so costly it erodes any potential profit margin. In
fact, in a financial marketplace that approaches perfect competi­
tion, the individual depository institution has little control over
its prices. It is the marketplace, not the individual financial firm,
that ultimately sets prices. Financial institutions, like most other
businesses, are price takers, not price makers. In such a mar­
ketplace, management must decide if it wishes to attract more
deposits and hold all those it currently has by offering deposi­
tors at least the market-determined price, or whether it is willing
to lose funds.
Managing and Pricing Deposit Services ■ 229

Factoid
Several deposit-related fees charged by depository institu­
tions have increased faster than inflation in recent years.
These more rapidly rising bank fees include charges for
checks returned for insufficient funds, stop-payment orders,
ATM-usage fees, and overdraft fees.
12.5 PRICING DEPOSITS AT CO ST
PLUS PROFIT MARGIN
The idea of charging the customer for the full cost of
deposit-related services is relatively new. In fact, until a
few decades ago the notion that customers should receive
most deposit-related services fre e o f c h a rg e was hailed as a
wise innovation—one that responded to the growing chal­
lenge posed by other financial intermediaries that were
invading traditional deposit markets. Many managers soon
found reason to question the wisdom of this marketing
strategy, however, because they were flooded with numer­
ous low-balance, high-activity accounts that ballooned their
operating costs.
The development of interest-bearing checkable deposits (par­
ticularly NOWs) offered financial managers the opportunity to
reconsider the pricing of deposit services. Unfortunately, many
of the early entrants into this new market moved aggressively to
capture a major share of the customers through b e lo w - c o s t p ric ­
ing. Customer charges were set below operating and overhead
costs associated with providing deposit services. The result was
a substantially increased rate of return to the customer, known
as the im p licit in te re st rate —the difference between the true
cost of supplying fund-raising services and the service fees actu­
ally assessed the customer.
In the United States, variations in the implicit interest rate
paid to the customer were the principal way most banks
competed for deposits over the 50 years stretching from
the Great Depression to the beginning of the 1980s. This
was due to the presence of regulatory ceilings on deposit
interest rates, beginning in 1933 with passage of the Glass-
Steagall Act. These legal interest rate ceilings (Regulation
Q) were designed to protect depository institutions from
"excessive" interest rate competition for deposits, which
could allegedly cause them to fail. Prevented from offering
higher explicit interest rates, U.S. depositories competed
instead by offering free bank-by-mail services, gifts ranging
from teddy bears to toasters, and convenient neighborhood
branch offices.
230 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Unfortunately, such forms of n o n p ric e c o m p e titio n tended
to distort the allocation of scarce resources in the financial
sector. Congress finally responded to these problems with
passage of the Depository Institutions Deregulation Act of
1980, a federal law that called for a gradual phaseout of fed­
eral limits on the interest rates depositories could offer their
customers. Today, the responsibility for setting deposit prices
has been transferred largely from public regulators to private
decision makers—that is, to depository institutions and their
customers.
Factoid
Which type of depository institution—small banks versus
large banks, interstate banks versus single-state banks—tend
to charge the highest fees for deposit-related services? As
noted by Hannan [9], larger banks and interstate banks tend
to levy higher deposit-related fees, especially; low-balance,
insufficient funds, and stop-payment fees.
Deregulation has brought more frequent use of u n b u n d le d
se rv ic e p ricin g as greater competition has raised the average
real cost of a deposit for deposit-service providers. This means
that deposits are usually priced separately from other services.
And each deposit service may be priced high enough to recover
all or most of the cost of providing that service, using the follow­
ing cost-plus pricing formula:
Estimated
Unit price overhead Planned
charged the Operating expense profit
customer = expense + allocated to + margin (1 2 . 1 )
for each per unit the deposit- from each
deposit of deposit service service
service service function unit sold
Tying deposit pricing to the cost of deposit-service pro­
duction, as Equation (12.1) does, has encouraged deposit
providers to match prices and costs more closely and
eliminate many formerly free services. In the United States,
for example, more depositories are now levying fees for
excessive withdrawals, customer balance inquiries, bounced
checks, stop-payment orders, and ATM usages, as well as
raising required minimum deposit balances. The results
of these trends have generally been favorable to depository
institutions, with increases in service fee income generally
outstripping losses from angry customers closing their
accounts.
12.6 NEW DEPOSIT IN SURAN CE
RULES-INSIGHTS AND ISSUES
Summary of Deposit Insurance Coverage
Provided by the FDIC
A major reason depository institutions are able to sell deposits
at relatively low rates of interest compared to interest rates
offered on other financial instruments is because of government-
supplied deposit insurance. The Federal Deposit Insurance
Corporation (FDIC) was established in 1934 to insure depos­
its and protect the U.S. money supply in those cases where
depository institutions having FDIC membership failed. Insured
depository institutions must display an official sign at each teller
station, indicating they hold an FDIC membership certificate.
FDIC insurance covers only those deposits made in the United
States, though the depositor does not have to be a U.S. resident
to receive FDIC protection. All types of deposits normally are
covered up to at least $250,000 for each single account holder.
As the table below illustrates FDIC insurance coverage has
increased substantially in recent years in an effort to promote
public confidence in the banking system and deal with inflation,
among other factors.
FD IC Insurance Coverage Lim its:
Standard
Standard Coverage
Year Coverage Limit Year Limit
1934 $2,500 1968-73 $2 0 , 0 0 0
1934-49 5,000 1974-79 40,000
1950-65 1 0 ,0 0 0 1980-2007 1 0 0 ,0 0 0
1966-68 15,000 2008 250,000
Note: *Coverage of up to $250,000 was temporary in 2008 and 2009
and made permanent in 2010 with passage of the Dodd-Frank Wall
Street Reform and Consumer Protection Act.
Savings deposits, checking accounts, NOW accounts,
Christmas Club accounts, time deposits, cashiers' checks,
money orders, officers' checks, and any outstanding drafts
normally are protected by federal insurance. Certified checks,
letters of credit, and traveler's checks for which an insured
depository institution is primarily liable also are insured if these
are issued in exchange for money or in return for a charge
against a deposit. On the other hand, U.S. government secu­
rities, shares in mutual funds, safe deposit boxes, and funds
stolen from an insured depository institution are not covered by
FDIC insurance. Depository institutions generally carry private
insurance for these items.
C hap ter 12
Deposits placed in separate financial institutions are insured
separately, each eligible for full coverage. However, deposits
held in more than one branch office of the same depository
institution are added together to determine the total amount
of insurance protection available. If two formerly independent
institutions merge, for example, and a depositor holds $250,000
in each of these two merging institutions, the total protection
afforded this depositor would then be a maximum of $250,000,
not $500,000, as it would have been before the merger. How­
ever, the FDIC normally allows a grace period so that, for a short
time, a depositor with large deposits in two institutions that
merge can receive expanded coverage up to at least $500,000
until arrangements can be made to transfer some of the deposi­
tor's funds to other institutions.
Insurance coverage may also be increased at a single institution
by placing funds under different categories of legal ownership.
For example, a depositor with $250,000 in a savings deposit
and another $250,000 in a time deposit might achieve greater
insurance coverage by making one of these two accounts a
joint ownership account with his or her spouse. Also, if a family
is composed of husband and wife plus one child, for example,
each family member could own an account and each pair of
family members could also hold joint accounts, resulting in insur­
ance coverage up to $1,500,000 in total. Only natural persons,
not corporations or partnerships, can set up insurance-eligible
joint accounts.
Each co-owner of a joint account is assumed to have equal right
of withdrawal and is also assumed to own an equal share of a
joint account unless otherwise stated in the account record. No
one person's total insured interest in all joint accounts at the same
insured depository institution can exceed $250,000. For example,
suppose Mr. Jones has a joint account with Mrs. Jones amount­
ing to $700,000. Then each is presumed to have a $350,000
share and each would have maximum FDIC insurance coverage
of $250,000 unless the deposit record shows that, for example,
Mrs. Jones owns $500,000 of the $700,000 deposit and Mr. Jones
would be covered, therefore, for a maximum of only $2 0 0 , 0 0 0 .
IRA and Keogh retirement deposits also became fully insured
up to $250,000 with the passage of recent legislation. Deposits
belonging to pension and profit-sharing plans receive "pass­
through insurance" provided the individual participants' ben­
eficial interests are ascertainable and the depository institution
involved is at least "adequately capitalized."
Funds deposited by a corporation, partnership, or unincorporated
business or association are insured up to the maximum allowed by
law and are insured separately from the personal accounts of the
company's stockholders, partners, or members. Funds deposited
by a sole proprietor are considered to be personal funds, however,
Managing and Pricing Deposit Services ■ 231
and are added to any other single-owner accounts the individual
business owner has and are protected at least up to $250,000.
The amount of insurance premiums each FDIC-insured deposi­
tory institution must pay is determined by the volume of deposits
it receives from the public and by the insurance rate category in
which each institution falls. Under the current risk-based deposit
insurance system more risky depository institutions must pay higher
insurance premiums. The degree of risk exposure is determined by
the interplay of two factors: (1 ) the adequacy of capital maintained
by each depository institution and (2 ) the risk class in which the
institution is judged to be according to its regulatory supervisors.
Well-capitalized, A-rated depositories pay the lowest deposit insur­
ance fee per each $ 1 0 0 of deposit they hold, while undercapital­
ized, C-rated institutions pay the greatest insurance fees.
Twice each year the board of directors of the FDIC must decide
what insurance rates to assess insured institutions. If the federal
insurance fund falls below $1.25 in reserves per $100 in covered
deposits (known as the Designated Reserve Ratio [DRR]), the
FDIC will raise its insurance fees. When the amount of reserves
exceeds the $1.25 per $100 standard, insurance fees may be
lowered or eliminated.
The boards of the FDIC and the National Credit Union Administra­
tion are authorized to increase the insurance limit every five years in
order to protect against inflation, provided this seems warranted.
Moreover, the 1.25 percent required DRR mentioned above—
sometimes referred to as the "hard" target—may be altered at the
FDIC's discretion to form a "soft" target—that is, the FDIC has the
authority to allow the DRR to range between 1.15 and 1.50 percent
of all insured deposits. Thus, the FDIC now has more flexibility in
deciding when it needs to change insurance fees and the amount
of depositor insurance protection that it provides.
S o u rc e : Federal Deposit Insurance Corporation.
12.7 USING M ARGINAL CO ST TO SET
INTEREST RATES ON DEPOSITS
Many financial analysts argue that, whenever possible, m arginal
c o s t —the added cost of bringing in new funds—and not h isto ri­
cal a v e ra g e co st, which looks at the past, should be used to help
price funds sources for a financial-service institution. The reason
is that frequent changes in interest rates will make historical
average cost a treacherous standard for pricing. For example,
if interest rates are declining, the added (marginal) cost of rais­
ing new money may fall well below the historical average cost
over all funds raised. Some loans and investments that looked
unprofitable when compared to historical cost will now look
profitable when measured against the lower marginal interest
232 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
cost we must pay today. Conversely, if interest rates are on the
rise, the marginal cost of today's new money may substantially
exceed the historical cost of funds. If management books new
assets based on historical cost, they may turn out to be unprofit­
able when measured against the higher marginal cost of raising
new funds in today's market.
Economist James E. McNulty [8 ] has suggested a way to use the
marginal, or new money, cost idea to help a depository institu­
tion set the interest rates it will offer on new deposit accounts.
To understand this marginal cost pricing method, suppose a
bank expects to raise $25 million in new deposits by offering its
depositors an interest rate of 7 percent. Management estimates
that if the bank offers a 7.50 percent interest rate, it can raise
$50 million in new deposit money. At 8 percent, $75 million is
expected to flow in, while a posted deposit rate of 8.5 percent
will bring in a projected $100 million. Finally, if the bank prom­
ises an estimated 9 percent yield, management projects that
$125 million in new funds will result from both new and existing
deposits that customers will keep in the bank to take advantage
of the higher rates offered. Let's assume as well that manage­
ment believes it can invest the new deposit money at a yield of
10 percent. This investment yield represents m arginal re ve n u e,
the added operating revenue the bank will generate by making
new investments from new deposits. Given these facts, what
deposit interest rate should the bank offer its customers?
As Table 12.2 shows, we need to know at least two crucial items
to answer this question: the m arginal c o s t of moving the deposit
rate from one level to another and the m arginal c o s t rate,
expressed as a percentage of the volume of additional funds
coming into the bank. Once we know the marginal cost rate,
we can compare it to the expected additional revenue (mar­
ginal revenue) the bank expects to earn from investing its new
deposits. The items we need are:
Marginal cost = Change in total cost = New interest rate
X Total funds raised at new rate - Old interest rate (12.2)
X Total funds raised at old rate
and
Change in total cost
Marginal cost rate (12.3)
Additional funds raised
For example, if the bank raises its offer rate on new deposits
from 7 percent to 7.5 percent, Table 12.2 shows the marginal
cost of this change: Change in total cost = $50 million
X 7.5 percent - $25 million X 7 percent = $3.75 million
— $1.75 million = $2.00 million. The marginal cost rate, then, is
the change in total cost divided by the additional funds raised, or
$ 2 million
— 8 present
$25 million
Table 12.2 Using Marginal Cost to Choose the Interest Rate to O ffer Custom ers on Deposits

Example of a Bank Attempting to Raise New Deposit Funds

Marginal Cost Expected Difference

Expected Average Total Marginal as a Percentage Marginal between
Amounts Interest Interest Cost of of New Funds Revenue Marginal
of New the Bank Cost of New Attracted (return) from Revenue and Total Profits
Deposits That Will Pay on New Funds Deposit (marginal cost Investing the Marginal Cost Earned (after
Will Flow In New Funds Raised Money rate) New Funds Rate interest cost)

$25 7.0% $1.75 $1.75 7.0% . %

1 0 0 +3% $0.75

50 7.5 3.75 2 .0 0 8 .0 1 0 .0 +2 % 1.25

75 8 .0 6 .0 0 2.25 9.0 1 0 .0 +1 % 1.50
1 0 0 8.5 8.50 2.50 1 0 .0 1 0 .0 + 0 1.50
125 9.0 11.25 2.75 1 1 .0 1 0 .0 - 1% 1.25
Note: Figures in millions except percentages.

a deposit rate of 9 percent, the marginal cost rate balloons

Factoid
By 2010 total estimated FDIC-insured deposits reached a
record $6.2 trillion compared to only $4.3 trillion three years
before."
Notice that the marginal cost rate at 8 percent is substantially
above the average deposit cost of 7.5 percent. This happens
because the bank must not only pay a rate of 7.5 percent to
attract the second $25 million, but it must also pay out the same
7.5 percent rate to those depositors who were willing to contrib­
ute the first $25 million at only 7 percent.
Because the bank expects to earn 10 percent on these new funds,
marginal revenue exceeds marginal cost by 2 percent at a deposit
interest cost of 8 percent. Clearly, the new deposits will add more
to revenue than they will to cost. The bank is justified (assuming
its projections are right) in offering a deposit rate at least as high
as 7.5 percent. Its total profit will equal the difference between
total revenue ($50 million X 10 percent = $5 million) and total
cost ($50 million X 7.5 percent — $3.75 million), for a profit of
$1.25 million.
Scanning down Table 12.2, we note that the bank continues to
improve its total profits, with marginal revenue exceeding mar­
ginal cost, up to a deposit interest rate of 8.5 percent. At that
rate the bank raises an estimated $ 1 0 0 million in new money at
a marginal cost rate of 1 0 percent, matching its expected mar­
ginal revenue of 1 0 percent.
There, total profit tops out at $1.5 million. It would not pay the
bank to go beyond this point, however. For example, if it offers
upward to 1 1 percent, which exceeds marginal revenue by a full
percentage point. Attracting new deposits at a 9 percent offer
rate adds more to cost than to revenue. Note, too, that total
profits at a 9 percent deposit rate fall back to $1.25 million. The
8.5 percent deposit rate is clearly the best choice, given all the
assumptions and forecasts made.
The marginal cost approach provides valuable information to
the managers of depository institutions, not only about setting
deposit interest rates, but also about deciding just how far the
institution should go in expanding its deposit base before the
added cost of deposit growth catches up with additional rev­
enues, and total profits begin to decline. When profits start to
fall, management needs either to find new sources of funding
with lower marginal costs, or to identify new assets promising
greater marginal revenues, or both.
Conditional Pricing
The appearance of interest-bearing checking accounts in the
New England states during the 1970s led to fierce competi­
tion for customer transaction deposits among depository
institutions across the United States. Out of that boiling
competitive cauldron came widespread use of conditional
pricing, where a depository sets up a schedule of fees in
which the customer pays a low fee or no fee if the deposit
balance remains above some minimum level, but faces a
higher fee if the average balance falls below that minimum.
Thus, the customer pays a price conditional on how he or she
uses a deposit account.

C hap ter 12 Managing and Pricing Deposit Services ■ 233

Conditional pricing techniques vary deposit prices based on one
or more of these factors:
1. The number of transactions passing through the account (e.g.,
number of checks written, deposits made, wire transfers, stop-
payment orders, or notices of insufficient funds issued).
2. The average balance held in the account over a designated
period (usually per month).
3. The maturity of the deposit in days, weeks, months,
or years.
The customer selects the deposit plan that results in the lowest
fees possible and/or the maximum yields, given the number of
checks he or she plans to write, or charges planned to be made,
INSIGHTS AND ISSUES
THE TRUTH IN SAVINGS ACT
In November 1991, the U.S. Congress passed the Truth in
Savings Act, which requires depository institutions to make
greater disclosure of the terms attached to the deposits they
sell the public. On September 14, 1992, the Federal Reserve
Board issued Regulation DD to spell out the rules that depos­
itories must follow to conform with this law.
The Fed's regulation stipulates that consumers must be fully
informed of the terms on deposit plans before they open a new
account. A depository institution must disclose the minimum
balance required to open the account, how much must be
kept on deposit to avoid paying fees or obtain the promised
yield, how the balance in each account is figured, when interest
actually begins to accrue, any penalties for early withdrawal,
options available at maturity, reinvestment and disbursement
options, advance notice of the approaching end of the depos­
it's term if it has a fixed maturity, and any bonuses available.
When a consumer asks for the current interest rate the offering
institution must provide that customer with the rate offered
within the most recent seven calendar days and also provide
a telephone number so consumers can get the latest offered
rate if interest rates have changed. On fixed-rate accounts
offering institutions must disclose to customers what period
of time the fixed rate will be in effect. On variable-rate depos­
its institutions must warn consumers that interest rates can
change, how frequently they can change, how a variable inter­
est rate is determined, and specify if there are limits on how
far deposit rates can move over time. For all interest-bearing
accounts the depository must disclose the frequency with
which interest is compounded and credited.
If a customer decides to renew a deposit that would not be
automatically renewed on its own, the renewed deposit is
considered a new account, requiring full disclosure of terms.
Customers must also be told if their account is automatically
renewed and, if not, what will happen to their funds (e.g.,
234 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
the number of deposits and withdrawals expected, and the
planned average balance. Of course, the depository institution
must also be acceptable to the customer from the standpoint of
safety, convenience, and service availability.
Economist Constance Dunham [7] has classified checking
account conditional price schedules into three broad catego­
ries: (1) flat-rate pricing, (2) free pricing, and (3) condition­
ally free pricing. In flat-rate pricing, the depositor's cost is
a fixed charge per check, per time period, or both. Thus,
there may be a monthly account maintenance fee of $ 2 ,
and each check written or charge drawn against that account
may cost the customer 1 0 cents, regardless of the level of
account activity.
will they be placed in a noninterest-bearing account?) if the
customer does not remember to renew his or her deposit.
(Generally, customers must receive at least 10 days' advance
notice of the approaching maturity date for deposits over
one year to maturity that are not automatically renewed.) If
a change is made in terms that could reduce a depositor's
yield, a 30-day advance notice must be sent to the depositor.
Depository institutions must send to their customers the
amount of interest earnings received, along with the annual
percentage yield earned. The annual percentage yield (or
APY) must be calculated using:
APY earned = 100 [(1 + Interest earned/Average account
balance)(365/Daysinperiod) - 1 ]
where the account balance is the average daily balance kept
in the deposit for the period covered by each account state­
ment. Customers must be informed of the impact of early
withdrawals on their expected APY.
For example, suppose a depositor had $1,500 in an interest
bearing account for the first 15 days and $500 in the account
for the remaining 15 days. The average daily balance in this
case is $1,000, or [($1,500 X 15 days + $500 X 15 days)/
30 days]. Suppose the account has been credited with $5.25 in
interest for the latest 30-day period. Then the APY earned is:
APY = 100 [(1 + 5.25/1000)365/3° - 1] = 6.58 percent
In determining the balance on which interest earnings are
figured, the depository institution must use the full amount of
the principal in the deposit for each day, rather than count­
ing only the minimum balance that was in the account on one
day during the statement period. Methods that do not pay
interest on the full principal balance are prohibited. Deposit
plans covered by the Truth in Savings Act are confined to
those accounts held by individuals for a personal, family, or
household purpose.
 INSIGHTS AND ISSUES
HOW U.S. DEPOSITORY INSTITUTIONS
SHOULD DISCLOSE THE TERMS ON THEIR
DEPOSIT SERVICES TO CUSTOMERS
In order to help institutions selling deposit services in the
United States conform to the Truth in Savings Act, the Fed­
eral Reserve Board provides managers with examples of
proper disclosure forms to use to inform customers of the
terms being quoted on their deposits. For example, the Fed
has provided an example of a proper disclosure form for cer­
tificates of deposit as shown below.
Sample Disclosure Form for XYZ Savings Bank
One-Year Certificate of Deposit
Rate Information The interest rate for your account is
5.20% with an annual percentage yield of 5.34%. You will be
paid this rate until the maturity date of the certificate. Your
certificate will mature on September 30, 2017. The annual
percentage yield assumes interest remains on deposit until
maturity. A withdrawal will reduce earnings.
Interest will be compounded daily and credited to your
account on the last day of each month. Interest begins to
accrue on the business day you deposit any noncash item (for
example, checks).
Minimum Balance Requirements You must deposit $1,000
to open this account. You must maintain a minimum balance
of $ 1 , 0 0 0 in your account every day to obtain the annual
percentage yield listed above.
Balance Computation Method We use the daily bal­
ance method to calculate the interest on your account. This
method applies a daily periodic rate to the principal in the
account each day.
Transaction Limitations After the account is opened, you
may not make deposits into or withdrawals from the account
until the maturity date.
Early Withdrawal Penalty If you withdraw any principal
before the maturity date, a penalty equal to three months'
interest will be charged to your account.
Renewal Policy This account will be automatically renewed
at maturity. You have a grace period often (10) calendar days
Free pricing, on the other hand, refers to the absence of
a monthly account maintenance fee or per-transaction
charge. Of course, the word free can be misleading. Even if
a deposit-service provider does not charge an explicit fee
for deposit services, the customer may incur an implicit fee
in the form of lost income (opportunity cost) because the
C hap ter 12
after the maturity date to withdraw the funds without being
charged a penalty.
Both the Truth in Savings Act and the Federal Reserve's
Regulation DD stipulate that advertising of deposit terms
may not be misleading. If interest rates are quoted in an
advertisement, the institution must tell the public what the
other relevant terms of the deposit are, such as the minimum
balance needed to earn the advertised yield and whether any
fees charged could reduce the depositor's overall yield.
The Federal Reserve has recently developed sample adver­
tisements to guide managers in making sure that advertising
contains all the essential information the consumer needs.
For example, the sample advertisement form for CDs shown
below was developed recently by the Federal Reserve Board.
The sample advertisement illustrates the basic require­
ments for legitimate advertising of deposits under the Truth
in Savings Act: (a) deposit rates must be quoted as annual
percentage yields (APY), (b) the dates and minimum balance
required must be explicit, and (c) the depositor must be
warned of penalties or fees that could reduce the yield.
Bank XYZ Always Offers You Competitive CD Rates!!
Certificate of Deposit Annual Percentage Yield (APY)
5-year 6.31%
4-year 6.07%
3-year 5.72%
2 -year 5.25%
1 -year 4.54%
6 -month 4.34%
90-day 4.21%
APYs are offered on accounts
from 2 0 1 0 through 2017.
The minimum balance to open an account and obtain
the APY is $1,000. A penalty may be imposed for early
withdrawal.
For more information call: (202) 123-1234.
effective interest rate paid may be less than the going rate on
investments of comparable risk. Many depository institutions
have found free pricing decidedly unprofitable because it
tends to attract many small, active deposits that earn positive
returns for the offering institution only when market interest
rates are high.
Managing and Pricing Deposit Services ■ 235

Factoid
Who cares most about the location of a depository
institution—high-income or low-income consumers? Recent
research suggests that low-income consumers care more
about location in choosing an institution to hold their deposit,
while high-income customers appear to be more influenced by
the size of the financial firm holding their account.
C o n d itio n a lly fre e deposits have come to replace both flat-
rate and free deposit pricing systems in many financial-service
markets. Conditionally free pricing favors large-denomination
deposits because services are free if the account balance stays
above some minimum figure. One of the advantages of this
pricing method is that the customer, not the offering institution,
chooses which deposit plan is preferable. This self-selection
process is a form of m a rket sig n a lin g that can give the deposi­
tory institution valuable data on the behavior and cost of its
deposits. Conditionally free pricing also allows the offering insti­
tution to divide its deposit market into high-balance, low-activity
accounts and low-balance, high-activity accounts.
As an example of the use of co n d itio n a l p ricin g techniques for
deposits, the fees for regular checking accounts and savings
accounts posted by two banks are given in Exhibit 12.1.
We note that Bank A in Exhibit 12.1 appears to favor high-
balance, low-activity checking deposits, while Bank B is more
lenient toward smaller checking accounts. For example, Bank A
begins assessing a checking-account service fee when the cus­
tomer's balance falls below $600, while Bank B charges no fees
for checking-account services until the customer's account bal­
ance drops below $500. Moreover, Bank A assesses significantly
higher service fees on low-balance checking accounts than
does Bank B—$5 to $10 per month versus $3.50 per month. On
the other hand, Bank A allows unlimited check writing from its
regular accounts, while B assesses a fee if more than 10 checks
or withdrawals occur in any month. Similarly, Bank A assesses
a $3 per month service fee if a customer's savings account dips
below $200, while Bank B charges only a $2 fee if the customer's
savings balance drops below $ 1 0 0 .
These price differences reflect differences in the philoso­
phy of management and owners of these two banks and the
types of customers each bank is seeking to attract. Bank A is
located in an affluent neighborhood of homes and offices and
is patronized primarily by high-income individuals and busi­
nesses who usually keep high deposit balances, but also make
many charges and write many checks. Bank B, on the other
hand, is located across the street from a large university and
actively solicits student deposits, which tend to have relatively
low balances. Bank B's pricing schedules are set up to accept

Bank A Bank B

R eg u la r ch e ck in g a cco u n t: R e g u la r ch e ck in g a cco u n t:

Minimum opening balance $ 1 0 0 Minimum opening balance $ 1 0 0

If minimum daily balance is If minimum daily balance is

$600 or more No fee $500 or more No fee
$300 to $599 $5.00 per mo. Less than $500 $3.50 per mo.

Less than $300 $ 1 0 . 0 0 per mo.

If the depositor's collected monthly balance averages $1,500, If checks written or ATM transactions $0.15 per debit
there is no fee (debits) exceed 1 0 per month and
balance is below $500
No limit on number of checks written
R eg u la r sa vin g s a cco u n t: R e g u la r sa vin g s a cco u n t:

Minimum opening balance $ 1 0 0 Minimum opening balance $ 1 0 0

Service fees: Service fees:

If balance falls below $200 $3.00 per mo. If balance falls below $100 $2 . 0 0 per mo.
Balance of $200 or more No fee Balance above $100 No fee
Fee for more than two Fee for more than three
withdrawals per month $2 . 0 0 withdrawals per month $2 . 0 0

Exhibit 12.1 Exam ple of the use of conditional deposit pricing by tw o banks serving the same m arket area.

236 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
low-balance deposits, but the bank also recognizes that it The Role That Pricing and Other
needs to discourage excessive charges and check writing by
Factors Play When Customers Choose
numerous small depositors, which would run up costs. It does
so by charging higher per-check fees than Bank A. In these two
a Depository Institution to Hold Their
instances we can see that deposit pricing policy is sensitive to Accounts
at least two factors: To be sure, deposit pricing is important to financial firms offer­
1. T h e ty p e s o f cu sto m e rs each d e p o s ito ry institution plan s ing this service. But how important is it to the customer? Are
to se rv e —each institution establishes price schedules that interest rates and fees the most critical factors a customer con­
appeal to the needs of individuals and businesses repre­ siders when choosing an institution to hold his or her deposit
senting a significant portion of its market area. account? The correct answer appears to be no.

2. T h e c o s t that se w in g d iffe re n t ty p e s o f d e p o s ito rs will p r e s ­
e n t to th e o ffe rin g in stitu tion —most institutions today price
deposit plans in such a way as to cover all or at least a sig­
nificant portion of anticipated service costs.
12.8 PRICING BASED ON THE TOTAL
CU STO M ER RELATIONSHIP AND
CH O O SIN G A D EPO SITO RY
Related to the idea of targeting the best customers for special
treatment is the notion of pricing deposits according to the
n u m b e r o f s e rv ic e s th e c u s to m e r u se s. Customers who pur­
chase two or more services may be granted lower deposit fees
compared to the fees charged customers having only a limited
relationship to the offering institution. The idea is that selling
a customer multiple services increases the customer's depen­
dence on the institution and makes it harder for that customer
to go elsewhere. In theory at least, relationship pricing pro­
motes greater customer loyalty and makes the customer less
sensitive to the prices posted on services offered by compet­
ing financial firms.
Households and businesses consider multiple factors, not just
price, in deciding where to place their deposits, recent stud­
ies conducted at the Federal Reserve Board, the University of
Michigan, and elsewhere suggest. As shown in Table 12.3, these
studies contend that households generally rank c o n v e n ie n ce ,
se rv ic e availability, and sa fe ty above price in choosing which
financial firm will hold their transaction account. Moreover, fam il­
iarity, which may represent not only nam e re co g n itio n but also
sa fe ty, ranks above the interest rate paid as an important factor
in how individuals and families choose a depository institution to
hold their savings account.
Factoid
There is research evidence today that the interest rates
banks pay on deposits and the account fees they charge
for deposit services do influence which depository institu­
tion a customer chooses to hold his or her account. Inter­
estingly, rural financial-service markets appear to be more
responsive to interest rates and fees than do urban markets,
on average.

Table 12.3 Factors in Household and Business Custom ers' Choice of a Financial Firm fo r Their Deposit Accounts
(ranked from most im portant to least im portant)

In Choosing a Financial Firm to Hold In Choosing a Financial Firm to Hold In Choosing a Financial Firm to Supply
Their Checking (Transaction) Accounts, Their Savings Deposits, Households Their Deposits and Other Services,
Households Consider Consider Business Firms Consider

1. Convenient location. 1. Familiarity. 1. Financial health of lending institution.

2. Availability of many other services. 2. Interest rate paid, 2. Whether bank will be a reliable
3. Safety 3. Transactional convenience (not source of credit in the future.
4. Low fees and low minimum balance. location). 3. Quality of bank officers.
5. High deposit interest rates. 4. Location. 4. Whether loans are competitively
5. Availability of payroll deduction. priced.
6. Fees charged. 5. Quality of financial advice given.
6. Whether cash management and
operations services are provided.

Source: Based on studies by the Federal Reserve Board, Survey o f Consumer Finances.

C hap ter 12 Managing and Pricing Deposit Services ■ 237

 CONCEPT CHECK
12.6. Describe the essential differences between the follow­
ing deposit pricing methods in use today: cost-plus
pricing, conditional pricing, and relationship pricing.
12.7. A bank determines from an analysis of its cost­
accounting figures that for each $500 minimum-balance
checking account it sells, account processing and other
operating costs will average $4.87 per month and over­
head expenses will run an average of $ 1 . 2 1 per month.
The bank hopes to achieve a profit margin over these
particular costs of 1 0 percent of total monthly costs.
What monthly fee should it charge a customer who
opens one of these checking accounts?
12.8. To price deposits successfully, service providers
must know their costs. How are these costs deter­
mined using the historical average cost approach?
The marginal cost of funds approach? What are the
advantages and disadvantages of each approach?
ETHICS IN BANKING AND FINANCIAL SERVICES
THE CONTROVERSY OVER DEPOSIT
OVERDRAFT PROTECTION
Financial managers, customers, and government regulators
have weighed in recently on one of the most controversial ser­
vices financial institutions offer today. That service is overdraft
protection (sometimes called "bounce protection"). If you acci­
dentally overdraw your deposit account, this service is designed
to make sure your incoming checks and drafts are paid and that
you avoid excessive NSF (not sufficient funds) fees.
There are a variety of these deposit protection plans, but
most commonly your bank will set you up with a line of credit
(say, $1,000) in return for an annual fee (perhaps $25 to $50
per year). Another type of overdraft plan calls for you to
maintain a second account from which the financial-service
provider will transfer enough money to pay any overdrafts.
What's so controversial about that?
After all, as long as you don't write checks or drafts that are
too large and go beyond your credit limit the financial-service
provider pays all your overdrafts and saves you from insuf­
ficient funds charges both from the service provider and from
the merchants who received your bad checks. Sometimes just
one bad check can run up $50 or more in fees, never mind
the hassle of contacting the merchant who received your bad
check and straightening things out.
Priced correctly, deposit overdraft protection can bring in
substantial revenues for the financial firm. You pay a fee just
238 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
12.9. How can the historical average cost and marginal cost of
funds approaches be used to help select assets, (such as
loans) that a depository institution might wish to acquire?
12.10. What factors do household depositors rank most highly
in choosing a financial firm for their checking account?
Their savings account? What about business firms?
12.11. What does the 1991 Truth in Savings Act require
financial firms selling deposits inside the United States
to tell their customers?
12.12. Use the APY formula required by the Truth in Sav­
ings Act for the following calculation. Suppose that
a customer holds a savings deposit in a savings bank
for a year. The balance in the account stood at $2,000
for 180 days and $ 1 0 0 for the remaining days in the
year. If the savings bank paid this depositor $8.50
in interest earnings for the year, what APY did this
customer receive?
to get signed up even before you use the service. Then, if
the lender has to cover your bad checks, you will have to
pay off the loan the lender extended to you (normally within
30 days) plus pay a substantial contract interest rate (say,
18 percent). The combined charges plus short-term nature
of the overdraft loan may force you to pay an actual interest
rate (measured by the APR) of 200 percent or more. To some
observers these loans resemble predatory lending, especially
for low-income individuals who may need short-term credit
just to get by each month.
Moreover, customers, knowing they will be covered if they
spend too much, may tend to run repeated overdrafts, wind­
ing up paying large amounts of interest instead of preparing
for the possibility of overdrafts by building up their savings.
Moreover, feeling they are safe, people may tend to avoid
balancing their account statement each month, making more
frequent overdrafts likely. Faced with adverse public and
regulators' comments some financial firms have reduced or
eliminated their overdraft fees.
Still, this is a service that has remained popular, especially
in recent years when most NSF fees have been sharply on
the rise at a pace faster than the rate of inflation. Customers
seem to like the convenience, particularly in making sure their
most important bills (e.g., home mortgage payment and util­
ity bills) get paid on time. For the financial-service provider
it is an important source of fee income that flows through to
the bottom line and increases profits.
Indeed, surveys indicate that household customers tend to be
extremely loyal to their depository institutions—about a third
reported never changing their principal bank of deposit. When
an institutional affiliation is changed, it appears to be due mainly
to customer relocation, though once a move occurs many cus­
tomers seem to pay greater attention to competing institutions
and the relative advantages and disadvantages they offer as well
as pricing. Three-quarters of the households surveyed recently
by the University of Michigan's Survey Research Center cited
location as the primary reason for staying with the financial firm
they first chose.
Factoid
Recent research suggests that at least half of all households
and small businesses hold their primary checking account at
a depository institution situated within three miles of their
location.
Business firms, on the other hand, prefer to leave their deposits
with financial institutions that will be reliable sources of credit
and, relatedly, are in good financial shape. They also rate highly
the quality of officers and the quality of advice they receive
from financial-service managers. Recent research suggests that
financial-service providers need to do a better job of letting
their customers know about the cost pressures they face today
and why they need to charge fully and fairly for any services
customers use.
12.9 BASIC (LIFELIN E) BANKING:
K E Y SER V ICES FO R LOW -INCOM E
CUSTO M ERS
Our overview in this chapter would not be complete without
a brief look at a controversial social issue—basic (or lifeline)
banking. Should every adult citizen be guaranteed access to
certain basic financial services, such as a checking account or
personal loan? Is there a minimum level of financial service
to which everyone is entitled? Can an individual today really
function—secure adequate shelter, food, education, a job, and
health care—without access to certain financial services?
Some authorities refer to this issue as lifeline banking because
it originated in the controversy surrounding electric, gas, and
telephone services. Many people believe these services are so
essential for health and comfort they should be provided at
reduced prices to those who could not otherwise afford them.
The basic, or lifeline, banking issue catapulted to nationwide
C hap ter 12
attention during the 1980s and 1990s when several consumer
groups, such as the Consumers Union and AARP, first studied
the problem and campaigned actively for resolution of the issue.
Some depositories have been picketed and formal complaints
have been lodged with federal and state regulatory agencies.
The dimensions of the lifeline banking issue have been hinted at
in several recent consumer surveys (see, for example, Good [4]).
During the 1990s inquiries by the Federal Reserve indicated that
about 12 percent of Americans had neither checking nor savings
accounts and about 15 percent had no transaction deposits.
A more up-to-date FDIC population survey (12), carried out in
2010 in conjunction with the U.S. Census, found that a substan­
tial segment of the U.S. population is either (1) "unbanked"
(i.e., with no deposits or loans of any kind), about 8 percent
or 9 million households; or (2) "underbanked" (i.e., having
access to some critical services but not others), amounting to
about 18 percent or 21 million households. Among the "under­
banked" are those families relying on expensive payday loans,
check cashing firms, pawnshops, and money order services to
pay their bills.
Racial and ethnic minorities are substantially more likely than
the general population to be "underbanked." Moreover, most
families in this situation report the lowest incomes, little formal
education, and often represent single-parent households that
do not have trust in the banking system. Yet, only a minority of
banks seem concerned about this issue.
Many members of the unbanked population represent poten­
tially profitable customers for traditional financial-service
providers. Among the financial services most in demand are
wire transfers or remittances of money sent to loved ones
elsewhere. For example, thousands of documented and
undocumented workers regularly wire billions of dollars annu­
ally from the United States to families and friends in Latin
America. It has been estimated that the wire-transfer mar­
ket generates well over $100 billion in business annually for
participating financial firms.
One of the most serious problems individuals outside the finan­
cial mainstream face is lack of access to a deposit account Many
of these potential deposit customers do not have Social Security
numbers or other acceptable ID required to open an account
under current U.S. law (especially the USA Patriot Act). Others
who can submit acceptable ID find most conventional deposit
plans too expensive to meet their needs.
Without a checking or savings account, few people can get
approval for credit because most lending institutions prefer to
make loans to those customers who keep deposits with them.
Yet access to credit is essential for most families to secure
adequate housing, medical care, and other important services.
Managing and Pricing Deposit Services ■ 239
Several depository institutions have responded to this problem
with basic deposit plans that allow users to cash some checks
(such as Social Security checks), make a limited number of per­
sonal withdrawals or write a small number of checks (such as 10
free checks or charges per month), or earn interest on even the
smallest balances. As yet, few laws compel financial institutions
to offer basic services, except in selected states—for example,
Illinois, Massachusetts, Minnesota, Pennsylvania, and Rhode
Island—though many states have debated such legislation.
Another component was added to this dilemma when the U.S.
Congress passed the Debt Collection Improvement Act in
1996 and when the U.S. Treasury launched its Electronic Funds
Transfer program in 1999. Both events require that government
payments, such as paychecks and Social Security checks, eventu­
ally be delivered via electronic means. This, of course, implies
that some sort of deposit account be available in the recipient's
name in which these funds can be placed.
What, if anything, should government do? Even if new legisla­
tion is not forthcoming, do financial institutions have a responsi­
bility to serve all customers within their communities? These are
not easy questions to answer. Most financial-service providers
are privately owned corporations responsible to their stockhold­
ers to earn competitive returns. Providing financial services at
prices so low they do not cover production costs interferes with
that important goal.
However, the issue of lifeline banking may not be that simple
because many financial firms are not treated in public policy
like other private firms. For example, entry into the banking
industry is regulated, with federal and state regulatory agencies
compelled by law to consider "public convenience and needs"
in permitting new banks to be established. Moreover, the Com­
munity Reinvestment Act of 1977 requires regulatory agencies
to consider whether a covered financial organization applying to
set up new branch offices or merge with another institution has
really made an "affirmative effort" to serve all segments of the
communities in which it operates.
This most recent legal requirement to fully serve the local com­
munity may include the responsibility to offer lifeline financial
services. Moreover, depository institutions receive important aid
from the government that grants them a competitive advantage
over other financial institutions. One of the most important of
these aids is deposit insurance, in which the government guar­
antees most of the deposits these institutions sell. If depository
institutions benefit from insurance backed ultimately by the
public's taxes, do they have a public responsibility to offer some
services that are accessible to all? If yes, how should they decide
which customers should have access to low-price services?
Should they insist on imposing a means test on customers?
240 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Someone must bear the cost of producing services. Who should
bear the cost of lifeline services? Answers to these questions are
not readily apparent, but one thing is certain: These issues are
not likely to go away.
CONCEPT CHECK
12.13. What is lifeline banking? What pressures does
it impose on the managers of banks and other
financial institutions?
12.14. Should lifeline banking be offered to low-income
customers? Why or why not?
SUM MARY *•
Deposits are the vital input for banks and their closest competi­
tors, the thrift institutions—the principal source of financial
capital to fund loans and security investments and help gener­
ate profits. The most important points this chapter has brought
forward include:
• In managing their deposits financial firms must grapple with
two key questions centered upon cost and volume. Which
types of deposits will help minimize the cost of fund-raising?
How can a depository institution raise sufficient deposits to
meet its fund-raising needs?
• The principal types of deposits offered by depository
institutions today include (1) transaction (or payments)
accounts, which customers use primarily to pay for purchases
of goods and services; and (2) nontransaction (savings or
thrift) deposits, which are held primarily as savings to prepare
for future emergencies and for the expected yield they prom­
ise. Transaction deposits include regular checking accounts,
which often bear no interest return, and interest-bearing
transaction deposits (such as NOWs), which usually pay a low
yield and, in some cases, limit the number of checks or other
drafts that can be written against the account. Nontransac­
tion deposits include certificates of deposit (CDs), savings
accounts, and money market accounts.
• Transaction deposits often are among the most profitable
deposit services because of their nonexistent or low interest
rates and the higher service fees these accounts usually carry.
In contrast, nontransaction, or thrift, deposits generally have
the advantage of a more stable funding base that allows a
depository institution to reach for longer-term and higher-
yielding assets.
• The most popular deposit-pricing methods today is condi­
tional pricing. In this case the interest rate the customer may
 earn and the fees he or she may be asked to pay are condi­
tional on the intensity of use of deposit services and the bal­
ance in the account. In contrast, the cost-plus pricing method
calls for estimating all operating and overhead costs incurred
in providing each service and adds a margin for profit. Under
marginal cost pricing, the offering institution will set its price
at a level just sufficient to attract new funds and still earn a
profit on the last dollar of new funds raised. Finally, relation­
ship pricing calls for assessing lower fees or promising more
generous yields to those customers who are the most loyal.
• Recently new rules have entered the deposit market. The
Truth in Savings Act requires banks and thrift institutions to
make full and timely disclosure of the terms under which
each deposit service is offered. This includes information on
minimum-balance requirements, how deposit balances are
determined, what yield is promised, what the depositor must
do to earn the promised return, and any penalties or fees
that might be assessed.
• Finally, one of the most controversial issues in modern
banking—lifeline banking—continues to be debated in the
deposit-services industry. Depository institutions have been
asked in several states to offer low-cost financial services,
especially deposits and loans, for those customers unable
to afford conventional services. Some institutions have
responded positively with limited-service, low-cost accounts,
while others argue that most financial firms are profit-making
corporations that must pay close attention to profitability and
cost of each new service.

K E Y TERM S
transaction deposit, 222 passbook savings deposits, 224 conditional pricing, 233
NOW accounts, 223 time deposits, 224 Truth in Savings Act, 234
money market deposit core deposits, 226 relationship pricing, 237
accounts, 223 cost-plus pricing, 230 basic (lifeline) banking, 239
Super NOWs, 223 Federal Deposit Insurance Corporation
thrift deposits, 224 (FDIC), 231

C hap ter 12 Managing and Pricing Deposit Services ■ 241

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

PROBLEM S AND PRO JECTS

1. Rhinestone National Bank reports the following figures in

Regular (passbook) 501 596 646 709
its current Report of Condition: savings deposits

Liabilities and Money market deposit 863 812 749 725

accounts
Assets (millions) Equity (millions)
Retirement deposits 650 603 542 498
Cash and interbank $ 50 Core deposits $ 50
deposits CDs under $100,000 327 298 261 244

Short-term security 15 Large negotiable 150 CDs $100,000 and over 606 587 522 495
investments CDs
3. First Metrocentre Bank posts the following schedule of fees
Total loans, gross 400 Deposits placed 65 for its household and small-business transaction accounts:
by brokers
• For average monthly account balances over $1,500,
Long-term securities 150 Other deposits 45
there is no monthly maintenance fee and no charge
Other assets 10 Money market 195 per check or other draft.
liabilities
• For average monthly account balances of $1,000 to
Total assets $625 Other liabilities 65 $1,500, a $2 monthly maintenance fee is assessed and
Equity capital 55 there is a 10c charge per check or charge cleared.
Total liabilities and $625 • For average monthly account balances of less than
equity capital $1,000, a $4 monthly maintenance fee is assessed and
there is a 15c per check or per charge fee.
a. Evaluate the funding mix of deposits and nondeposit
sources of funds employed by Rhinestone. Given the What form of deposit pricing is this? What is First Metro­
mix of its assets, do you see any potential problems? centre trying to accomplish with its pricing schedule?
What changes would you like to see management of Can you foresee any problems with this pricing plan?
this bank make? Why? 4. Fine-Tuned Savings Association finds that it can attract the
b. Suppose market interest rates are projected to rise following amounts of deposits if it offers new depositors
significantly. Does Rhinestone appear to face signifi­ and those rolling over their maturing CDs at the interest
cant losses due to liquidity risk? Due to interest rate rates indicated below:
risk? Please be as specific as possible.
Expected Volume of Rate of Interest Offered
2. Kalewood Savings Bank has experienced recent changes New Deposits Depositors
in the composition of its deposits (see the following
table; all figures in millions of dollars). What changes $10 million 2.00%
have recently occurred in Kalewood's deposit mix? Do 15 million 2.25
these changes suggest possible problems for manage­ 20 million 2.50
ment in trying to increase profitability and stabilize
24 million 2.75
earnings?
26 million 3.00
One Two Three
Management anticipates being able to invest any new
Types of Deposits This Year Years Years
deposits raised in loans yielding 5.50 percent. How far
Held Year Ago Ago Ago
should this thrift institution go in raising its deposit inter­
Regular and special $235 $294 $337 $378 est rate in order to maximize total profits (excluding
checking accounts interest costs)?
Interest-bearing check­ 392 358 329 287 5. New Day Bank plans to launch a new deposit campaign
ing accounts
next week in hopes of bringing in from $100 million to

242 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
$600 million in new deposit money, which it expects
to invest at a 4.25 percent yield. Management believes
that an offer rate on new deposits of 2 percent would
attract $100 million in new deposits and rollover
funds. To attract $200 million, the bank would prob­
ably be forced to offer 2.25 percent. New Day's fore­
cast suggests that $300 million might be available at
2.50 percent, $400 million at 2.75 percent, $500 million
at 3.00 percent, and $600 million at 3.25 percent. What
volume of deposits should the institution try to attract
to ensure that marginal cost does not exceed marginal
revenue?
6 . R&R Savings Bank finds that its basic transaction account,
which requires a $1000 minimum balance, costs this
savings bank an average of $3.25 per month in servic­
ing costs (including labor and computer time) and $1.25
per month in overhead expenses. The savings bank also
tries to build in a $0.50 per month profit margin on these
accounts. What monthly fee should the bank charge each
customer?
Further analysis of customer accounts reveals that for
each $100 above the $1,000 minimum in average bal­
ance maintained in its transaction accounts, R&R Sav­
ings saves about 5 percent in operating expenses with
each account. (Note: If the bank saves about 5 percent
in operating expenses for each $100 held in balances
above the $1,000 minimum, then a customer maintaining
an average monthly balance of $1,500 should save the
bank 25 percent in operating costs.) For a customer who
consistently maintains an average balance of $1,200 per
month, how much should the bank charge in order to
protect its profit margin?
7 . Lucy Lane maintains a savings deposit with Monarch
Credit Union. This past year Lucy received $10.75 in
interest earnings from her savings account. Her savings
deposit had the following average balance each month:
January $450 July $450
February 350 August 425
March 300 September 550
April 550 October 600
November
May 225 625
June 400 December 500
What was the annual percentage yield (APY) earned on
Lucy's savings account?
C hap ter 12
8 . The National Bank of Mayville quotes an APY of 2.75 per­
cent on a one-year money market CD sold to one of the
small businesses in town. The firm posted a balance of
$2,500 for the first 90 days of the year, $3,000 over the
next 180 days, and $3,700 for the remainder of the year.
How much in total interest earnings did this small busi­
ness customer receive for the year?
Internet Exercises
1. Your education has paid off. You have stepped five years
into the future and are reviewing your bank accounts. The
money has just piled up. You have a joint account with
your fiancee containing $265,000 to be used for your
first home. You have a joint account with your mother
containing $255,000, and you have an account in your
own name with $155,000 for the necessities of life. All
three accounts are at the Monarch National Bank. Go
to the following FDIC website www2.fdic.gov/edie and
have Edie determine the insurance coverage. How much
is uninsured? Can you describe the rules determining
coverage?
2. How has the composition of deposits changed at
your favorite local depository institution over the past
10 years? You can find this deposit information for banks
and savings institutions at the FDIC's website. Utilize the
Statistics on Depository Institutions link at www2.fdic
.gov/sdi. Using the points made in this chapter, explain
why your local institution's mix of deposits is changing
the way it is. How can depository institution managers
influence the trends occurring in the composition of their
deposits?
3 . Which depository institutions currently quote the highest
interest rates on checking accounts? Savings accounts?
Money market deposits? Three- and six-months CDs?
Visit www.fisn.com,banked.com and www.banx.com for
the answers.
4 . Compare your local depository institution's interest
rates on six-month and one-year certificates of deposit
(check newspaper ads, call its customer service line,
or visit its website) with the best rates on these same
savings instruments offered by depository institutions
quoting the highest deposit interest rates in the United
States, (See websites listed in Exercise 3.) Why do
you think there are such large interest-rate differences
between your local institution and those posting the
highest interest rates?
Managing and Pricing Deposit Services ■ 243
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

CA SE ASSIGN M EN T FO R CH APTER 12

YOUR BANK S DEPOSITS: VOLATILITY to select Total Deposits and view this in Percentages of Total
AND COST Assets. To assess the overall importance of deposits as a
Chapter 12 examines the major source of funds for depository source of funding, focus on total deposits to total assets.
institutions—deposits. The importance of attracting and maintain­ From the Total Deposits report you will collect information
ing deposits as a stable and low-cost source of funds cannot be to break down deposits in several ways: (1 ) total deposits
overstated. This chapter begins by describing the different types into domestic deposits versus foreign; (2 ) total deposits into
of deposits, then explains why a depository institution's manage­
interest-bearing deposits versus noninterest-bearing depos­
ment is concerned with cost, volatility (risk of withdrawals), and
the trade-off between the two. In this assignment, you will be its; and (3) domestic deposits into their basic types. All the
comparing the character of your bank's deposits across time and data for rows 109-123 are available from the Total Deposits
with its peer group of banks to glean information concerning the report; however, you will have to derive NOW accounts in
cost and stability of this source of funds. Chapter 12's assignment row 1 2 0 by subtracting demand deposits from transaction
is designed to develop your deposit-related vocabulary and to deposits. Finally, we will go to the Interest Expense report
emphasize the importance of being able to attract funds in the
and gather information on the proportion of interest paid
form of deposits, which is unique to banks and thrift institutions.
for foreign and domestic deposits to total assets. Enter the
The Character and Cost of Your Bank's Deposits— percentage information for these items as an addition to the
Trend and Comparative Analysis spreadsheet for comparisons with the peer group as follows:

A. Data Collection: Once again the FDIC's website located at B. Having collected all the data for rows 109-125, you will
www 2 .fdic.gov/sdi/ will provide access to the data needed calculate the entries for rows 126 and 127. For example,
for your analysis. Use Statistics on Depository Institutions the entry for cell B126 is created using the formula func­
(SDI) to create a four-column report of your bank's informa­ tion B124/B113.
tion and peer group information across years. In this part of C. Compare the columns of row 109. How has the reliance on
the assignment, for Report Selection use the pulldown menu deposits as a source of funds changed across periods? Has

a c** * Real Numbers for Real Banks Chapter 12 - Microsoft Excel

File Insert Page Layout Formulas Data Review View Acrobat Q Tell me what you want to do...

* Cut w
on
«- m z*.
■D Eg) Copy -
Calibri - 11 - A* a ' = ^ T I f ' Wrap Text General
m
N o rm al Bad G ood N e u tra l C a lc u la tio n
EB
E Fi
Paste
Format Painter
B I U Hd - ^ * ^ t= 1= H I Merge & C % » *oo n
Formatting-’ Table -
Inp ut L in k e d C e ll N o te Insert Delete Format
Sa
Clipboard n Font Alignment Number 15 Styles Cells

A107 D e p o sits

H M N

106
107 D e p o s its BB& T P e e r G ro u p BB& T P e e r G ro u p
108 D ate 31-12-2010 31-12-2010 31-12-2009 31-12-2009
109 T o ta l D e p o s its 70.13% 68.22% 71.23% 68.20%
110 D e p o s its h e ld in d o m e s t ic o ffic e s 67.04% 52.48% 69.47% 52.12%
111 D e p o s its h e ld in fo re ig n o ffic e 3.09% 15.74% 1.77% 16.08%
112 T o ta l D e p o s its 70.13% 68.22% 71.23% 68.20%
113 In te r e s t- b e a r in g d e p o s its (d o m e stic ) 53.54% 38.70% 57.71% 39.20%
114 In te r e s t- b e a r in g d e p o s it s (fo re ig n ) 2.96% 14.69% 1.67% 15.40%
115 N o n in te re s t- b e a r in g d e p s o it s (d o m e stic ) 13.50% 13.77% 11.76% 12.92%
116 N o n in te re s t- b e a r in g d e p s o it s (fo re ig n ) 0.13% 0.86% 0.10% 0.68%
117 BB& T P e e r G ro u p BB& T P e e r G ro u p
118 T o ta l d o m e s t ic d e p o s its 67.04% 52.48% 69.47% 52.12%
119 D e m a n d d e p o s its 3.89% 5.22% 3.19% 4.98+%
120 N O W a cc o u n ts 2.64% 1.34% 2.11% 1.37%
121 M o n e y m a rk e st d e p o s its a c c o u n ts (M M D A s) 39.83% 26.50% 35.92% 26.60%
122 O t h e r sa v in g s d e p o s its (e x c lu d in g M M D A s) 2.76% 8.42% 2.32% 7.06%
123 T o ta l t im e d e p o s its 17.92% 9.00% 25.92% 12.11%
124 D o m e s tic o ffic e d e p o s its ( in t e r e s t e x p e n s e ) 0.60% 0.28% 0.84% 0.44%
125 F o re ig n o ffic e d e p o s its ( in t e r e s t e x p e n s e ) 0.00% 0.09% 0.01% 0.10%
A v e ra g e in t e r e s t co st in d o m e s t ic o ffic e in te re s -
126 b e a rin g d e p o s its 1.12% 0.72% 1.46% 1.12%
A v e ra g e in t e r e s t co st in fo re ig n o ffic e in te re s -
127 b e a rin g d e p o s its 0.00% 0.60% 0.60% 0.65%
128 T ra n sa c tio n a cc o u n ts 6.53% 6.56% 5.30% 6.35%
129
130

Basic information Y ear-to -Y ear C o m p ariso n s C o m p a ris o n s w ith P eer G ro u p © : M

Ready

244 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

your bank relied more or less on depositors than the aver­ proportion of interest-bearing deposits than the peer group
age bank in the peer group? and a comparable proportion of noninterest-bearing depos­
its. The average interest cost on domestic interest-bearing
D. Use the chart function in Excel and the data by columns
deposits for BB&T for 2010 is 1.12 percent, which is 40 basis
in rows 113 through 116 to create a group of four bar charts
points above the peer group average of 0.72 percent.
illustrating the reliance on deposits as a source of funds
However, for foreign interest-bearing deposits the average
and drawing attention to the breakdown of foreign versus
interest cost for BB&T in 2010 was 0 percent—a whopping
domestic and interest-bearing versus noninterest-bearing
60 basis points lower than the peer group's average interest
deposits. You will be able to select the block and create
cost. For domestic interest-bearing deposits in 2009, BB&T
the chart with just a few clicks of the mouse, saving it as a
paid 32 basis points above the peer group's average interest
separate sheet to insert into your document. Remember to
cost of 1.12 percent These changes in pricing deposits help
provide titles, labels, and percentages; otherwise, we have
to explain how BB&T maintained their deposit base. In fact
something reminiscent of abstract art. Write one or two
the proportion of domestic deposits-to-total assets for BB&T
paragraphs for your BHC summarizing the breakdown of
declined only slightly from 69.47 percent to 67.04 percent.
deposits. Paragraphs describing deposits at BB&T in 2010
and 2009 illustrate how to write your financial data. E. Once again use the chart function in Excel and the data
by columns in rows 119 through 123 to create a group
Deposits provide a significant portion of the funding for
of four columns charts illustrating the types of domestic
bank holding companies. In 2010 more than 70 percent of
deposits supporting assets for your BHC and its peer group.
BB&T's assets were funded by deposits and in 2009 more
This time we will utilize the column charts that sum to
than 71 percent of their assets were funded by depos­
1 0 0 percent to focus on composition by types of domestic
its. These ratios may be compared to 68.22 percent of
deposits, rather than the contribution to funding sources as
deposits-to-total assets for the peer group of institutions in
illustrated in Part D. By choosing different types of charts
2 0 1 0 and 6 8 . 2 0 percent of deposits-to-total assets for the
we can focus our discussions on particular issues, emphasiz­
peer group of institutions in 2009. This indicates that BB&T
ing what we view to be most important. The above column
is more reliant on deposits than its peer group, as illustrated
chart illustrates BB&T's deposit composition relative to its
by the associated column chart.
peer group for 2010 and 2009.
In the above exhibit, we see that BB&T receives a greater pro­
portion of funds from domestic deposits than the Peer Group Using your column chart as a supportive graphic, write one or
of Institutions in both 2010 and 2009 and a smaller propor­ two paragraphs describing your BHC's domestic deposit com­
position with inferences concerning interest costs and deposit
tion of funds from foreign deposits than the Peer Group of
volatility (withdrawal risk).
Institutions in both years. In aggregate, BB&T has a greater
Domestic Deposits Composition: A Comparison of
Breakdown of Deposits-to-Tota! Assest BB &T with Peers
80%

70%

60%

50%

40%

30%

20%

10%

0%
12/31/2010 12/31/2010 12/31/2009 12/31/2009
BB&T Peer Group BB&T Peer Group
BB&T Peer Group BB&T Peer Group
d Total time deposits o Other savings deposits □ Money markets deposits
n Noninterest-bearing deposits (foreign) D Noninterest-bearing deposits (domestic) (excluding MMDAs) accounts (MMDAs)
□ Interest-bearing deposits (foreign) ■ Interest-bearing deposits (domestic) n NOW accounts ■ Demand deposits

C hap ter 12 Managing and Pricing Deposit Services ■ 245

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
Selected References
For a discussion of recent trends in deposit services, see these
sources:
1. Gerdes, Geoffrey R,; Jack K. Walton II; May X. Liu; and
Darrel W. Parke. "Trends in the Use of Payment Instruments
in the United States." Federal Reserve Bulletin, Spring
2005, pp. 180-201.
2. Santomero, Anthony M. "The Changing Patterns of
Payments in the United States." Business Review, Federal
Reserve Bank of Philadelphia, Third Quarter 2005, pp. 1-8.
3. Rose, Peter S. "Pricing Deposits in an Era of Competi­
tion and Change." The Canadian Banker, vol. 93, no. 1
(February 1986), pp. 44-51.
For a discussion of the controversy over lifeline banking
services, see:
4. Good, Barbara A. "Bringing the Unbanked Aboard."
Economic Commentary, Federal Reserve Bank of
Cleveland, January 15, 1999.
For a discussion of the role of depositors in disciplining bank risk
taking and bank behavior, see especially:
5. Vaughan, Mark D.; and David C. Wheelock. "Deposit Insur­
ance Reform: Is It Deja Vu All Over Again?" The Regional
Economist, Federal Reserve Bank of St. Louis, October
2002, pp. 5-9.
6 . Federal Deposit Insurance Corporation. "Privatizing
Deposit Insurance: Results of the 2006 FDIC Study." FDIC
Quarterly 1, no. 2 (2007), pp. 23-32.
For a discussion of deposit pricing techniques, see these studies:
7. Dunham, Constance. 'Unraveling the Complexity of NOW
Account Pricing." New England Economic Review, Federal
Reserve Bank of Boston, May/June 1983, pp. 30-45.
246 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
8. McNulty, James E. "Do You Know the True Cost of Your
Deposits?" Review, Federal Home Loan Bank of Atlanta,
October 1986, pp. 1-6.
For a discussion of recent trends in deposit service availability
and service fees, see:
9. Hannan, Timothy H. "Retail Fees of Depository Institutions,
1994-99." Federal Reserve Bulletin, January 2001,
pp. 1 - 1 1 .
For a discussion of the impact of the Truth in Savings Act on the
cost of bank regulatory compliance, see:
10. Elliehausen, Gregory, and Barbara R. Lowrey. The Cost of
Implementing Consumer Financial Regulation; An Analysis
of the Experience with the Truth in Savings Act. Staff
Study No. 170, Board of Governors of the Federal Reserve
System, December 1997.
For an international view of reaching out to unbanked custom­
ers, see, for example:
11. Skelton, Edward C, "Reaching Mexico's Unbanked,
"Economic Letter, Federal Reserve Bank of Dallas, vol, 5,
no. 7 (July 2008), pp. 1-8.
For a close view of the Federal Deposit Insurance Corporation's
most recent study of unbanked and underbanked customers see
in particular:
12. Federal Deposit Insurance Corporation. "Findings from the
FDIC Survey of Bank Efforts to Serve the Unbanked and
Underbanked," FDIC Quarterly, vol. 3, no. 2 (First Quarter
2009), pp. 39-47.
Managing
Nondeposit
Liabilities
Learning Objectives
After completing this reading you should be able to:

Distinguish the various sources of non-deposit liabilities at Calculate overall cost of funds using both the historical
a bank. average cost approach and the pooled-funds approach.

Describe and calculate the available funds gap.

Discuss factors affecting the choice of non-deposit

funding sources.

Excerpt is Chapter 13 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

247
K E Y TOPICS IN THIS CH APTER
• Liability Management
• Customer Relationship Doctrine
• Alternative Nondeposit Funds Sources
• Measuring the Funds Gap
• Choosing among Different Funds Sources
• Determining the Overall Cost of Funds
13.1 INTRODUCTION
The traditional source of funds for most depository institutions
is the deposit account—both checking and savings deposits
sold to individuals, businesses, and governments. The public's
demand for deposits supplies much of the raw material for
lending and investing and, ultimately, for the profits these insti­
tutions earn. But what does management do to find new money
when deposit volume is inadequate to support all loans and
investments these institutions would like to make?
In Chapter 9 we found part of the answer to this question is that
services like standby credit letters and credit guarantees may be
sold to bring in customer fees and loans may be securitized or
sold outright to attract new funds in order to make new loans.
Chapter 4 provides another part of the answer—when depos­
its don't bring in enough money some security investments,
previously acquired, may be sold to generate more cash. In
the present chapter we explore yet another important nonde­
posit source of funding—selling lOUs in the money and capital
markets for periods of time that may stretch from overnight to
several years.
13.2 LIABILITY M AN AGEM EN T
AN D TH E CU STO M ER RELATIONSHIP
D O CTR IN E1
Managers of lending institutions learned over the years that
turning down a profitable loan request with the usual excuse—
"We don't have enough deposits or other funds sources to
support the loan"—is not well received by their customers.
Denial of a credit request often means the immediate loss of a
customer account and perhaps the loss of any future business
from the disappointed customer. On the other hand, granting
1 Portions of this chapter are based on an article by Peter S. Rose in The
Canadian Banker [4] and are used with permission.
248 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
a loan request—even when deposits and other cash flows
are inadequate—usually brings in both new deposits and the
demand for other services as well. And the benefits may reach
far beyond the borrowing customer alone. For example, a loan
made to a business firm often brings in personal accounts from
the firm's owners and employees.
Filmtoid
What 2003 drama casts Philip Seymour Hoffman as an assis­
tant bank manager with authority over sources and uses of
funds at the bank whose love of Atlantic City gets him into
trouble?
Answer: Owning Mahowny.
The financial community learned long ago the importance of
the customer relationship doctrine, which proclaims that the
first priority of a lending institution is to make loans to all those
customers from whom the lender expects to receive positive net
earnings. Thus, lending decisions often precede funding deci­
sions; all loans and investments whose returns exceed their cost
and whose quality meets the lending institution's credit stan­
dards should be made. If enough deposits are not immediately
available to cover these loans and investments, then manage­
ment should seek out the lowest-cost source of borrowed funds
available to meet its customers' credit needs.
Of course, the customer relationship doctrine has its limitations.
Sometimes it results in scores of poor-quality loans. For example,
during the collapse of the subprime mortgage market in the
2007-2009 business recession regulators found that many mort­
gage lenders went overboard in approving loans, falling well below
normal industry standards and made in haste with little or no docu­
mentation. Moreover, this wild lending spree was amply supported
by cheap money with money market borrowing rates at historic
lows. Subsequently, the volume of home foreclosures rose rapidly
and many mortgage lenders appeared to abandon positive cus­
tomer relationship strategies in favor of a concentrated effort simply
to recover at least some of their funds from beleaguered borrowers.
During the 1960s and 1970s, the customer relationship doctrine
spawned the liquidity management strategy known as liability
management as discussed in Chapters 5 and 18. Liability man­
agement consists of buying funds, mainly from other financial
institutions, in order to cover good-quality credit requests and
satisfy any legal reserve requirements on deposits and other
borrowings that law or regulation may require. A lending institu­
tion may acquire funds by borrowing short term, such as in the
domestic Federal funds market, or borrowing abroad through
the Eurocurrency market.
Table 13.1 Sam ple Use of N ondeposit Funds Sources to Supplem ent Deposits and Make Loans

First National Bank and Trust Company Balance Sheet (Report of Condition)

Assets Liabilities and Equity

Loans: Funding sources found to support the

New loans to be made, $100,000,000 new loans: Newly deposited funds
expected today $50,000,000
Nondeposit funds sources:
Federal funds purchased 19,000,000
Borrowings of Eurodollars abroad 2 0 ,0 0 0 , 0 0 0
Securities sold under agreements
to repurchase (RPs) 3,000,000
Borrowings from a nonbank subsidiary of
the bank's holding company that
sold commercial paper in the money
market +8 ,0 0 0 , 0 0 0
Total new deposit and nondeposit
funds raised to cover the new loans $1 0 0 ,0 0 0 , 0 0 0

Table 13.1 illustrates the basic idea behind liability manage­
ment. In this instance, one of a lender's business custom­
ers has requested a new loan amounting to $ 1 0 0 million.
However, the deposit division reports that only $50 million
in new deposits are expected today. If management wishes
to fully meet the loan request of $ 1 0 0 million, it must find
another $50 million from nondeposit sources. Some quick
work by the lender's money market division, which contacted
correspondent banks in New York and London and negoti­
ated with nonbank institutions with temporary cash surpluses,
resulted in raising the entire $50 million by borrowing domes­
tic Federal funds, borrowing from a subsidiary part of the
same holding company that sold notes (commercial paper) in
the open market, selling investment securities under a security
repurchase agreement, and borrowing Eurocurrencies from
branch offices abroad.

INSIGHTS AND ISSUES

Is This Really the Time to Borrow So Much portfolio may reveal a better overall balance between short-
Money Short Term? and long-term debt.

We note in the example of liability management in Table 13.1
that nondeposit borrowings are most often short term rather
than long term. Why would the liability manager rely so heav­
ily upon short-term debt, especially overnight loans? Hasn't
she heard about interest rate risk and the danger that the
lender may be forced to borrow short term over and over
again at higher and higher interest rates to fund a loan?
Yes, but there are good reasons for "going short" in most
nondeposit borrowings. For one thing, the borrowing cus­
tomer likely is standing there waiting for his loan. Today there
may not be enough time to find and negotiate long-term
debt contracts; tomorrow may be another story and longer
term deposits may soon roll in.
Second, in the example in Table 13.1 we are dealing with
funding just one loan. A glance at the lender's whole loan
Third, financial firms have gotten much better at managing
interest rate risk than used to be the case. As we saw in Parts
Two and Three, they now have a lot of risk-management tools
to work with.
Moreover, many assets institutions hold are also short term,
including some overnight and intraday loans. Financial-
service managers have learned to keep a rough balance
between their shorter-term assets and shorter-term
liabilities in order to protect against liquidity crises. Finally,
should the current interest-rate forecast call for declining
market interest rates, perhaps this liability manager is in a
good position after all. With falling interest rates, tomor­
row's borrowing costs should be lower than today's costs.
Much depends on the reliability of the outlook for interest
rates and market conditions.

C h ap ter 13 Managing Nondeposit Liabilities ■ 249

Unfortunately, the money market division cannot rest on its
laurels. They know that a substantial portion of the $50 million
just raised will be available only until tomorrow when many of
the borrowed funds must be returned to their owners. These
departing funds will need to be replaced quickly to continue to
support the new loan. Customers who receive loans spend their
funds quickly (otherwise, why get a loan?) by writing checks and
wiring funds to other financial institutions. This lender, there­
fore, must find sufficient new funds to honor all those outgoing
checks and wire transfers that its borrowing customers initiate.
Clearly, liability management is an essential tool lenders need
to sustain the growth of their lending programs. However, it
also poses real challenges for financial-service managers, who
must keep abreast of the market every day to make sure their
institution is fully funded. Moreover, liability management is an
interest-sensitive approach to raising funds. If interest rates rise
and the lender is unwilling to pay those higher rates, funds bor­
rowed from the money market will be gone in minutes. Money
market suppliers of funds typically have a highly elastic response
to changes in market interest rates.
Yet, viewed from another perspective, funds raised by liability
management techniques are flexible: the borrower can decide
exactly how much he or she needs and for how long and usu­
ally find a source of funds that meets those requirements. In
contrast, when deposits are sold to raise funds, it is the deposi­
tor who decides how much and how long funds will be left with
each financial firm. With liability management institutions in
need of more funds to cover expanding loan commitments or
deficiencies in cash reserves can simply raise their offer rate in
order to reduce their volume of money market borrowing.
13.3 ALTERNATIVE N O N D EPO SIT
SO U R CES O F FUNDS
As Table 13.2 suggests, the usage of nondeposit sources of
funds has fluctuated in recent years, but generally has risen to
provide a bigger share of funds for depository institutions. While
smaller banks and thrift institutions usually rely most heavily on
deposits for their funding needs, leading depository institutions
around the globe have come to regard the nondeposit funds
market as a key source of short-term money to meet both loan
demand and unexpected cash emergencies.
Table 13.3 shows the relationship between the size of banks
and their affinity for non-deposit borrowing. Clearly, the
smallest-size banks (each under $ 1 0 0 million in assets) sup­
port only a small share (about 4 percent) of their assets by
nondeposit borrowings. Among the largest institutions (over
$ 1 billion in assets), however, nondeposit borrowings covered
250 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
about four times as much among large commercial bank
assets (or 16 percent).
Overall, nondeposit borrowings have often outstripped the
growth of traditional deposits, as Table 13.2 suggests, in part
because of the greater flexibility of nondeposit borrowings,
which are less regulated, and the loss of some deposits in recent
years to competing financial institutions, such as mutual funds,
insurance companies, hedge funds, and pension funds, that are
competing aggressively today to attract the public's savings. In
the sections that follow we examine the most popular nonde­
posit funds sources that financial firms use today.
Federal Funds Market ("Fed Funds")
The most popular domestic source of borrowed reserves among
depository institutions is the Federal funds market. Originally,
Fed funds consisted exclusively of deposits held at the Federal
Reserve banks. These deposits are owned by depository institu­
tions at the Fed primarily to satisfy legal reserve requirements,
clear checks, and pay for purchases of government securities.
These Federal Reserve balances can be transferred from one
institution to another in seconds through the Fed's wire transfer
network (Fedwire), linking all Federal Reserve banks. Today,
however, deposits that depository institutions hold with each
other also can be moved around the banking system the same
day a request is made. The same is true of large collected
demand deposit balances that securities dealers and govern­
ments own. All these types of deposits make up the raw mate­
rial traded in the market for Federal funds. In technical terms,
Fed funds are simply short-term borrowings of immediately
available money.
Financial institutions needed little time to realize the potential
source of profits inherent in these same-day monies. Because
reserves deposited with the Federal Reserve banks and many
demand deposits held by business firms pay little or no inter­
est, bank and nonbank firms have a strong economic incentive
to lend excess reserves or any demand deposit balances not
needed to cover immediate cash needs. Moreover, there are no
legal reserve requirements on Fed funds borrowings currently
and few regulatory controls—features that have stimulated the
growth of the market and helped keep the cost of borrowing
down. Financial firms in need of immediate funds can negotiate
a loan with a holder of surplus interbank deposits or reserves at
the Fed, promising to return the borrowed funds the next day if
need be.
The main use of the Fed funds market today is still the tradi­
tional one: a mechanism that allows depository institutions short
of reserves to meet their legal reserve requirements or to satisfy
loan demand by tapping immediately usable funds from other
Table 13.2 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-lnsured Banks and Thrifts
Billions of Dollars at Year-End
Nondeposit Sources
of Borrowed Funds
1990 1992 1994 1996 1998 2000 2002 2004 2007 2010*
Money market
negotiable (jumbo)
CDs ($100,000+) $431.8 $366.5 $344.9 $476.9 $671.4 $821.3 $814.0 $1,505.1 $2,382.2 $1,800.0
Eurodollar
borrowings from
own foreign offices 168.0 160.4 185.9 177.3 148.8 194.3 231.5 382.6 154.5 2 0 1 . 8 ***
Federal funds
borrowings and
security RPs 180.1 149.9 2 2 1 .1 199.8 206.1 235.5 476.8 727.4 838.5 760.7
Commercial paper
issued** 420.8 406.5 443.7 601.2 936.2 1,275.8 1,194.0 1,395.0 1,788.1 ,
1 0 2 0 .0

Borrowings from
the Federal Reserve
banks 0.3 0 .1 0.5 0 .2 0 .1 0 .2 0 .1 0.0 48.6 0.7
Total nondeposit
funds raised by U.S.-
insured banks and
thrifts $1 ,2 0 1 . 0 $1,083.4 $1,196.1 $1,455.4 $1,962.5 $2,527.1 $2,716.4 $4,010.1 $5,211.9 $3,791.2
Total deposits
of FDIC-insured
depository
institutions $3,637.3 $3,527.1 $3,611.6 $3,925.2 $4,386.1 $4,914.8 $5,568.7 $5,026.0 $6,590.7 $7,513.7
Ratio of nondeposit
funds to total deposits
for all FDIC-insured
banks and thrifts 33% 31% 33% 37% 45% 51% 49% 80% 79% 50%
Notes: *Figures for money market CDs, Eurodollar borrowings, and repurchase agreements (RPs) are for second quarter 2010. **lncludes all finance-
company paper issued directly to investors by banks and other financial-service providers. *** Figures for Eurodollar commitments to foreign affili­
ates fourth quarter of 2009.
Sources: Federal Reserve Board and Federal Deposit Insurance Corporation.

Table 13.3 The Relationship between the Size of institutions possessing temporarily idle funds. Fed funds are also
Banks and Their Use of Nondeposit Borrowings (2007 used to supplement deposit growth and give lenders a relatively
figures for FDIC insured banks) safe outlet for temporary cash surpluses on which interest can
be earned (even for a loan lasting only a few hours). Moreover,
Percent of Assets the Fed funds market serves as a conduit for the policy initia­
Size Group end Type of Supported by tives of the Federal Reserve System designed to control the
Depository Institution Nondeposit Borrowings growth of money and credit and stabilize the economy.
The largest U.S. commercial banks By performing all of these functions, the Fed funds market effi­
(over $ 1 billion in assets each) 16%
ciently distributes reserves throughout the financial system to
The smallest U.S. commercial areas of greatest need. To help suppliers and demanders of Fed
banks (under $ 1 0 0 million in funds find each other, funds brokers soon appeared to trade
assets each) 4 Fed funds in return for commissions. Large, accommodating
Note: Thrift institutions include savings and loan associations and sav­ banks, play a role similar to that of funds brokers for smaller
ings banks insured by the Federal Deposit Insurance Corporation. depository institutions in their region. An accommodating bank
Source: Federal Deposit Insurance Corporation. buys and sells Fed funds simultaneously in order to make a

C h ap ter 13 Managing Nondeposit Liabilities ■ 251

market for the reserves of its customer institutions, even though
the accommodating bank itself may have no need for extra
funds at the moment.
The procedure for borrowing and lending Fed funds is a simple
one. Borrowing and lending institutions communicate either
directly with each other or indirectly through a correspondent
bank or funds broker. Once borrowing and lending institutions
agree on the terms of a Fed funds loan, the lending institution
arranges to transfer reserves from a deposit it holds, either at
a Federal Reserve bank or with an accommodating bank into
a deposit controlled by the borrowing institution. This may be
accomplished by wiring Fed funds if the borrowing and lending
institutions are in different regions. If lender and borrower hold
reserve deposits with the same Federal Reserve bank or with
the same correspondent bank, the lending institution simply
asks that bank to transfer funds from its reserve account to the
borrower's reserve account—a series of bookkeeping entries
accomplished in seconds via computer. When the loan comes
due, the funds are automatically transferred back to the lending
institution's reserve account. (See Table 13.4 for a description
of the accounting entries involved.) The interest owed may also
be transferred at this time, or the borrower may simply send a
check to the lender to cover any interest owed.
The interest rate on a Fed funds loan is subject to negotiation
between borrowing and lending institutions. While the interest
rate attached to each Fed funds loan may differ from the rate
on any other loan, most of these loans use the effective interest
rate prevailing each day—a rate of interest posted by Fed funds
brokers and major accommodating banks operating at the cen­
ter of the funds marketplace. In recent years, tiered Fed funds
rates (i.e., interest-rate schedules) have appeared at various
times, with borrowing institutions in trouble paying higher inter­
est rates or simply being shut out of this market completely.
The Fed funds market typically uses one of three types of loan
agreements: (1) overnight loans, (2) term loans, or (3) continuing
contracts. Overnight loans are unwritten agreements, negoti­
ated via wire or telephone, with the borrowed funds returned
the next day. Normally these loans are not secured by specific
collateral, though where borrower and lender do not know
each other well or there is doubt about the borrower's credit
standing, the borrower may be required to place selected
government securities in a custody account in the name of
the lender until the loan is repaid. Term loans are longer-term
Fed funds contracts lasting several days, weeks, or months,
often accompanied by a written contract. Continuing contracts
are automatically renewed each day unless either borrower
or lender decides to end this agreement. Most continuing
contracts are made between smaller respondent institutions
and their larger correspondents, with the correspondent
252 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
automatically investing the smaller institution's deposits held
with it in Fed funds loans until told to do otherwise.
Repurchase Agreements as a Source
of Funds
Less popular than Fed funds and more complex are repur­
chase agreements (RPs), often viewed as collateralized Fed
funds transactions. In an ordinary Fed funds transaction, the
seller (lender) is exposed to credit risk because the borrowing
institution may not have the funds to repay. If the purchaser of
Fed funds were to provide collateral in the form of marketable
securities, however, credit risk would be reduced. This is what
happens in a repurchase agreement, or RP.
Most domestic RPs are transacted across the Fed Wire system,
just as are Fed funds transactions. RPs may take a bit longer to
transact then a Fed funds loan because the seller of funds (the
lender) must be satisfied with the quality and quantity of securi­
ties provided as collateral. 2
RPs get their name from the process involved—the institution
purchasing funds (the borrower) is temporarily exchanging secu­
rities for cash. They involve the temporary sale of high-quality,
easily liquidated assets (the "starting leg"), such as Treasury
bills, accompanied by an agreement to buy back those assets
on a specific future date at a predetermined price (the "closing
leg"). (See Table 13.5.) An RP transaction is often for overnight
funds; however, it may be extended for days, weeks, or even
months.
The interest cost for both Fed funds and repurchase agreements
can be calculated from the following equation:
Number of days
Interest Amount Current in RP borrowing
X x ------------------------ — (13.1)
cost of RP borrowed RP rate 360 days
For example, suppose a bank borrows $50 million through an RP
transaction collateralized by government bonds for three days
and the current RP rate in the market is 6 percent. Then this
bank's total interest cost would be:
Interest 3
r = $50,000,000 X 0.06 X — - = $24,995
cost of RP 360
A major innovation occurred in the RP market with the inven­
tion of General Collateral Finance (GCF) RPs in 1998, under the
As a result of losses on RPs associated with the collapse of two gov­
ernment securities dealers in 1985, Congress passed the Government
Securities Act, which requires dealers in U.S. government securities to
report their activities and requires borrowers and lenders to put their RP
contracts in writing, specifying the nature and location of collateral.
Table 13.4 The Mechanics of Borrowing and Lending Federal Funds

First Way to Lend Fed Funds

Step 1. Lending Reserve Balances Held at the Federal Reserve Banks to a Borrowing institution
Lender's Balance Sheet Borrower's Balance Sheet
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Federal funds Borrower's Federal funds purchased
sold (loaned) +1 0 0 reserves on (borrowed) to
Lender's reserves deposit at support loans and
on deposit at the Fed +100 investments +1 0 0
the Fed - 1 0 0

Step 2. Repaying the Loan of Fed Funds through the Federal Reserve Banks
Lender's Balance Sheet Borrower's Balance Sheet
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Lender's reserves Borrower's Federal funds purchased
on deposit at reserves on (borrowed) to
the Fed +1 0 0 deposit at the support loans and
Federal funds Fed -100 investments - 1 0 0

sold (loaned) - 1 0 0

Second Way to Lend Fed Funds

Step 1. Lending Fed Funds by a Respondent (usually smaller) Depository Institution to a Correspondent (usually larger)
Depository Institution Who May Loan Those Funds to Another Institution (usually located in a major
money center where credit demands are often heavy)
Lender's (respondent's) Balance Sheet Borrower's (correspondent's) Balance Sheet
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Lender's deposits Federal funds purchased
held with (borrowed) to
correspondent - 1 0 0 support loans and
Federal funds investments +1 0 0
sold (loaned) +1 0 0 Respondent's bank
deposit - 1 0 0

Step 2. Correspondent Repaying the Loan to the Respondent Depository Institution

Respondent Institution Correspondent Institution
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Lender's deposits Federal funds purchased
held with (borrowed) to
correspondent +1 0 0 support loans and
Federal funds investments - 1 0 0

sold (loaned) - 1 0 0 Respondent's bank

deposit +1 0 0

leadership of the Bank of New York, JP Morgan Chase, and the
Fixed Income Clearing Corporation (FICC). What is a GCF RP?
How does it differ from the traditional RP?
Conventional (fixed-collateral) repurchase agreements desig­
nate specific securities to serve as collateral for a loan, with the
lender taking possession of those particular instruments until
the loan matures. In contrast, the general-collateral GCF RP
has been used for low-cost collateral substitution. Borrower
and lender can agree upon a variety of securities, any of which
may serve as loan collateral. This agreed-upon array of eligible

C h ap ter 13 Managing Nondeposit Liabilities ■ 253

Table 13.5 Raising Loanable Funds through a Repurchase Agreement Involving the Borrower's Securities
Step 1. Bank Sells Some of Its Securities under an RP Agreement
ercial Bank Temporary Buyer of the Bank's Securities
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Securities Securities
sold - 1 0 0 purchased +1 0 0
Seller's reserve Cash
balances at account - 1 0 0

the Fed +1 0 0

Step 2. The RP Agreement Ends and the Securities Are Returned

Commercial Bank Temporary Buyer of the Bank's Securities
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Securities Securities
repurchased +1 0 0 returned - 1 0 0

Seller's reserve Cash

balances at account +1 0 0
the Fed - 1 0 0

REAL BANKS, REAL DECISIONS

Charging U.S. D epository Institutions
a "Lom bard R a te "? W hat's T h at?
The Federal Reserve's recent changes in the rules (Regula­
tion A) governing its discount window loans bring this aspect
of U.S. central banking much closer to what central banks in
Europe do.
Before 2003 the Federal Reserve's discount rate was fre­
quently the lowest interest rate in the money market and
often below the Fed funds interest rate. With the discount
rate so low, many depository institutions were tempted to
borrow from the Fed and relend the money in the Fed funds
market. Some did!
Today the U.S. primary-credit discount rate is now set slightly
higher than the Fed funds interest rate on overnight loans,
which the Federal Reserve is using as a target to stabilize
the economy. Setting the Fed's discount rate above market
mirrors the "Lombard" credit facilities used by several
European central banks. (Incidentally, the term Lombard owes
its origin to a German word for collateralized loan. One of the
earliest users of above-market loan rates for banks in need
of funds was the Bundesbank, Germany's central bank.) Lom­
bard loan rates have been employed by the European Central
Bank (ECB) and the central banks of Austria, Belgium, France,
Germany, Italy, and Sweden. Similar lending rules were
adopted recently by the Bank of Canada and Bank of Japan.
With the discount or Lombard rate set above market levels
for similar loans, central banks are less inclined to restrict
borrowing from the discount window and less concerned
about what borrowers do with the money. Moreover, recent
evidence suggests that an above-market Lombard rate
tends to act as a ceiling on overnight borrowing rates and
may serve as an effective ceiling for the U.S. Fed funds
interest rate.

collateral might include, for example, any obligation of the Trea­
sury or a federal agency. Thus, the same securities pledged at
the beginning do not have to be delivered at the end of a loan.
Moreover, GCF RPs may be settled on the books of the FICC,
which allows netting of obligations between lenders, borrowers,
and brokers so that less money and securities must be trans­
ferred. Finally, GCF RPs can be reversed early in the morning
and settled late each day, giving borrowers greater flexibility
during daylight hours in deciding what to do with collateral
securities. GCF RPs can make more efficient use of collateral,
lower transactions cost, and help make the RP market somewhat
more liquid. (For further discussion of this RP innovation, see
especially Fleming and Garbade [1].)
Overall, however, the RP market has contracted somewhat
recently, especially during the 2007-2009 credit crisis, due to
concern over the quality and market value of securities being

254 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 CONCEPT CHECK
13.1. What is liability management?
13.2. What advantages and risks does the pursuit
of liability management bring to a borrowing
institution?
13.3. What is the customer relationship doctrine, and
what are its implications for fund-raising by lending
institutions?
13.4. For what kinds of funding situations are Federal funds
best suited?
13.5. Chequers State Bank loans $50 million from its reserve
account at the Federal Reserve Bank of Philadelphia
to First National Bank of Smithville, located in the New
York Federal Reserve Bank's district, for 24 hours, with
the funds returned the next day. Can you show the
correct accounting entries for making this loan and for
the return of the loaned funds?
13.6. Hill side Savings Association has an excess balance of
$35 million in a deposit at its principal correspondent,
Sterling City Bank, and instructs the latter institution to
loan the funds today to another institution, returning
them to its correspondent deposit the next business
day. Sterling loans the $35 million to Imperial Security
National Bank for 24 hours. Can you show the proper
accounting entries for the extension of this loan and for
the recovery of the loaned funds by Hillside Savings?
13.7. Compare and contrast Fed funds transactions with RPs.
13.8. What are the principal advantages to the borrower of
funds under an RP agreement?

pledged as collateral for these loans. Moreover, one of the fac­
tors that contributed significantly to the well-publicized troubles
of Bear Stearns and Lehman Brothers, leading investment banks,
was their inability to find adequate support from the RP market.
Borrowing from Federal Reserve Banks
For a depository institution with immediate reserve needs, a via­
ble alternative to Fed funds and RPs is negotiating a loan from a
central bank for a short period of time. For example, depository
institutions operating in the United States may be eligible for
loans granted by the Federal Reserve Bank in their particular
region. The Fed will make the loan through its discount window
by crediting die borrowing institution's reserve account. (See
Table 13.6 for an overview of the typical accounting entries
associated with a discount window loan.)
Each loan made by the Federal Reserve banks must be backed
by collateral acceptable to the Fed. Most depository institutions
keep U.S. government securities in the vaults of the Federal
Reserve banks for this purpose. The Fed will also accept certain

Table 13.6 Borrowing Reserves from the Federal Reserve Bank in the District
Securing a Loan from a Federal Reserve Bank
Borrowing Depository Institution Federal Reserve Bank
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Reserves on Notes payable +100 Loan and Bank reserve accounts +1 0 0
deposit at advances + 1 0 0

the Federal
Reserve Bank +1 0 0

Repaying a Loan from a Federal Reserve Bank

Borrowing Depository Institution Federal Reserve Bank
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Reserves on Notes payable -100 Loan and Bank reserve accounts - 1 0 0

deposit at advances - 1 0 0

the Federal
Reserve Bank - 1 0 0

C h ap ter 13 Managing Nondeposit Liabilities ■ 255

federal agency securities, high-grade commercial paper, and
other assets judged satisfactory.
Several types of loans are available from the Fed's discount
window:
1. P rim ary cre d it —loans available for short terms (usually
overnight but occasionally extending out to 90 days) to
depository institutions in sound financial condition. Primary
credit normally carries an interest rate slightly above the
Federal Reserve's target Fed funds interest rate. Users of
primary credit do not have to show (as they did in the past)
that they have exhausted other sources of funds before ask­
ing the Fed for a loan. Moreover, the borrowing institution
is no longer prohibited from borrowing from the Fed and
then loaning that money to other depository institutions in
the Fed funds market.
2. S e c o n d a ry cre d it —loans
available at a higher interest
rate to depository institutions not qualifying for primary
credit. These loans are subject to monitoring by the Federal
Reserve banks to make sure the borrower is not taking on
excessive risk. The interest rate on secondary credit may
be about 50 basis points above the primary credit rate and
150 basis points above the Fed funds rate. Such a loan can
be used to help resolve financial problems, to strengthen
the borrowing institution's ability to find additional funds
from private-market sources, and to reduce its debt to the
Fed. However, secondary credit is not supposed to be used
to fund the expansion of a borrowing institution's assets.
3. S e a so n a l cre d it —loans covering longer periods than pri­
mary credit for small and medium-sized depository insti­
tutions experiencing seasonal (intrayear) swings in their
deposits and loans (such as those swings experienced by
farm banks during planting and harvesting time). The sea­
sonal credit interest rate is set at the average level of the
effective Fed funds rate and the secondary market rate on
90-day certificates of deposit.
Thus, each type of discount window loan carries its own loan
rate, with secondary credit generally posting the highest interest
rate and seasonal credit the lowest.
In 1991 the U.S. Congress passed the FDIC Improvement Act,
which places limits on how far the Federal Reserve banks can go
in supporting a troubled depository institution with loans. Gen­
erally speaking, undercapitalized institutions cannot be granted
discount window loans for more than 60 days in each 1 2 0 -day
period. Long-term Fed support is only permissible if the borrow­
ing institution is a "viable entity." If the Fed exceeds these limi­
tations, it can be held liable to the FDIC for any losses incurred
by the insurance fund should the troubled institution ultimately
fail. Overall, the Fed's discount window is not a particularly
256 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
popular source of funding due to regulations, collateral require­
ments, and cost, though the credit crisis of 2007-2009 increased
the popularity of the Fed's "window" as a source of borrowed
funds for a wide range of troubled firms.
Advances from Federal Home Loan Banks
Recently another government agency—the Federal Home Loan
Bank (FHLB) System—has been lending huge amounts of money
to scores of home mortgage lenders. The FHLB System, com­
posed of 1 2 regional banks, was created by federal charter in
1932 in order to extend cash advances to depository institutions
experiencing runs by anxious depositors. By allowing these trou­
bled institutions to use the home mortgages they held in their
portfolios as collateral for emergency loans, the FHLB improved
the liquidity of home mortgages and encouraged more lenders
to provide credit to the housing market.
In recent years the number of financial institutions eligible to
borrow from the FHLB has increased dramatically, especially
among smaller community banks and thrift institutions. A recent
study (Maloney and Thomson [3]) found that close to 6,000 com­
mercial banks, more than 1,300 thrift institutions, over
700 credit unions, and close to 80 insurance companies had
FHLB loans, amounting collectively to more than $500 billion.
Managers of mortgage-lending institutions have been attracted
to FHLB loans because they represent a stable source of fund­
ing at below-market interest rates. Fully collateralized by home
mortgages the maturities of FHLB loans range from overnight
to more than 2 0 years, bearing either fixed or variable interest
rates. The system's federal charter enables it to borrow money
cheaply and pass those savings along to member institutions
who also hold FHLB stock and receive dividends on that stock.
Should a borrowing institution fail, the FHLB, legally, is first in
line (even ahead of the FDIC) in recovering its funds. In general,
this can be a popular funds source due to lower costs and flex­
ibility in the maturity of loans permitted.
Development and Sale of Large
Negotiable CDs
The concept of liability management and short-term borrow­
ing to supplement deposit growth was given a significant
boost early in the 1960s with the development of a new kind
of deposit, the n e g o tia b le C D . This funding source is really a
hybrid account: legally, it is a deposit, but, in practical terms,
the negotiable CD is just another form of IOU issued to tap tem­
porary surplus funds held by large corporations, wealthy indi­
viduals, and governments. A CD is an interest-bearing receipt
evidencing the deposit of funds in the accepting depository
 ISSUES AND INSIGHTS
The Fed's Term Auction and Securities Lending
Facilities as Sources of Medium-Term Credit
The turmoil in the financial marketplace during 2007-2009
gave rise to a "credit crunch" among lending institutions
worldwide. In particular, the demand for loans bearing one-
to six-month maturities— longer than normal Federal funds
loans, RPs, and discount window loans—soared as financial
managers desperately searched for medium-term money.
In December 2007, concerned that its current monetary
policy tools were not adequate to provide liquidity to sup­
port the collapsing subprime mortgage market, the Federal
Reserve System launched a new source of temporary credit
known as the Term Auction Facility (TAF). The Fed began
announcing how much it would be willing to loan deposi­
tory institutions for 28-day periods at interest rates below its
conventional discount rate. The Fed set up an auction system
for these medium-term loans very much like the way Treasury
bills are sold, using a single-price auction with sealed bids.
Auctions of 28-day loans were held biweekly as 2008 began.
Then in March 2008, with several key financial markets
(including mortgages, auto loans, credit card receivables, and
student loans) imperiled by a deepening shortage of liquid­
ity, the Fed set up a Term Securities Lending Facility (TSLF)
to put a floor of liquidity under these troubled markets. Pri­
mary security dealers (who work regularly with the Federal
Reserve) were invited to borrow from the Fed, pledging as
collateral qualified triple-A-rated securities backed by home
mortgages, student loans, and auto and credit card loans.
For its part the Fed promised to temporarily swap some of
institution for a specified time period at a specified interest rate
or specified formula for calculating the interest rate.
There are four main types of negotiable CDs today. Domestic
CDs are issued by U.S. institutions inside the territory of the
United States. Dollar-denominated CDs issued by banks outside
the United States are known as EuroCDs. The largest foreign
banks active in the United States (such as Deutsche Bank and
HSBC) sell CDs through their U.S. branches, called Yankee CDs.
Finally, nonbank savings institutions sell thrift CDs.
During the 1960s, faced with slow growth in checkbook depos­
its held by their largest customers because these customers
had found other higher-yielding outlets for their cash surpluses,
money center banks began to search the market for new sources
of funds. First National City Bank of New York (now Citibank),
one of the more innovative financial firms in the world, was the
first to develop the large ($100,000+) negotiable CD. Citigroup
designed this marketable deposit to compete for funds with
other well-known money market instruments. It was made large
the Treasury securities it holds in exchange for the dealers'
triple-A-rated securities for a period of up to 28 days. This
move seemed to help stabilize markets the Fed had targeted,
at least for a time. Later in 2011 the Fed supplemented its
weapons with a policy called "twist", buying long-term bonds
and selling short-term financial instruments to stimulate long­
term investment.
Actually the Fed has broad power to provide emergency
credit in "unusual" and "exigent" circumstances. For exam­
ple, Section 13, Paragraph 3, of the Federal Reserve Act
allows the Fed to lend money to "any individual, partner­
ship, or corporation" on the affirmative vote of at least five
members of the Federal Reserve Board. The Fed first made a
substantial volume of these Section 13 loans to nonbank enti­
ties during the Great Depression of the 1930s and continued
to do so for almost 20 years, especially during World War II
to increase production. Most recently in 2008 the New York
Fed loaned $29 billion to help support the buyout of trou­
bled security dealer Bear Stearns by JP Morgan Chase.
Some authorities in the field have suggested that the Fed's
new credit facilities should be retained in the central bank's
arsenal of policy weapons, giving the Fed new tools to deal
with liquidity crises and avoid direct pressure on key inter­
est rates. Other experts, however, have contended that the
Fed's recent, unprecedented actions have simply gone too
far, encouraging inflation and failing to invoke the discipline
of the marketplace on those individuals and institutions who
were, in effect, gambling in the housing and credit markets
and threatening the stability of the entire financial system.
enough—generally sold in multiples of $ 1 million—to appeal to
major corporations. Negotiable CDs would be confined to short
maturities, ranging from seven days to one or two years in most
cases, but concentrated mainly in the one- to six-month maturity
range for the convenience of CD buyers. And the new instrument
would be negotiable—able to be sold in the secondary market
any number of times before reaching maturity—in order to pro­
vide corporate customers with liquidity. To make the sale of nego­
tiable CDs in advance of their maturity easier, they were issued in
bearer form. Moreover, several dealers agreed to make a regular
market in negotiable CDs carrying maturities of six months or less.
The negotiable CD was an almost instant success. Large-
denomination CDs grew from almost zero in the early 1960s to
nearly $2 trillion as recently as 2011. As with all liability manage­
ment instruments, management can control the quantity of CDs
outstanding simply by varying the yield offered to CD customers.
Interest rates on fixed-rate CDs, which represent the major­
ity of all large negotiable CDs issued, are quoted on an
C h ap ter 13 Managing N ondeposit Liabilities ■ 257
interest-bearing basis, and the rate is computed assuming a
360-day year. For example, suppose a depository institution
promises an 8 percent annual interest rate to the buyer of a
$100,000 six-month (180-day) CD. The depositor will have the
following at the end of six months:
Amount
Days to maturity
due = Principal + Principal X X
360 days
CD customer
180
= $ 1 0 0 , 0 0 0 + $ 1 0 0 , 0 0 0 x — - x 0.08
360
= $104,000
CDs that have maturities over one year normally pay interest
to the depositor every six months. Variable-rate CDs have their
interest rates reset after a designated period of time (called a
leg or roll period). The new rate is based on a mutually accepted
reference interest rate, such as the London Interbank Offer Rate
(LIBOR) attached to borrowings of Eurodollar deposits or the
average interest rate prevailing on prime-quality CDs traded in
the secondary market.
The net result of CD sales to customers is often a simple transfer
of funds from one deposit to another within the same deposi­
tory institution, particularly from checkable deposits into CDs.
The selling institution gains loanable funds even from this
simple transfer because, in the United States at least, legal
reserve requirements are currently zero for CDs, while checking
accounts at the largest depository institutions carry a reserve
requirement of 10 percent. Also, deposit stability is likely to be
greater for the receiving depository institution because the CD
normally will not be withdrawn until maturity. In contrast, check­
able (demand) deposits can be withdrawn at any time. However,
the sensitive interest rates attached to the largest negotiable
CDs mean that depository institutions must work harder to com­
bat volatile earnings and make aggressive use of rate-hedging
techniques. Nevertheless, this is a popular borrowing medium
due to its modest cost, large volume of funds available, and
flexibility.
The Eurocurrency Deposit Market
The development of the U.S. negotiable CD market came on the
heels of another deposit market that began in Europe during the
1950s—the Eurocurrency deposit market. Eurocurrency depos­
its were developed originally in Western Europe to provide liq­
uid funds that could be swapped among multinational banks or
loaned to the banks' largest customers. Most such international
borrowing and lending has occurred in the Eurodollar market.
Eurodollars are dollar-denominated deposits placed in bank
offices outside the United States. Because they are denomi­
nated on the receiving banks' books in dollars rather than in the
258 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
currency of the home country and consist of accounting entries
in the form of time deposits, they are not spendable on the
street like currency. 3
The banks accepting these deposits may be foreign branches of
U.S. banks overseas, or international banking facilities (IBFs) set up
on U.S. soil but devoted to foreign transactions on behalf of a par­
Annual rate
ent U.S. bank. The heart of the worldwide Eurodollar market is in
of interest
London, where British banks compete with scores of American and
other foreign banks for these deposits. The Eurocurrency market is
(13.2)
the largest unregulated financial market-place in the world.
A domestic financial firm can tap the Euromarket for funds by
contacting one of the major international banks that borrow
and lend Eurocurrencies every day. The largest U.S. banks also
use their own overseas branches to tap this market. When one
of these branches lends a Eurodeposit to its home office in the
United States, the home office records the deposit in an account
labeled liabilities to foreign branches. When a U.S. financial
firm borrows Eurodeposits from a bank operating overseas, the
transaction takes place through the correspondent banking sys­
tem. The lending bank will instruct a U.S. correspondent bank
where it has a deposit to transfer funds in the amount of the
Eurocurrency loan to the correspondent account of the borrow­
ing institution. These borrowed funds will be quickly loaned to
qualified borrowers or, perhaps, used to meet a reserve deficit.
Later, when the loan falls due, the entries on the books of cor­
respondent banks are reversed. This process of borrowing and
lending Eurodollars is traced out in Table 13.7.
Most Eurodollar deposits are fixed-rate time deposits. Begin­
ning in the 1970s, however, floating-rate CDs (FRCDs) and
floating-rate notes (FRNs) were introduced in an effort to pro­
tect banks and their Eurodepositors from the risk of fluctuating
interest rates. FRCDs and FRNs tend to be medium to long
term, stretching from 1 year to as long as 20 years. The offer
rates on these longer-term negotiable deposits are adjusted,
usually every three to six months, based upon interest rate
movements in the interbank Euromarket. The majority of Euro­
deposits mature within six months; however, some are as short
as overnight. Most are interbank liabilities whose interest yield
is tied closely to LIBOR—the interest rate money center banks
quote each other for the loan of short-term Eurodeposits. Large-
denomination Euro CDs issued in the interbank market are
called tap CDs, while smaller-denomination Euro CDs sold to a
wide range of investors are called tranche CDs. As with domes­
tic CDs, there is an active resale market for these deposits.
3ln general, whenever a deposit is accepted by a bank denominated
in the units of a currency other than the home currency, that deposit is
known as a Eurocurrency deposit. While the Eurocurrency market began
in Europe (hence the prefix Euro), it reaches worldwide today.
Table 13.7 U .S. Bank Borrowing Eurodollars from Foreign Banks

Step 1. Loan Is Made to a U.S. Bank from a Foreign Bank in the Eurodollar Market
U.S. Bank Serving
U.S. Bank as Correspondent Foreign Bank
Borrowing Eurodollars to a Foreign Bank Lending Eurodollars
Assets Liabilities Assets Liabilities Assets Liabilities
Deposits Deposits Deposits due to Deposits at U.S.
held at due to foreign bank - 1 0 0 correspondent
other foreign bank - 1 0 0

banks +1 0 0 bank + 1 0 0

(Eurodollars
Deposits of U.S. Eurodollar loan
borrowed)
correspondent to U.S. bank +100
bank doing
the borrowing + 1 0 0

(Eurodollars
borrowed)
Step 2. Loan Is Repaid by the Borrowing U.S. Bank
U.S. Bank Serving
U.S. Bank as Correspondent Foreign Bank
Borrowing Eurodollars to a Foreign Bank Lending Eurodollars
Assets Liabilities Assets Liabilities Assets Liabilities
Deposits Deposits Deposits due to Deposits at U.S.
held at due to foreign bank + 1 0 0 correspondent
other foreign bank +1 0 0
banks - 1 0 0 bank — 1 0 0

(Eurodollars
Deposits of U.S. Eurodollar loan
borrowed)
correspondent to U.S. bank - 1 0 0

bank doing
the borrowing - 1 0 0

(Eurodollars
borrowed)

Major banks and their large corporate customers practice arbi-
trage between the Euro and American CD markets. For example,
if domestic CD rates were to drop significantly below Euro interest
rates on deposits of comparable maturity, a bank or its corporate
customers could borrow in the domestic CD market and lend those
funds offshore in the Euromarket. Similarly, an interest rate spread in
the opposite direction might well lead to increased Euroborrowings
with the proceeds flowing into CD markets inside the United States.
Commercial Paper Market
During the 1960s and 1990s large banks and finance companies
faced with intense demand for loans found a new source of
loanable funds—the commercial paper market. Commercial
paper consists of short-term notes, with maturities normally
ranging from three or four days to nine months, issued by
well-known companies to raise working capital. The notes are
generally sold at a discount from face value through security
dealers or through direct contact with the issuing company.
A substantial portion of this paper—often called industrial
paper—is designed to finance the purchase of inventories of
goods or raw materials and to meet other immediate cash
needs of nonfinancial companies. Another form of commercial
paper—usually called finance paper—is issued mainly by finance
companies (such as GE Capital Corporation) and the affiliates
of financial holding companies (such as HSBC Finance Corpo­
ration). The proceeds from issuing finance paper can be used
to purchase loans off the books of other financial firms in the
same organization, giving these institutions additional funds to
make new loans. Table 13.8 summarizes the process of indirect
borrowing through commercial paper issued by affiliated firms.
This funds source tends to be high in volume and moderate in
cost but also volatile in available capacity and subject to credit
risk. Recently foreign banks, such as Barclays Capital, have

C h ap ter 13 Managing Nondeposit Liabilities ■ 259

Table 13.8 Commercial Paper Borrowing by a Holding Company That Channels the Borrowed Funds to One
of Its Affiliated Lending Institutions
Step 1. Commercial Paper Is Sold by an Affiliat*?d Corporation in the Money Market
Lending Institution
Liabilities
Assets and Net Worth
Step 2. The Affiliated Corporation Purchases Loans from Lenders That Are Part of the Same Organization
Lending Institution
Liabilities
Assets and Net Worth
Loans -100
Reserves +100
accelerated their mining of both European and American paper
markets despite the pressures of the Great Recession.
Long-Term Nondeposit Funds Sources
The nondeposit sources of funds discussed to this point are
mainly short-term borrowings. The loans involved usually range
from hours to days, occasionally stretching into weeks or months.
However, many financial firms also tap longer-term nondeposit
funds stretching well beyond one year. Examples include mort­
gages issued to fund the construction of buildings and capital
notes and debentures, which usually range from 5 to 12 years in
maturity and are used to supplement equity (owners') capital.
These longer-term nondeposit funds sources have remained
relatively modest over the years due to regulatory restrictions
and the augmented risks associated with long-term borrowing.
CONCEPT CHECK
13.9. What are the advantages of borrowing from the Fed­
eral Reserve banks or other central banks? Are there
any disadvantages? What is the difference between
primary, secondary, and seasonal credit? What is a
Lombard rate, and why might such a rate be useful in
achieving monetary policy goals?
13.10. How is a discount window loan from the Federal
Reserve secured? Is collateral really necessary for
these kinds of loans?
260 Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
filiated Corporation
Liabilities
Assets and Net Worth
Cash account +1 0 0 Commercial
paper + 1 0 0
filiated Corporation
Liabilities
Assets and Net Worth
Cash account - 1 0 0
Loans
purchased
from lending
institution +1 0 0
Also, because most assets and liabilities held by depository insti­
tutions are short- to medium-term, issuing long-term indebted­
ness creates a significant maturity mismatch. Nevertheless, the
favorable leveraging effects of such debt have made it attractive
to larger financial firms in recent years.
Because of the long-term nature of these funding sources,
they tend to be a sensitive barometer of the perceived risk
exposure (particularly the risk of default) of their issuing insti­
tutions. In 1990, for example, when there were fears of major
bank defaults, the capital notes of troubled Southeast Banking
Corp. and the Bank of Boston carried annual yields of close to
20 percent, while notes issued by the Bank of New England
were trading at a discount equal to only about one-fifth of their
face value. By 2010 nearly $150 billion in capital notes and
debentures (subordinated to the claims of depositors) had been
issued by U.S. insured depository institutions.
13.11. Posner State Bank borrows $10 million in primary
credit from the Federal Reserve Bank of Cleveland.
Can you show the correct entries for granting and
repaying this loan?
13.12. Which institutions are allowed to borrow from the
Federal Home Loan Banks? Why is this source so
popular for many institutions?
13.13. Why were negotiable CDs developed?
 13.14. What are the advantages and disadvantages of CDs
as a funding source?
13.15. Suppose a customer purchases a $1 million 90-day
CD, carrying a promised 6 percent annualized yield.
How much in interest income will the customer earn
when this 90-day instrument matures? What total vol­
ume of funds will be available to the depositor at the
end of 90 days?
13.16. Where do Eurodollars come from?
13.17. How does a bank gain access to funds from the Euro­
currency markets?
13.18. Suppose that JP Morgan Chase Bank in New York
elects to borrow $250 million from Barclays Bank in
London and loans the borrowed funds for a week to a
13.4 CH O O SIN G AM ON G
ALTERNATIVE N O N D EPO SIT
SO U RCES
With so many different nondeposit funds sources to draw upon,
managers of financial firms must make choices among them. In
using nondeposit funds, funds managers must answer the fol­
lowing key questions:
1. How much in total must be borrowed from these sources to
meet funding needs?
2. Which nondeposit sources are best, given the borrowing
institution's goals, at any moment in time?
Measuring a Financial Firm's Total Need
for Nondeposit Funds: The Available
Funds Gap
The demand for nondeposit funds is determined basically by the
size of the gap between the institution's total credit demands
and its deposits and other available monies. Managers respon­
sible for the asset side of the institution's balance sheet must
choose which of a wide variety of customer credit requests they
will meet by adding direct loans and investment securities to
the institution's asset portfolio. Management must be prepared
to meet, not only today's credit requests, but all those it can
reasonably anticipate in the future. This means that projections
of current and anticipated credit demands must be based on
knowledge of the current and probable future funding needs of
each institution's customers, especially its largest borrowers. Such
projections should not be wild guesses; they should be based on
security dealer, and then returns the borrowed funds.
Can you trace through the resulting accounting entries?
13.19. What is commercial paper? What types of organiza­
tions issue such paper?
13.20. Suppose that the finance company affiliate of Citi­
group issues $325 million in 90-day commercial paper
to interested investors and uses the proceeds to pur­
chase loans from Citibank. What accounting entries
should be made on the balance sheets of Citibank
and Citigroup's finance company affiliate?
13.21. What long-term nondeposit funds sources do banks
and some of their closest competitors draw upon
today? How do these interest costs differ from those
costs associated with most money market borrowings?
information gathered from frequent contacts between the finan­
cial firm's officers and both existing and potential customers.
The second decision that must be made is how much in deposits
and other available funds is likely to be attracted in order to finance
the desired volume of loans and security investments. Projections
must be made of customer deposits and withdrawals, with special
attention to the largest customers. Deposit projections must take
into account current and future economic conditions, interest rates,
and the cash flow requirements of the largest customers.
The difference between current and projected outflows and
inflows of funds yields an estimate of each institution's available
funds gap. Thus,
Available funds = Current and projected loans and
gap (AFG) investments the lending institution
desires to make - Current and (13.3)
expected deposit inflows and other
available funds
For example, suppose a commercial bank has new loan requests
that meet its quality standards of $150 million; it wishes to pur­
chase $75 million in new Treasury securities being issued this
week and expects drawings on credit lines from its best corpo­
rate customers of $135 million. Deposits and other customer
funds received today total $185 million, and those expected in
the coming week will bring in another $100 million. This bank's
estimated available funds gap (AFG) for the coming week will be
as follows (in millions of dollars):
AFG = ($150 + $75 + $135) - ($185 + $100)
= $306 - $285
= $75
C h ap ter 13 Managing N ondeposit Liabilities ■ 261
Most institutions will add a small amount to this available funds
gap estimate to cover unexpected credit demands or unantici­
pated shortfalls in deposits and other inflowing funds. Various
nondeposit funds sources then may be tapped to cover the esti­
mated funds gap.
Nondeposit Funding Sources: Factors
to Consider
Which nondeposit sources will management use to cover a
projected available funds gap? The answer to that question
depends largely upon five factors:
1. The relative costs of raising funds from each source.
2. The risk (volatility and dependability) of each funding source.
3. The length of time (maturity or term) for which funds are
needed.
A sample of interest rates on money market borrowings, aver­
aged over selected years, is shown in Table 13.9. Note that the
various funds sources vary significantly in price—the interest
rate the borrowing institution must pay for use of the money.
Among the cheapest short-term borrowed funds source is usu­
ally the prevailing effective interest rate on Federal funds loaned
overnight to borrowing institutions. In most cases the interest
rates attached to domestic CDs and Eurocurrency deposits
are slightly higher than the Fed funds rate. Commercial paper
(short-term unsecured notes) normally may be issued at inter­
est rates slightly above the Fed funds and CD rates, depend­
ing upon maturity and time of issue. Today the discount rate
attached to loans from the Federal Reserve banks (known as the
primary credit rate) is generally among the highest short-term
borrowing rates because this form of Federal Reserve credit
is generally priced above the central bank's target for the Fed
funds rate.

4. The size of the institution that requires more funds.
5. Regulations limiting the use of alternative funds sources.
Relative Costs
Managers of financial institutions practicing liability manage­
ment must constantly be aware of the going market interest
rates attached to different sources of borrowed funds. Major
lenders post daily interest rates at which they are willing to com­
mit funds to other financial firms in need of additional reserves.
In general, managers would prefer to borrow from the cheapest
sources of funds, although other factors do play a role.
Although low compared to most other borrowing rates, the
effective Fed funds rate prevailing in the marketplace tends
to be volatile, fluctuating around the central bank's target
(intended) Fed funds rate. The key advantage of Fed funds is
their ready availability through a simple phone call or online
computer request. Moreover, their maturities often are flex­
ible and may be as short as a few hours or last as long as
several months. The key disadvantage of Fed funds is their
volatile market interest rate—its often wide fluctuations (espe­
cially during the settlement day that depository institutions
are trying to meet their legal reserve requirements) that make
planning difficult.

Table 13.9 Money Market Interest Rates Attached to Nondeposit Borrowings and Large ($100,000 + ) CDs
Interest Rate Averages Quoted for the Years

Sources of Borrowed Funds 1994 1996 1998 2000 2002 2004 2005 2007 2010*

Federal funds borrowings 4.47% 5.30% 5.35% 6.24% 1.34% 1.35% 3.22% 5.02% 0.17%
Borrowings from the Federal 3.76 5.00 4.98 5.50 1.25 2.34 4.19 5.86 0.72
Reserve banks**
Selling commercial paper 4.65 5.43 n.a. 6.27 1 .6 8 1.41 3.27 5.07 0 .2 0

(1 -month, directly placed)

Issuing negotiable CDs 4.60 5.35 5.49 6.35 1.39 1.45 3.34 5.23 0.26
(secondary market, 1 -month)
Selling Eurodollar deposits 4.80 5.38 5.44 6.45 1.39 1.55 3.51 5.32 0.39
(3-month maturities)
Notes: *Selected figures based on year-end interest rates.
**Posted by the Federal Reserve banks. Beginning in 2003 the quoted discount rate on loans from the Federal Reserve banks is the primary credit
rate, initially set at 100 basis points above the Fed's target for the Federal funds rate, but then changed more recently to a range around 50 basis
points above the Federal funds interest rate target.
Source: Board of Governors of the Federal Reserve System.

262 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent

Factoids
What interest rate attached to nondeposit borrowings tends
to be among the lowest?
Answer: The effective Federal funds rate is often among the
lowest borrowing rate for depository institutions.
Is the Fed funds interest rate usually the absolute lowest in
the money market?
Answer: No, the interest rate on the shortest-term U.S. Trea­
sury bills is often slightly lower than the Fed funds rate.
In contrast, market interest rates on CDs and commercial paper
are usually somewhat more stable, but generally hover close
to and slightly above the Fed funds rate due to their longer
average maturity and because of the marketing costs spent
in finding buyers for these instruments. CDs and commercial
paper usually are less popular in the short run than Fed funds
and borrowings from the central bank's discount window when
a depository institution needs money right away. In contrast, CD
and commercial paper borrowings are usually better for longer-
term funding needs that stretch over several days or weeks.
The rate of interest is usually the principal expense in borrowing
nondeposit funds. However, noninterest costs cannot be ignored
in calculating the true cost of borrowing nondeposit funds, includ­
ing the time spent by management and staff to find the best
funds sources each time new money is needed. A good formula
for doing cost comparisons among alternative sources of funds is:
Note that the cost associated with attracting each funds source
is compared to the net amount of funds raised after deductions
are made for reserve requirements (if any), insurance fees, and
that portion of borrowed funds diverted into such nonearn­
ing assets as excess cash reserves or fixed assets. We use net
investable funds as the borrowing base because we wish to
compare the dollar cost that must be paid out to attract bor­
rowed funds relative to the dollar amount of those funds that
can actually be used to acquire earning assets and cover the
cost of fund-raising.
Let's see how the above formulas might be used to estimate
the real cost of borrowing funds. Suppose that Fed funds are
currently trading at an interest rate of 6.0 percent. Moreover,
management estimates that the marginal noninterest cost, in the
form of personnel expenses and transactions fees, from raising
additional monies in the Fed funds market is 0.25 percent. Sup­
pose that a depository institution will need $25 million to fund
the loans it plans to make today, of which only $24 million can
be fully invested due to other immediate cash demands. Then
the effective annualized cost rate for Fed funds would be calcu­
lated as follows:
Current interest cost
= 0.06 X $25 million = $1.5 million
on Federal funds
Noninterest cost to
= 0.0025 X $25 million = $0,063 million
access Federal funds
Net investable
= $25 million - $1 million — $24 million
funds raised

Current interest Noninterest costs Therefore, the effective annualized Fed funds cost rate is
Effective cost
cost on amounts + incurred $1.5 million + $0,063 million
rate on ---------- $ 2 4 mi||bn---------- = 0.0651 or 6.51 percent
borrowed to access these funds
deposit
Net investable funds raised
and nondeposit The depository institution in the above example would have
from this source
sources of funds (13.4) to earn a net annualized return of at least 6.51 percent on the
loans and investments it plans to make with these borrowed Fed
where
funds just to break even.
Prevailing interest
Current interest cost Amount of funds Suppose management decides to consider borrowing funds
rate in the money X
on amounts borrowed borrowed by issuing negotiable CDs that carry a current interest rate of
market
(13.5) 7.00 percent. Moreover, raising CD money costs 0.75 percent in
noninterest costs. Then the annualized cost rate incurred from
Estimated cost selling CDs would be as follows:
Noninterest costs to rate representing ^ Amount of funds
access funds staff time, facilities, borrowed Effective CD (0.07 X $25 million + $0.0075 X $25 million)
and transaction costs , „ cost rate $24 million
(13.6)
_ $1.75 million + $0.1875 million
Total amount borrowed less legal reserve $24 million
Net investable funds _ requirements (if any), deposit insurance = 0.0807 or 8.07 percent
raised assessments (if any), and funds placed
in nonearning assets An additional expense associated with selling CDs to raise
(13.7) money is the deposit insurance fee. In the United States this fee

Chapter 13 Managing Nondeposit Liabilities ■ 263

varies with the risk and capitalization of each depository institu­
tion whose deposits are insured by the Federal Deposit Insur­
ance Corporation (FDIC).
To illustrate how the FDIC insurance fee works assume the
current insurance rate is $0.0027 per dollar of deposits—a
fee sometimes charged the riskiest insured depository insti­
tutions. (We should note as well that the FDIC requires an
insured depository institution to pay this insurance fee not
just on the actual insured portion of a customer's deposit
account but on the full face amount (beyond the insured
amount) of each deposit received from the public.) Thus, the
total insurance cost for the riskiest depository institutions on
the $25 million we are talking about raising through selling
CDs would be
Total deposits
Insurance fee
received from X $25 million X 0.0027
per dollar
the public (13.8)
$67,500 or $0.0675 million
If we deduct this fee from the new amount of CDs actually avai
able for use, we get:
Effective CD _ $1.9375 million
cost rate $24 million - $0.0675 million
$1.9375 million
0.0810 or 8 .1 0 percent
$23,925 million
Clearly, issuing CDs would be more expensive in the above
example than borrowing Fed funds. However, CDs have the
advantage of being available for several days, weeks, months, or
years, whereas Fed funds loans must often be repaid in 24 hours.
Nondeposit sources of funds generally are moderate in cost
compared to other funding sources. Nondeposit funds tend to
be more expensive than checkable deposits but less expensive
than thrift (time and savings) deposits. We must add a note of
caution here, however, because the costs and the profits associ­
ated with nondeposit funds tend to be more volatile from year
to year than the cost and profitability of deposits. Nondeposit
funds do have the advantage of quick availability compared to

FIGURING THE OVERALL COST OF FUNDS

In our discussion of determining how much each source of borrowed funds costs, we looked at each funding source separately.
However, borrowing institutions draw simultaneously on not one, but many different funds sources, including deposits, nonde­
posit borrowings, and owner's equity capital. Can we find a method for determining the cost of funding that brings together all
the sources of funding normally in use?
The answer is yes. Here we examine two of the most popular overall funds cost methods—the historical average cost approach
and the pooled-funds approach.

The Historical Average Cost Approach

This approach for determining how much funds cost looks at he past. It asks what funds the financial firm has raised to date and
what they cost.

Average Amount of Average Rate of Total Interest Paid for Each

Sources of Funds Drawn Upon Funds Raised (millions) Interest Incurred Funds Source (millions)

Noninterest-bearing demand deposits $ 1 0 0 0 % $ 0

Interest-bearing transaction deposits 2 0 0 7% 14

Savings accounts 1 0 0 5% 5
Time deposits 500 8 % 40
Money market borrowings 1 0 0 6 % 6

Total funds raised = $1,000 All interest costs = $65

Then the average interest cost of deposits and money market borrowings is:

Weighted
All interest paid $65
average interest = = 6.5 percent
Total funds raised $ 1,000
expense

264 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
But other operating costs, such as salaries and overhead, must also be covered. If these are an estimated $10 million, we have

Break-even
cost rate Interest + Other
on borrowed operating costs $65 + 10
= 10 percent
funds invested All earning assets $750
in earning
assets
This cost rate is called break-even because the borrowing institution must earn at least this rate on its earning assets
(primarily loans and securities) just to meet the total operating costs of raising borrowed funds. But what about the bor­
rowing institution's stockholders and their required rate of return (assumed hereto be 1 2 percent after taxes)?
Weighted Before-tax cost of the
Break-even
average stockholders'
cost on
overall investment
borrowed
cost of in the
funds
capital borrowing institution
After-tax cost of
stockholders' Stockholders'
Break-even investment investment
cost (1 — Tax rate) Earning assets

1 2 percent 1 0 0
= 10 percent + —— — — X = 1 0 percent + 2.5 percent
(1 —0.35) 750
= 12.5 percent

Thus, 12.5 percent is the lowest rate of return over all fund-raising costs the borrowing institution can afford to earn on its
assets if its equity shareholders invest $ 1 0 0 million in the institution.

The Pooled-Funds Approach

This method of costing borrowed funds looks at the future: What minimum rate of return must be earned on any future loans
and investments just to cover the cost of all new funds raised? Suppose our estimate for future funding sources and costs is as
follows:

Interest
Expense and
Dollars of New Portion of New Dollar Amount Other Operating
Deposit and Borrowings That Can Be Expenses of All Operating
Nondeposit That Will Be Placed in Borrowing Expenses
Profitable New Deposits Borrowings Placed in New Earning Assets Relative to Incurred
and Nondeposit Borrowings (millions) Earning Assets (millions) Amounts Raised (millions)

Interest-bearing transaction
deposits $ 1 0 0 50% $50 8 % $ 8

Time deposits 1 0 0 60% 60 9% 9

New stockholders' investment
in the institution 1 0 0 90% 90 13% 13
Total $300 $ 2 0 0 $30

(Continued)

C h ap ter 13 Managing Nondeposit Liabilities ■ 265

 The overall cost of new deposits and other borrowing sources must be

Pooled
All expected
deposit and
operating expenses $30 million
nondeposit = = 1 0 percent
All new $300 million
funds
funds expected
expense

But because only two-thirds of these expected new funds ($200 million out of $300 million raised) will actually be available to
acquire earning assets,
Hurdle All expected
rate of return _ operating costs $30 million
overall Dollars available million =
$ 2 0 0 15 perCent
earning assets to place in
earning assets
Thus, the borrowing financial firm in the example above must earn at least 15 percent (before taxes), on average, on all the new
funds it invests to fully meet its expected fund-raising costs.

most types of deposits, but they are clearly not as stable a fund­
ing source for most institutions as time and savings deposits.
The Risk Factor
The managers of financial institutions must consider at least
two types of risk when selecting among different nondeposit
sources. The first is interest rate risk—the volatility of credit
costs. All the interest rates shown in Table 13.9, except most
central banks' discount rates, are determined by demand and
supply forces in the open market and therefore are subject to
erratic fluctuations. The shorter the term of the loan, the more
volatile the prevailing market interest rate tends to be. Thus,
most Fed funds loans are overnight and, not surprisingly, this
market interest rate tends to be the most volatile of all.
Management must also consider credit availability risk. There
is no guarantee in any credit market that lenders will be willing
and able to accommodate every borrower. When general credit
conditions are tight, lenders may have limited funds to loan and
may ration credit, confining loans only to their soundest and
most loyal customers. Sometimes a financial firm may appear so
risky to money market lenders they will deny credit or make the
price so high that its earnings will suffer. Experience has shown
that the negotiable CD, Eurodollar, and commercial paper mar­
kets arc especially sensitive to credit availability risks. Funds
managers must be prepared to switch to alternative sources of
credit and, if necessary, pay more for any funds they receive.
The Length of Time Funds Are Needed
As we have seen, some funds sources may be difficult to access
immediately (such as commercial paper and long-term debt
capital). A manager in need of loanable funds this afternoon
would be inclined to borrow in the Fed funds market. However,
if funds are not needed for a few days, selling longer-term debt
becomes a more viable option. Thus, the term, or maturity, of
the funds need plays a key role as well.
The Size of the Borrowing Institution
The standard trading unit for most money market loans is
$ 1 million—a denomination that may exceed the borrowing
requirements of the smallest financial institutions. For example,
Eurodollar borrowings are in multiples of $1 million and usually
are available only to money-center financial firms with the high­
est credit ratings. Large negotiable CDs from the largest deposi­
tory institutions are preferred by most investors because there is
an active secondary market for prime-rated CDs. Smaller depos­
itory institutions may not have the credit standing to be able to
sell the largest negotiable CDs. The same is true of commercial
paper. In contrast, the central bank's discount window and the
Fed funds market can make relatively small denomination loans
that are suitable for smaller depository institutions.
Regulations
Federal and state regulations may limit the amount, frequency,
and use of borrowed funds. For example, in the United States CDs
must be issued with maturities of at least seven days. The Federal
Reserve banks may limit borrowings from the discount window,
particularly by depository institutions that appear to display sig­
nificant risk of failure. Other forms of borrowing may be subjected
to legal reserve requirements by action of the central bank. For
example, during the late 1960s and early 1970s, when the Fed­
eral Reserve was attempting to fight inflation with tight-money
policies, it imposed legal reserve requirements for a time on Fed

266 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent

CONCEPT CHECK
13.22. What is the available funds gap?
13.23. Suppose JP Morgan Chase Bank of New York
discovers that projected new loan demand next
week should total $325 million and customers
holding confirmed credit lines plan to draw down
$510 million in funds to cover their cash needs
next week, while new deposits next week are pro­
jected to equal $680 million. The bank also plans
to acquire $420 million in corporate and govern­
ment bonds next week. What is the bank's pro­
jected available funds gap?
13.24. What factors must the manager of a financial insti­
tution weigh in choosing among the various non­
deposit sources of funding available today?
funds borrowing, repurchase agreements, and commercial paper
issued to purchase assets from affiliated lending institutions. While
these particular requirements are not currently in force, it seems
clear that in times of national emergency, government policymak­
ers would move swiftly to impose new controls, affecting both the
costs and risks associated with nondeposit borrowings.
SUM M ARY *•
Although the principal funding source for many financial institu­
tions is deposits, nearly all depository institutions today supple­
ment the funds they attract through sales of deposits with
nondeposit borrowings in the money and capital markets. In
this chapter we explore the most important nondeposit funds
sources and the factors that bear on the managerial decision
about which sources of funds to draw upon. The key points in
the chapter include:
• Today's heavy use of nondeposit borrowings by depository insti­
tutions arose with the development of liability management,
which calls upon managers of financial institutions to actively
manage their liabilities as Well as their assets on the balance
sheet and to use market interest rates as the control lever.
K E Y TERM S
customer relationship doctrine, 248 discount window, 255
liability management, 248 negotiable CD, 256
Federal funds market, 250 Eurocurrency deposit, 258
repurchase agreements (RPs), 252 commercial paper market, 259
• The use of nondeposit borrowings as a key source of funds
was given a boost by the emergence of the customer
relationship doctrine. This managerial strategy calls for put­
ting the goal of satisfying the credit requests of all quality
customers at the top of management's list. If deposits are
inadequate to fund all quality loan requests, other sources of
funds, including borrowings in the money and capital mar­
kets, should be used. Thus, the lending decision comes first,
followed by the funding decision.
• One of the key sources of nondeposit funds today is the
Federal funds market, where immediately available reserves
are traded between financial institutions and usually returned
within 24 hours. Borrowing from selected government
agencies—in the United States, the discount windows of the
Federal Reserve banks and advances from die Federal Home
Loan banks—has also grown rapidly in recent years.
• Other key funds sources include selling negotiable jumbo
($100,000+) CDs, borrowing Eurocurrency deposits from
international firms offshore, issuing commercial paper in the
open market through affiliated corporations, executing repur­
chase agreements where loans collateralized by top-quality
assets are made available for a few hours or days, or pursuing
longer-term borrowings in the capital markets through the
issuance of longer-term debt.
• Before tapping nondeposit borrowings, however, the
managers of financial firms must estimate their funding
requirements. One such estimate for a depository institution
comes from the available funds gap, the spread between the
current and expected volume of loans and investments and
the current and expected volume of funds sources.
• The particular nondeposit funds source(s) chosen by man­
agement will rest upon such factors as ( 1 ) the relative cost
of each source; (2 ) the risk or dependability of each funds
source; (3) the length of time funds will be needed; (4) the
size of the borrowing institution and its funding needs;
and (5) the content of government regulations affecting
fund-raising.
• Among the most important government regulations bearing
on the use of nondeposit funds are legal reserve require­
ments imposed by central banks around the world and rules
dictating the content of contractual agreements when funds
are loaned by one financial institution to another.
available funds gap, 261
interest rate risk, 266
credit availability risk, 266
C h ap ter 13 Managing Nondeposit Liabilities ■ 267
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
PROBLEM S AND PRO JECTS
1. Robertson State Bank decides to loan a portion of its
reserves in the amount of $70 million held at the Fed­
eral Reserve Bank to Tenison National Security Bank for
24 hours. For its part, Tenison plans to make a 24-hour
loan to a security dealer before it must return the funds to
Robertson State Bank. Please show the proper accounting
entries for these transactions.
2. Masoner Savings, headquartered in a small community,
holds most of its correspondent deposits with Flagg Metro-
center Bank, a money center institution. When Masoner has
a cash surplus in its correspondent deposit, Flagg automat­
ically invests the surplus in Fed funds loans to other money
center banks. A check of Masoner's records this morning
reveals a temporary surplus of $11 million for 48 hours.
Flagg will loan this surplus for two business days to Secoro
Central City Bank, which is in need of additional reserves.
Please show the correct balance sheet entries to carry out
this loan and to pay off the loan when its term ends.
3. Relgade National Bank secures primary credit from the
Federal Reserve Bank of San Francisco in the amount
of $32 million for a term of seven days. Please show the
proper entries for granting this loan and then paying off
the loan.
4. Shad Corporation purchases a 60-day negotiable CD with a
$5 million denomination from Bait Bank and Trust, bearing a
2.95 percent annual yield. How much in interest will the bank
have to pay when this CD matures? What amount in total will
the bank have to pay back to Shad at the end of 60 days?
5. Deep Valley Bank borrows $125 million overnight through
a repurchase agreement (RP) collateralized by Treasury
bills. The current RP rate is 2.50 percent. How much will the
bank pay in interest cost due to this borrowing?
6 . Thyme Bank of New York expects new deposit inflows next
month of $265 million and deposit withdrawals of $425 mil­
lion. The bank's economics department has projected that
new loan demand will reach $400 million and customers
with approved credit lines will need $175 million in cash.
The bank will sell $450 million in securities, but plans to
add $60 million in new securities to its portfolio. What is its
projected available funds gap?
7. Wells Fargo Bank borrowed $150 million in Fed funds from
JP Morgan Chase Bank in New York City for 24 hours to
fund a 30-day loan. The prevailing Fed funds rate on loans
268 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
of this maturity stood at 2.25 percent when these two insti­
tutions agreed on the loan. The funds loaned by Morgan
were in the reserve deposit that the bank keeps at the
Federal Reserve Bank of New York. When the loan to Wells
Fargo was repaid the next day, JP Morgan used $50 million
of the returned funds to cover its own reserve needs and
loaned $100 million in Fed funds to Bank of America, Char­
lotte, for a two-day period at the prevailing Fed funds rate
of 2.40 percent. With respect to these transactions, (a) con­
struct T-account entries similar to those you encountered
in this chapter, showing the original Fed funds loan and its
repayment on the books of JP Morgan, Wells Fargo, and
Bank of America and (b) calculate the total interest income
earned by JP Morgan on both Fed funds loans.
8. Blue Skies Bank of Florida issues a three-month (90-day)
negotiable CD in the amount of $20 million to ABC Insur­
ance Company at a negotiated annual interest rate of
2.75 percent (360-day basis). Calculate the value of this CD
account on the day it matures and the amount of interest
income ABC will earn. What interest return will ABC Insur­
ance earn in a 365-day year?
9. Banks and other lending affiliates within the holding com­
pany of Best-of-Times Financial are reporting heavy loan
demand this week from companies in the southeastern
United States that are planning a significant expansion of
inventories and facilities before the beginning of the fall
season. The holding company plans to raise $775 million in
short-term funds this week, of which about $700 million will
be used to meet these new loan requests. Fed funds are
currently trading at 2.25 percent, negotiable CDs are trad­
ing in New York at 2.40 percent, and Eurodollar borrowings
are available in London at all maturities under one year at
2.30 percent. One-month maturities of directly placed com­
mercial paper carry market rates of 2.35 percent, while the
primary credit discount rate of the Federal Reserve Bank
of Richmond is currently set at 2.75 percent—a source
that Best-of-Times has used in each of the past two weeks.
Noninterest costs are estimated at 0.25 percent for Fed
funds, discount window borrowings, and CDs; 0.35 percent
for Eurodollar borrowings; and 0.50 percent for commercial
paper. Calculate the effective cost rate of each of these
sources of funds for Best-of-Times and make a manage­
ment decision on what sources to use. Be prepared to
defend your decision.
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
10. Surfs-Up Security Savings is considering the problem of try­
ing to raise $80 million in money market funds to cover a
loan request from one of its largest corporate customers,
which needs a six-week loan. Assume that market interest
rates are at the levels indicated below:
Federal funds, average for week just concluded 1.98%
Discount window of the Federal Reserve Bank 2.25
CDs (prime rated, secondary market):
One month 2.52
Three months 2.80
Six months 3.18
Eurodollar deposits (three months) 3.00
Commercial paper (directly placed):
One month 2.33
Three months 2.70
Unfortunately, Surfs-Up's economics department is forecast­
ing a substantial rise in money market interest rates over the
next six weeks. What would you recommend to its funds
management department regarding how and where to raise
the money needed? Be sure to consider such cost factors as
legal reserve requirements, regulations, and what happens to
the relative attractiveness of each funding source if interest
rates rise continually over the period of the proposed loan.
Alternative scenario:
What if Surfs-Up's economists are wrong and money mar­
ket rates decline significantly over the next six weeks? How
would your recommendation to the funds management
department change on how and where to raise the funds
needed?
11. J une Bug Bank and Trust has received $750 million in total
funding, consisting of $ 2 0 0 million in checkable deposit
accounts, $400 million in time and savings deposits,
$100 million in money market borrowings, and $50 million
in stockholders' equity. Interest costs on time and savings
deposits are 2.50 percent, on average, while noninterest
costs of raising these particular deposits equal approxi­
mately 0.50 percent of their dollar volume. Interest costs
on checkable deposits average only 0.75 percent because
many of these deposits pay no interest, but noninterest
costs of raising checkable accounts are about 2 percent
of their dollar total Money market borrowings cost June
Bug an average of 2.75 percent in interest costs and
0.25 percent in noninterest costs. Management estimates
the cost of stockholders' equity capital at 1 2 percent before
taxes. (The bank is currently in the 35-percent corporate tax
bracket.) When reserve requirements are added in, along
with uncollected dollar balances, these factors are estimated
to contribute another 0.75 percent to the cost of securing
checkable deposits and 0.50 percent to, the cost of acquir­
ing time and savings deposits. Reserve requirements (on
Eurodeposits only) and collection delays add an estimated
0.25 percent to the cost of the money market borrowings.
a. Calculate June Bug's weighted average interest cost on
total funds raised, figured on a before-tax basis.
b. If the bank's earning assets total $700 million, what is its
break-even cost rate?
c. What is June Bug's overall historical weighted average
cost of capital?
12. Inspiration Savings Association is considering funding a
package of new loans in the amount of $400 million. Inspi­
ration has projected that it must raise $450 million in order
to have $400 million available to make new loans. It expects
to raise $325 million of the total by selling time deposits at
an average interest rate of 1.75 percent. Noninterest costs
from selling time deposits will add an estimated 0.45 per­
cent in operating expenses. Inspiration expects another
$125 million to come from noninterest-bearing transac­
tion deposits, whose noninterest costs are expected to be
2.00 percent of the total amount of these deposits. What
is the Association's projected pooled-funds marginal cost?
What hurdle rate must it achieve on its earning assets?
Internet Exercises
1. In terms of size, which banks in the U.S. financial system
seem to rely most heavily on deposits as a source of fund­
ing and which on nondeposit borrowings and liability man­
agement? To provide an example for the numbers reported
in Table 13.3, go to the FDIC's Institution Directory at
http://www2 .fdic.gov/idasp/ and search by city and state
to find a small bank holding company (BHC) located in your
hometown or somewhere you enjoy visiting. Write down
the BHC ID of your selected bank. Then go to www2
.fdic.gov/sdi/ to compare your small BHC with two larger
BHCs— Bank of America (BHC ID 1073757) and JP Morgan
Chase (BHC ID 1039502). Compare and contrast Deposits/
Total Assets and Liabilities/Total Assets for the three BHCs
to illustrate your point.
C h ap ter 13 Managing Nondeposit Liabilities ■ 269
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

If you need some help maneuvering around this site to 3. As a home mortgage lender, you are interested in borrow­
create a report, read on. The process to create a report ing from a Federal Home Loan Bank. First determine which
requires that you "Select the Number of Columns." You district you are in and then go to the bank in that district
want to select "3" to develop the format to collect data and find the interest rates on FHLB advances. The following
for the most recent report. This provides three pull-down site will get you started: www.fhlbanks.com.
menus, each labeled Select One. In the columns select 4. In this chapter you have been introduced to a number of
Bank Holding Company from the menu and go on to type instruments used for liability management. Repurchase
in the BHC ID #. After defining the three columns click on agreements are always a challenge. To learn a little more
Next. At this point, you focus on Report Selection, choos­ about these instruments go to http://www.ny.frb.org/
ing to View and to do calculations in Percentages. Then you cfcbsweb/Fleming.Bk_w.pdf. Who are the major partici­
get to identify the information you want to collect before pants in the RP market?
creating the report by clicking Next. You will find deposit
5. You have been introduced to the Eurodollar market.
and liability information in the Assets and Liabilities report.
To learn more about this market go to http://www
2. You are interested in borrowing from the discount window .richmondfed.org/publications/special_reports/
of the Federal Reserve Bank in your area. Go to www instruments_of_the_money_market/pdf/chapter_05.pdf.
.frbdiscountwindow.org/ and find out the current interest For market participants, what are the three basic sources of
rates at your FRB. What are they? risk associated with holding Eurodollars?

CASE ASSIGNMENT FOR CHAPTER 13

Your Bank's Use of Liability Management:
A Step Beyond Deposits
Liability management was first mentioned in Chapters 5 and the nondeposit sources of funds. We add negotiable CDs and
18 and further developed with the focus on sources of funds Eurodollar deposits to the nondeposit sources and we have
in Chapter 13. After deposits, where do bank managers go the materials most often used in liability management. We will
for funding? To the financial markets or, in the United States, once again visit the FDIC's SDI website located at www2.fdic
to the Federal Reserve banks and Federal Home Loan banks. .gov/sdi/to collect two items from the Memoranda section
These types of nondeposit borrowing are described in detail of the Assets and Liabilities report that may provide further
in this chapter. We will look at liabilities to see what they insights for your particular BHC and the peer group of large
reveal about our BHC's composition of sources of funds. banks (more than $10 billion in assets). You will create the
four-column report for your bank and the peer group across
Part One: Collecting the Data the two years. Access the Assets and Liabilities report using
the pull-down menus and collect the percentage information
We have already collected most of the data available to for the two items listed below. Once again, you will enter the
examine nondeposit sources of funds. In the spreadsheet percentages as illustrated using BB&T as an example.
used for comparisons with the peer group, rows 21-25 are

B C* ^ Real Numbers for Real Banks Chapter 13 - Microsoft Excel

File J Home | l.’.i. Page Layout Formulas Data Review View Acrobat Q Tell me what you want to do...

I*
OB
m
<X Cut
D (Tg Copy
Paste
*
Calibri * 11 * A A = 1= & / - [=7Wrap Text General

Conditional Format as |
Normal

|
Bad

...
Good Neutral Calculation
▼ ffl
Insert Delete Format
[T] Fil
B I U » FH ▼ ^ » ! § -= ±= ±= [ S Merge & Center - - % * *oo 4°o E x p la n a to ry Input Linked C ell Note ▼
Format Painter Formatting- Table- ▼ ^Cl
Clipboard r; Font Alignment ri Number Hi Styles Cells

A129 ^ * f* A dd itio n al Inform ation concerning Liab ilities

A B C D E F G H 1 J K L M N 0 P Q J R S T
129 A dd itio n al Inform ation co n cern in g L ia b ilitie s BB& T P e e r G roup BB&T P e e r G roup
130 Date 31-12-2010 31-12-2010 31-12-2009 31-12-2009
131 V o la tile lia b ilitie s 15.97% 29.42% 18.37% 32.08%
132 FHLB ad van ces 6.69% 1.98% 6.49% 3.09%
133
134
135
Basic Information Year-to-Year Com parisons C o m p ariso n s w ith Peer Group © : III__________ ~
Ready

270 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
Part Two: Analyzing the Data for Interpretation
A . Volatile liabilities include large-denomination time depos­
its, foreign-office deposits, Federal funds purchased,
securities sold under agreements to repurchase, and
other borrowings. These are the risk-sensitive sources
used in liability management You can compare the col­
umns of row 131 to get a sense of the proper answers
to the following questions; (1) Is your BHC increasing its
reliance on liability management? (2) Is your bank using
liability management more than its peers?
Selected References
For a fuller explanation of recent developments in nondeposit
funding see:
1. Fleming, Michael J.; and Kenneth D. Garbade. "The Repur­
chase Agreement Refined—The GCF Repo," Current Issues
in Economics and Finance, Federal Reserve Bank of New
York, vol. 9, No. 6 (June 2003), pp. 1-7.
2. Fleming, Michael J.; and Kenneth D. Garbade. "Repurchase
Agreements with Negative Interest Rates," Current Issues
in Economics and Finance, Federal Reserve Bank of New
York, vol. 10, no. 5 (April 2004), pp. 1-7.
3. Maloney, Daniel K.; and James B. Thomson. "The Evolv­
ing Role of the Federal Home Loan Banks in Mortgage
Markets," Economic Commentary, Federal Reserve Bank of
Cleveland, June 2003, pp. 1-4.
B. Once you have looked at the big picture using the
aggregated measure of volatile liabilities to total assets,
observe the comparative and trend differences of its
components, especially FHLB advances, Federal funds
purchased, and securities sold under agreements to
repurchase as a proportion of total assets,
C. Write one or two paragraphs discussing your BHC's use
of liability management from year to year and in com­
parison to its contemporaries.
4. Rose, Peter S. "The Quest for New Funds: New Dimensions
in a New Market," The Canadian Banker, vol. 94, no. 5
(September/October 1987), pp. 436-455.
5. Stevens, Ed. "The New Discount Window," Economic
Commentary, Federal Reserve Bank of Cleveland, May 15,
2003, pp. 1-4.
To examine the Federal Reserve System's recent addition to its
sources of borrowed funds for troubled depository institutions
in need—the TAF or Term Auction Facility—see especially the
parallel auction procedure recently used for Treasury bills:
6 . Rose, Peter S.; and Milton H. Marquis. Financial Institutions
and Markets, E-book, 11th edition, New York: McGraw-Hill/
Irwin, 2011, Chapters 10-13.
C h ap ter 13 Managing Nondeposit Liabilities ■ 271
 Learning Objectives
After completing this reading you should be able to:

Describe the mechanics of repurchase agreements (repos) Compare the use of general and special collateral in repo
and calculate the settlement for a repo transaction. transactions.

Discuss common motivations for entering into repos, Identify the characteristics of special spreads and explain
including their use in cash management and liquidity the typical behavior of US Treasury special spreads over an
management. auction cycle.

Discuss how counterparty risk and liquidity risk can arise Calculate the financing advantage of a bond trading spe­
through the use of repo transactions. cial when used in a repo transaction.

Assess the role of repo transactions in the collapses of

Lehman Brothers and Bear Stearns during the (2007-2009)
credit crisis.

Excerpt is Chapter 12 of Fixed Income Securities: Tools for Today's Markets, Third Edition, by Bruce Tuckman and Angel Serrat.

273
This chapter is about repurchase agreements or
repos. Repos are short-term contracts that are
used to lend money on the security of usually
high-grade collateral, to finance the purchase of
bonds, and to borrow bonds to be sold short.
Financial institutions have traditionally relied on
repos to finance some portion of fixed income inven­
tory. Repo financing, as secured, short-term borrow­
ing, is typically a relatively inexpensive way to borrow
money. The practice can leave firms in a perilous
situation, however, should lenders of cash through
repos, in times of trouble, fail to renew their loans.
This turned out to be an issue in the financial crisis
of 2007-2009, which is illustrated in this chapter by
two cases, one about liquidity management at Bear
Stearns and one about the financing relationship
between Lehman Brothers and JPMorgan Chase.
The last part of the chapter focuses on repo rates
and, in particular, on the specials market in the
United States, where market participants lend
money at relatively low rates predominantly in order
to borrow the most recently issued and most liquid
U.S. Treasury bonds. The behavior of these rates is
examined in some detail and linked empirically to
the auction cycle of U.S. government bonds. Hence, at the termination or unwind of the repo, depicted in
Figure 14.2, counterparty A repurchases the €100 million face
amount of the bund from counterparty B for about €111.838
14.1 REPU RCH ASE A G R EEM EN TS: million. (Bund is another name for a DBR.)
STRUCTURE AN D USES The next three subsections describe the three reasons to do
repo: to lend funds short-term on a secured basis, to finance a
A repurchase agreement or repo is a contract in which a security long position in a security, and to borrow a security in order to
is traded at some initial price with the understanding that the sell it short.
trade will be reversed at some future date at some fixed price.
Repos are used by several different types of market participants
for different purposes; Figures 14.1 and 14.2 begin the discussion Repos and Cash Management
by illustrating a simplified trade between generic counterparties. Investors holding cash for liquidity or safekeeping purposes
At initiation of the repo, depicted in Figure 14.1, counterparty A often find investing in repo to be an ideal solution. The most
sells €100 million face amount of the DBR 4s of January 4, 2037, significant example of this is the money market mutual fund
to counterparty B, for settlement on May 31, 2010, at an invoice industry, which invests on behalf of investors willing to accept
price of €111.772 million. At the same time, counterparty A relatively low returns in exchange for liquidity and safety. In
agrees to repurchase that € 1 0 0 million face amount three terms of Figures 14.1 and 14.2, a money market fund would be
months later, for settlement on August 31, 2010, at a purchase in the position of counterparty B, lending money while taking
price equal to the original invoice price plus interest at a repo collateral and then, at maturity, collecting the loan plus inter­
rate of .23%. Using the actual/360 convention of most money est and returning the collateral. Holding collateral makes the
market instruments, and noting that there are 92 days between lender less vulnerable to the creditworthiness of a counterparty
May 31, 2010, and August 31,2010, the repurchase price is because, in the event of a default by counterparty A, counter­
/ party B, in this case the money market fund, can sell the repo
.23% X 92
\

€111,772,000 1 + = €111,837,697.10 (14.1) collateral to recover any amounts owed. In summary, relative
V 360 / to super-safe and liquid non-interest-bearing bank deposits,

274 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
repo investments pay a short-term rate without sacrificing much course, collect only €106 million plus interest at maturity. In
liquidity or incurring significant default risk. addition, repo agreements are normally subject to margin calls,
through which the borrower of cash supplies extra collateral in
Municipalities constitute another significant category of repo
declining markets but may withdraw collateral in advancing
investors. As the timing of tax receipts has little to do with the
markets. Again using the example of this section, should the
schedule of public expenditures, municipalities tend to run cash
value of the bund collateral decline from its initial value of
surpluses from tax receipts so as to have money on hand to
€111.772 million to €110 million, the borrower would have to
meet expenditures. These tax revenues cannot be invested in
put up the €1.772 million difference in additional collateral to
risky securities, but neither should the cash collected lie idle.
protect the investor's loan. Combining the haircut and repric­
Short-term loans backed by collateral, like repos, again satisfy
ing features, after the drop in bund value the investor would
both revenue and safety considerations. Other institutions with
still have €111.772 million of collateral against the outstanding
similar cash management issues that choose to invest in repo
loan of €106 million.
are mutual funds, insurance companies, pension funds, and even
some nonfinancial corporations. It is worth noting, however, While repo investors care about the quality of the collateral they
that many lenders in the repo market during the recent financial accept, they do not usually care about which particular bond
crisis realized that they were not well positioned, either in exper­ they accept. Hence, while repo investors can be very particular
tise or operational ability, to take possession of and liquidate about which classes of securities they will take as collateral, e.g.,
repo collateral. Euro-area government bonds with less than five years to matu­
rity, they will not insist on receiving any particular security within
Since repo investors place a premium on liquidity, they tend to
that delineated class. For this reason these investors are said to
lend overnight, rather than for term, which refers to any matu­
accept general collateral, which trades at general collateral repo
rity longer than one day. Many investors planning to lend cash
rates. The types and determination of repo rates are discussed
through the repo market for an extended period of time will,
later in this chapter.
rather than lend for term, engage in an open repo, i.e., a one-
day repo that renews itself day-to-day until cancelled by either
party. Nevertheless, investors willing to take on some additional Repos and Long Financing
liquidity and counterparty risk, in addition to interest rate risk,
do lend through term repos. These are available at various Financial institutions are the typical borrowers of cash in
maturities, out to several months, although demand declines repo markets. Say that a client wants to sell €100 million face
rapidly with term. amount of the DBR 4s of January 4, 2037, to the trading desk
of a financial institution. The desk will buy the bonds and even­
Since safety is the other key consideration of investors in repo,
tually sell them to another client. Until that buyer is found,
only securities of the highest credit quality are typically
however, the trading desk needs to raise money to pay the cli­
accepted as collateral. The most common choices are govern­
ent. Put another way, it needs to finance the purchase of the
ment securities, debt issues of government-sponsored enter­
bunds. Rather than draw on the scarce capital of the financial
prises (GSEs), and mortgage-backed securities guaranteed by
institution for this purpose, the trading desk will repo or repo
the government or the GSEs. (See the Overview for institu­
out the securities, or sell the repo. This means that it will bor­
tional descriptions.) Even taking high-quality securities as col­
row the purchase amount from someone, like a money market
lateral, however, a lender of cash faces the risk that a borrower
fund, and use the DBR 4s, which it just bought, as collateral.
defaults at the same time those securities decline in value . 1 In
Thus, the trading desk acts as counterparty A in Figure 14.1.
that eventuality, selling the collateral might not fully cover the
Of course, any haircuts applied will require the trading desk to
loss of the loan amount. Therefore, repo agreements often
use some of its capital to make up the difference between the
provide haircuts through which investors require borrowers to
purchase price of the securities and the amount borrowed from
deliver securities worth more than the amount of the loan. In
the repo counterparty.
the example of this section, counterparty B might lend only
€106 million against the €111.772 million of securities and, of When the bunds are ultimately sold to some buyer, the desk
will, still as counterparty A but now in Figure 14.2, unwind
the repo, using the proceeds from the sale of the bunds to
1 In risk management parlance, however, this is called a right-way risk. repay the repo loan and using the returned collateral to make
If a repo borrower, typically a well-established financial institution, delivery of those bunds to that buyer. If no buyer is found
were to default, the market response would probably be a "flight-to-
before the expiration of the repo, the trading desk will have
quality trade" in which securities of the most creditworthy governments
increase in value. to roll or renew the repo for another period with the same

C hap ter 14 Repurchase A greem ents and Financing ■ 275


counterparty or unwind that repo and find a different coun­
terparty to finance the bond. This latter option is illustrated
in Figure 14.3. The trading desk, still as counterparty A, will
repay counterparty B the approximately €111.838 million due
and take back the bunds; then borrow funds from counter­
party C and deliver the bunds as collateral. Note that since the
cash obtainable from counterparty C depends on the price of
the bond at the time of the roll, while the cash due to coun­
terparty B depends on the amount owed from the previously
agreed-upon transaction, this renewal of the repo may leave
counterparty A, the trading desk, with a cash surplus or deficit.
Of course, had the trading desk hedged the price risk of its
inventory, the profit and loss from the hedge would offset this
cash surplus or deficit.
n the example of this subsection, the financial institution used
the repo market to finance its inventory for the purpose of mak­
ing markets. Other uses include financing its proprietary posi­
tions2 and positions for customers. Repo for proprietary
positions can be described by Figures 14.1 and 14.2, with the
relevant trading desk again as counterparty A, but with internal
rather than customer motivations for purchasing and then selling
the bunds. Repo for financing customer positions, at initiation,
can be described in terms of Figure 14.3. This time a customer,
e.g., a hedge fund, is counterparty B, who wants to finance the
purchase of the DBR 4s. The trading desk of the financial institu­
tion, counterparty A, does a repo with the customer, lending
cash and taking the DBR 4s as collateral. The trading desk then
does a back-to-back repo with counterparty C, who provides the
cash and takes the collateral originally supplied by the hedge
fund. Without haircuts the cash amounts shown would be the
same, but, in practice, the haircuts charged on each leg of the
trade depend on the creditworthiness and negotiating power of
the relevant counterparties.
Currently, the "Volcker rule" is envisioned as limiting the magnitude of
proprietary positions held by financial institutions.
276 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The issues surrounding financial institutions' use
of repo to finance their businesses are discussed
later in this chapter.
Reverse Repos and Short
Positions
Professional investors often want to short a
bond, either as an outright bet that interest
rates will rise or as part of a relative value bet
that the price of another security will rise rela­
tive to the price of the security being sold
short. Say that a hedge fund wants to short the
DBR 4s of January 4, 2037. It sells the bund, but then needs
to borrow it from somewhere in order to make delivery. In
terms of Figure 14.1, the hedge fund is counterparty B, initi­
ating the transaction not because it wants to lend cash but
because it wants to borrow the bund. From the point of view
of the hedge fund, it will do a reverse repurchase agree­
ment,3 will reverse or reverse in the securities, or will buy
the repo.
After initiating the reverse, the hedge fund will, at some point
in time, be ready to cover its short, i.e., to neutralize its eco­
nomic exposure to the bund by buying that bund back. At
that time the hedge fund will buy the bund and then unwind
its reverse as in Figure 14.2. Specifically, the hedge fund, as
counterparty B, will buy the bund at market and then deliver
it to counterparty A, who, in exchange, will return the hedge
fund's cash with interest. If the return on the bund has been
less than the repo rate of interest, the hedge fund will have
made money on an outright short position, while if the return
on the bund has been greater than the repo rate of interest,
the hedge fund will have lost money on an outright short. Of
course, the short might very well have been part of a larger
trade in which case the P&L has more components.
While Figures 14.1 and 14.2 were used to explain both repo
investment and reverse repos, it is important to keep in mind
that the former are initiated in order to invest cash while the
latter are initiated to borrow a bond. So while repo investors
are willing to accept general collateral, reverses require the
delivery of a particular bond. Repo transactions that require the
delivery of a particular bond are called special trades and they
take place at special collateral rates. The specials market is dis­
cussed further later in this chapter.
3 The practice of calling the trade a reverse repo is particularly confus­
ing because the same trade that is a reverse repo for the borrower of a
security is a repo for the lender of that security.
14.2 REPO, LIQUIDITY M ANAGEM ENT,
AND THE FIN AN CIAL CRISIS
O F 2007-2009
Broker-dealers rely less on repo financing currently than they did
before the 2007-2009 crisis. A financial institution can borrow
funds in many ways, some of which are more stable than others,
i.e., some of which can be easily maintained under conditions of
financial stress and some of which cannot be so easily maintained.
The most stable source of funds is equity capital because equity
holders do not have to be paid according to any particular sched­
ule and because they cannot compel a redemption of their shares.
Slightly less stable is long-term debt because bondholders have
to be paid interest and principal as set out in bond indentures.
At the other extreme of funding stability is short-term unsecured
funding, like commercial paper: these borrowings have to be
repaid in a matter of weeks or months, as they mature, when the
institution, under adverse conditions, might not be able to borrow
money elsewhere. Not surprisingly, the more stable sources of
funds are usually more expensive in terms of the expected return
required by the providers of funds. Through liquidity manage­
ment, firms balance the costs of funding against the risks of being
caught without the financing necessary to survive.
In the spectrum of financing choices, repo markets are relatively
liquid and repo borrowing rates relatively low. On the other hand,
by nature of its short maturities repo is on the less stable side
of the funding spectrum, although more stable than short-term,
unsecured borrowing. After all, repo collateral should prevent
repo lenders from bolting too quickly in response to unfavorable
rumors or news. Nevertheless, if repo investors do lose confi­
dence in a financial institution, that institution's repo financing can
disappear as fast as the repos mature, which is mostly overnight.
The beleaguered institution would no longer be able to facili­
tate customer trades by holding inventory, would not be able to
facilitate customer financing, and might not remain an acceptable
counterparty for derivative and even spot security transactions.
Furthermore, the institution would have to sell inventory and pro­
prietary positions to repay repo lenders, which sales, given their
size and public nature, would likely turn into fire sales and result
in significant losses. Essentially then, while significant business
losses rather than financing are the usual cause of a financial insti­
tution's difficulties, the loss of financing is often the killing blow.
The same argument, of course, applies to all leveraged investors,
like part of the hedge fund world. To the extent that a firm bor­
rows money to finance positions, losing the confidence of repo
and other secured financing counterparties can result in fire sales,
substantial losses, and possible bankruptcy.
The risks of repo funding juxtaposed with those of repo investing
create tensions between borrowers and lenders of cash as well as
C hap ter 14
difficulties for regulators. Borrowers want to extend the term of
their repo borrowings, 4 sometimes at the encouragement of their
regulators, so as to have more time, should conditions for refi­
nancing deteriorate, to arrange alternate financing, to raise capi­
tal, or even to sell corporate entities. Lenders, on the other hand,
want to shorten the term of their repo lendings, sometimes at the
encouragement of their regulators, so as to minimize exposure to
borrower defaults. Prices, in this case repo rates, allocate repos
of various terms across borrowers and lenders, but the financial
system as a whole cannot both extend the maturities of secured
financing and contract the maturities of secured lending.
In the run-up to the financial crisis of 2007-2009, borrowers
financed lower-quality collateral, like lower-quality corporate
bonds and lower-quality mortgage-backed securities, at the rela­
tively low rates and haircuts available in the repo market. Lenders,
for their part, accepted this collateral in exchange for rates some­
what higher than those available when lending on higher-quality
collateral. The resulting expansion of collateral accepted for repo
did not work out well during the crisis, particularly for borrowers
who were unable to meet margin calls caused by declining security
values, who were unable to post sufficient collateral in response to
lenders' raising haircuts, or who were unable to replace lost financ­
ing arrangements when lower-quality collateral found fewer and
fewer takers. The worst-hit borrowers suffered collateral liquida­
tions, losses, capital depletion, and business failure.
Case Study: Repo Financing
and the Collapse of Bear Stearns
This is an excerpt from the testimony of Paul Friedman before
the Financial Crisis Inquiry Commission on May 5, 2010 . 5
Mr. Friedman, a Senior Managing Director at Bear Stearns,
was responsible for its fixed income repo desk at the time of
the firm's demise in March 2008.
Bear Stearns generally financed its business by borrow­
ing funds on a secured and unsecured basis and through
the use of equity capital. During 2006, Bear Stearns
decided to reduce the amount of short-term unsecured
funding, primarily commercial paper, that it borrowed.
The firm made this decision primarily based on its belief,
which I shared, that commercial paper tended to be
confidence-sensitive, and could become unavailable at
a time of market stress, while secured borrowing based
4 As an operational aside, term repo financing usually includes rights of
substitution that enable the borrower of cash who needs to sell a par­
ticular bond being financed to replace that bond as collateral with other
bonds of comparable value and quality.
5 Source: http://fcic.gov/hearings/pdfs/2010-0505-Friedman.pdf
Repurchase A greem ents and Financing ■ 277
 on high-quality collateral is generally less credit sensitive repo loans, even when the loans were supported by
and therefore more stable. high-quality collateral such as agency securities; and
counterparties to non-simultaneous settlements of
Bear Stearns implemented this strategy in late 2006 and
foreign exchange trades refused to pay until Bear
2007, and succeeded in reducing its short-term unse­
Stearns paid first. . . [T]his loss of confidence in Bear
cured financing from $25.8 billion at the end of fiscal
Stearns . . . resulted in a rapid flight of capital from the
2006 to $11. 6 billion at the end of fiscal 2007, and spe­
firm that could not be survived.
cifically reduced its commercial paper borrowing from
$20.7 billion to $3.9 billion. That funding was replaced
by secured funding, principally repo borrowing . . . Case Study: JPMorgan Chase's Repo
As part of the firm's transition away from unsecured bor­ Exposure to Lehman Brothers
rowing, Bear Stearns also substantially increased the
The counterparty risk of lending money through a repo is that
average term of its secured funding during the first half
the borrower defaults and the value of the collateral turns out
of 2007. Bear Stearns was able to obtain longer term
to be insufficient to cover the loan amount. Any sterile discus­
repo facilities of six months or more to finance assets
sion of the topic cannot do justice to the bare-knuckle fighting
such as whole loans and non-agency mortgage backed
over collateral that takes place when a counterparty is at risk of
securities, and generally limit its use of short-term
default. A striking and well-publicized example of this through
secured funding to finance Treasury or agency securities.
2008 was the repo exposure of JPMorgan Chase (JPM) to
By increasing the amount of its long-term secured fund­
Lehman Brothers.
ing, the firm believed that it could better withstand a
liquidity event. JPM was Lehman's tri-party repo clearing agent. When repo
investors lend money to a financial institution through the tri­
From approximately August 2007 to the beginning of
party repo system, 7 taking collateral as security, their loans are,
2008, however, the fixed income repo markets started
literally, overnight. 8 During the day, however, the tri-party repo
experiencing instability, in which fixed income repo lend­
agent is lending this money to the financial institution on a
ers began shortening the duration of their loans and
secured basis. 9 Furthermore, given the operational structure of
asking all borrowers to post higher quality collateral to
the industry, a broker-dealer could not stay in business without
support those loans. Although the firm was successful in
its tri-party agent performing this function. Returning to JPM
obtaining some long-term fixed income repo facilities,
and Lehman, before Lehman's final week, JPM's tri-party lending
by late 2007 many lenders, both traditional and nontra-
to Lehman typically exceeded $100 billion. 1 0 Furthermore, JPM
ditional, were showing a diminished willingness to enter
had historically not taken any haircuts on its tri-party, intraday
into such facilities.
advances, but began to do so in early 2008. In Lehman's case,
During the week of March 10, 2008, Bear Stearns suf­ JPM phased in haircuts so as to match, by mid-August 2008, the
fered from a run on the bank that resulted, in my view, haircuts posted to overnight repo investors.
from an unwarranted loss of confidence in the firm by
Against this background, the following two excerpts describe
certain of its customers, lenders, and counterparties. In
differing viewpoints of the events of September 2008, the first
part, this loss of confidence was prompted by market
from a lawsuit filed by the estate of Lehman Brothers Holdings
rumors, which I believe were unsubstantiated and
untrue, about Bear Stearns' liquidity position. Neverthe­
less, the loss of confidence had three related conse­
quences: prime brokerage clients withdrew their cash 7 For a more complete description, see "Systemic Risk and the Tri-Party
and unencumbered securities at a rapid and increasing Repo Clearing Banks," by Bruce Tuckman, Center for Financial Stabil­
ity Policy Paper, February 2010. www.centerforfinancialstability.org/
rate; 6 repo market lenders declined to roll over or renew research-Tri-Party-Repo20100203.pdf
8 This is the reason that overnight repo trades are called that and not
one-day trades.
6 Unencumbered securities are securities that have not been posted as
9 As of the time of this writing, an industry task force is working to elimi­
collateral or otherwise committed. This part of the testimony seems to
nate this transfer of intraday risk from repo lenders to the tri-party repo
imply that Bear Stearns relied on customer cash and customer securities
agents.
(the latter could be posted as collateral to raise funds) to finance other
businesses of the firm. In the spectrum of financing stability, customer 10 See "Written Statement of Barry Zubrow Before the Financial Crisis
cash and unencumbered securities are extremely unstable sources of Inquiry Commission," September 1, 2010, p. 2. fcic-static.law.stanford.
funding as they can be withdrawn without notice at any time. edu/cdn_media/fcic-testimony/2010-0901 -Zubrow.pdf

278 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Inc. (LBHI) against JPM 11 and the second from the testimony of
Barry Zubrow, Chief Risk Officer of JPM, before the Financial
Crisis Inquiry Commission.
First, from Lehman's estate:
On the brink of LBHI's bankruptcy, JPMorgan leveraged
its life and death power as the brokerage firm's primary
clearing bank to force LBHI into a series of one-sided
agreements and to siphon billions of dollars in critically-
needed assets. The purpose of these last-minute maneu­
vers was to leapfrog JPMorgan over other creditors by
putting itself in the position of an overcollateralized
creditor, not just for clearing obligations, but for any and
all possible obligations of LBHI or any of its subsidiaries
that JPMorgan believed could result from an LBHI bank­
ruptcy. The effect of JPMorgan's actions—taken with the
benefit of unparalleled inside knowledge—was devas­
tating. JPMorgan not only took billions of dollars more
than it needed from LBHI, but it also accelerated LBHI's
freefall into bankruptcy by denying it an opportunity for
a more orderly wind-down, costing the LBHI estate tens
of billions of dollars in lost value . . .
In the weeks preceding LBHI's bankruptcy filing, JPM ­
organ's top management were the ultimate insiders to
the evolving crisis, enjoying real-time access to the key
decision-makers at the United States Treasury and the
Federal Reserve Bank of New York. JPMorgan's invest­
ment bankers were also attempting to assist Lehman's
primary potential bidder, the Korea Development Bank,
and consequently had first-hand knowledge of its inten­
tions regarding a potential acquisition. JPMorgan also
had direct access to internal financial information about
Lehman, including an opportunity to review and com­
ment on Lehman's presentation to the rating agencies.
At one crucial point, JPMorgan was invited to a meeting
with Lehman to consider rescue financing proposals,
but instead used it as an opportunity to probe Lehman's
financial condition and business plans from a risk man­
agement perspective. With all of the bank's tentacles
encircling the financial crisis at Lehman, JPMorgan was
uniquely positioned to capitalize on the opportunities
that crisis presented. . . .
JPMorgan . . . drained LBHI of desperately needed cash
by making repeated demands that LBHI increase the
amount of collateral payments it posted. In the last four
11 Lehman Brothers Holdings Inc., and Official Committee of Unsecured
Creditors of Lehman Brothers Holdings Inc., against JPMorgan Chase
Bank, N.A.
C hap ter 14
business days before LBHI's Chapter 11 filing, JPMorgan
seized $8 . 6 billion of cash collateral, including over $5
billion in cash on the final business day. All the while that
JPMorgan was aggressively leveraging its position to
grab increasingly more collateral, JPMorgan knew that it
was already overcollateralized by billions of dollars.
JPMorgan's . . . unjustified demands for billions in addi­
tional collateral, and its refusal to return that collateral
in the critical days before LBHI's bankruptcy filing,
severely constrained LBHI's liquidity and impeded its
ability to pursue and implement alternatives and initia­
tives that would have resulted in the preservation of bil­
lions in value. . . .
Next, from Barry Zubrow of JPM:
Increasing margin requirements [during the course of
2008] . . . did not protect JPMorgan fully from the risks it
faced in extending tens of billions of dollars of credit to
broker-dealers each morning . . . JPMorgan, unlike any
single triparty investor, took on a broker-dealer's entire
triparty repo book each day. This meant it would face far
greater risks in a liquidation scenario. Furthermore, JPM­
organ had no assurance that investors would return to
fund the broker-dealer in the evening . . . with the cash
necessary to repay JPMorgan's intraday advances. More­
over, the haircuts negotiated between investors and
the broker-dealers did not, in many cases, fully reflect
the liquidation risk for the increasingly large amount of
structured, difficult-to-value securities that were being
financed through the triparty repo program . . . .
By late August and early September 2008, Lehman's
deteriorating financing condition was becoming increas­
ingly apparent. . . . In addition, it came to light that
many of the securities Lehman had pledged to JPMor­
gan in June were illiquid, structured debt instruments
that appeared to have been assigned overstated values.
Nevertheless, JPMorgan . . . continued to . . . act on a
business-as-usual basis.
But JPMorgan's exposure to Lehman was growing. This
included exposure in areas unrelated to triparty repo
clearing. . . . JPMorgan searched for a way to protect
itself without triggering a run on Lehman. . . . JPMor­
gan determined that it could continue to face Lehman
in the market if it had $5 billion in additional collat­
eral . . . [This] was far from sufficient to cover all of
JPMorgan's potential exposures to Lehman . . . but
JPMorgan believed that it was an amount that Lehman
could reasonably provide . . . . Lehman executives
agreed to pledge additional collateral, and . . . did not
Repurchase A greem ents and Financing ■ 279
 indicate that JPMorgan's request was putting undue
pressure on Lehman. . . .
During the second week of September 2008 . . . a broad
review of Lehman's collateral securities . . . indicated
that some of the largest pieces of collateral pledged
to JPMorgan were illiquid, could not reasonably be
valued and were supported largely by Lehman's own
credit. . . . When the true nature of Lehman's collat­
eral came to light on September 11,2008, it became
apparent that JPMorgan . . . would need additional
collateral if it were to continue supporting Lehman.
JPMorgan decided that $5 billion in cash was . . . appro­
priate . . . even though its potential collateral shortfall
was greater, as it was a number that JPMorgan believed
Lehman could handle. . . . Later that night, JPMorgan
sent Lehman a letter stating that, if Lehman did not post
the collateral by the open of business the next day, JPM ­
organ would exercise its right to decline to extend credit
to Lehman. . . . Lehman delivered $5 billion of cash col­
lateral during the morning and early afternoon [of Sep­
tember 1 2 ]. . . .
Throughout all of this . . . JPMorgan continued to make
enormous—discretionary—extensions of credit to the
ailing bank, and it continued to trade with Lehman. . . .
14.3 G EN ER A L AND SP EC IA L REPO
RATES
As mentioned earlier in this chapter, repo trades can be divided
into those using general collateral (GC) and those using special
collateral or specials. In the former, the lender of cash is willing
to take any particular security, although the broad categories of
acceptable securities might be specified with some precision. In
specials trading, the lender of cash initiates the repo in order to
take possession of a particular security. For these trades, there­
fore, it makes more sense to say that "counterparty A is lend­
ing a security to counterparty B and taking cash as collateral"
as opposed to saying that "counterparty B is lending cash and
taking a security as collateral," although the two statements are
economically equivalent. For this reason, by the way, when using
the words "borrow" or "lend" in the repo context, it is best to
specify whether cash or securities are being borrowed or lent.
Also, as another note on market terminology, bonds most in
demand to be borrowed are said to be trading special, although
any request for specific collateral is a specials trade.
Each day there is a GC rate for each bucket of collateral and
each repo term. The most commonly cited GC rates are for
280 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
repos where any U.S. Treasury collateral is acceptable, and "the"
GC rate refers to the overnight rate for U.S. Treasury collateral.
With respect to special rates, there can be one for each security
for each term, e.g., the 35/ss of August 15, 2019, to September
30, 2010. But every special rate is typically less than the GC
rate: being able to borrow cash at a relatively low rate induces
holders of securities that are in great demand to lend those
securities, while being forced to lend cash at a relatively low rate
allocates securities that are in great demand to potential bor­
rowers of that security. Differences between the GC rate and
the specials rates for particular securities and terms are called
special spreads.
Relating GC and specials trades to the market participants
discussed earlier in this chapter, GC trades suit repo investors:
they obtain the highest rate for the collateral they are willing to
accept. Traders intending to short particular securities have to
do specials trades and must decide whether they are willing to
lend money at rates below GC rates in order to borrow those
securities. Funding trades are predominantly GC. Should an
institution find itself wanting to borrow money against a security
that is trading special, however, it will lend that security in the
specials market and borrow cash at a rate below GC, rather than
financing that security as part of a GC trade.
In the United States the GC rate is typically close to, but below,
the federal funds rate. The latter is the unsecured rate for over­
night loans between banks in the Federal Reserve system. By
contrast, repo loans secured by U.S. Treasury collateral are safer
and should trade at a lower rate of interest. From October 23
through July 1, 2010, for example, the GC rate was, on average,
about 16 basis points below the fed funds rate. This fed funds-
GC spread can vary, however, with the demand for Treasury
collateral. When the U.S. government was running surpluses
and paying down debt in the late 1990s and early 2000s, so that
U.S. Treasuries were becoming scarcer and expected to become
scarcer still, the fed funds-GC spread widened to reflect the
decreasing supply of Treasury collateral.
The fed funds-GC spread also widens during times of financial
stress. At such times the demand to hold Treasury bonds and
to lend cash on Treasury collateral increases as part of flight-to-
quality trades. In addition, willingness to lend Treasury bonds
in repo declines as market participants fear that collateral may
not be returned, either because a counterparty will fail to return
collateral or because a counterparty's counterparty will fail to
do so. Shortly after the collapse of Bear Stearns, for example,
after the Fed had hurriedly lowered its target for the fed funds
rate to 2.25%, GC traded at below .50%. Similarly, extremely
wide spreads prevailed in the months after the failure of
Lehman Brothers.
Table 14.1 Special Repo Spreads fo r Selected, Recently Issued U .S. Treasury Bonds as of May 28, 2010
General Collateral Rate .23%
Coupon Maturity Issue Date
3^% 5/15/20 5/17/10
3|% 2/15/20 2/16/10
11/15/19 11/16/09
rolco rolco
\0
00
5/15/40 5/17/10
\0
4|% 2/15/40 2/16/10
11/15/39 11/16/09
rolco
\0
Special rates for a particular issue to a particular date are deter­
mined by the demand of borrowing that issue to that date rela­
tive to the supply available. This statement is obvious in some
ways, but the important point is that the demand and supply
to borrow and lend issues is not the same as the demand and
supply to buy and sell issues. In fact, because some owners of
U.S. Treasuries, for institutional reasons, do not lend bonds in
repo markets, the amount of a particular issue available for bor­
row might be somewhat less or very much less than the amount
outstanding, depending on the distribution of ownership of
that issue across various types of institutions. Put another way,
a bond that trades rich relative to neighboring bonds, implies
a high demand to own that bond relative to the outstanding
supply. But the bond may or may not trade very special in repo
depending on the extent traders want to short it relative to the
supply available for borrow. Given this reasoning, predicting
the special spreads of individual bonds is quite difficult. Having
said that, there is one predominant explanatory factor for spe­
cial spreads in the United States, namely, the auction cycle: the
most recently issued bonds of each maturity trade special. This
is the topic of the next subsection.
Special Spreads in the United States
and the Auction Cycle
As mentioned, the U.S. government sells bonds of different
maturities according to a fixed schedule. As of this writing, for
example, a new 10-year issue is sold every three months. The
most recently issued bond of a given maturity is called the on-
the-run (OTR) or current issue while all other issues are called
off-the-run (OFR). However, the second most recently issued
bond of a given maturity does have its own designation as the
old issue; the third most recent as the double-old issue; etc. As a
general rule, at each maturity, the OTR trades the most special,
C hap ter 14
Designation Repo Rate Spread
OTR 10yr .09% . 14%
Old 10yr .2 1 % .0 2 %
Dbl-Old 10yr .2 1 % .0 2 %
OTR 30yr .18% .05%
Old 30yr .2 0 % .03%
Dbl-Old 30yr .2 1 % .0 2 %
followed by the old, followed by the double-old, etc. Table 14.1
lists the more recent 10- and 30-year U.S. Treasury bonds along
with representative overnight repo rates and spreads as of May
28, 2010. The special spreads equal the GC rate minus the
respective bond repo rates.
Table 14.1 illustrates how the more recently issued bonds at
each maturity trade more special. The table also shows that the
OTR 10-year trades more special than the OTR 30-year, a regu­
larity that has been true for some time. The discussion now turns
to why special rates are related to the auction cycle.
Current issues tend to be the most liquid. This means that
A O _
their bid-ask spreads are particularly low and that trades of large
size can be conducted relatively quickly. This phenomenon is
partly self-fulfilling. Since everyone expects a recent issue to be
liquid, investors and traders who require liquidity flock to that
issue and thus endow it with the anticipated liquidity. Also, the
dealer community, which trades as part of its business, tends to
own a lot of a new issue until it seasons and is distributed to
buy-and-hold investors. As a matter of historical interest, the
OTR 30-year bond had been such a dominant issue in terms of
liquidity that traders called it "the bond." This nickname persists
to this day despite the decline of the bond's importance relative
to that of shorter maturities, in particular of the 1 0 -year.
The extra liquidity of newly issued Treasuries makes them ideal
candidates not only for long positions but for shorts as well.
Most shorts in Treasuries are for relatively brief holding periods:1
2
12 This effect is particularly pronounced in the United States. In Ger­
many, the deliverability of a bond into highly liquid futures contracts
is the best determinant of liquidity. See "Liquidity Premia in German
Government Bonds," by Jacob W. Ejsing and Jukka Sihvonen, European
Central Bank Working Paper Series, no. 1081, August 2009. In Japan,
liquidity characteristics develop from a mix of the auction cycle and
futures contract deliverability.
Repurchase A greem ents and Financing ■ 281
a trading desk hedging the interest rate risk of its cur­ 500 -7
rent position; a corporation or its underwriter hedging an
upcoming sale of its own bonds; or an investor betting 400 -
!/)
that interest rates will rise. All else being equal, holders XI
CL

of these relatively brief short positions prefer to sell par­ "S 300
<D
ticularly liquid Treasuries so that, when necessary, they Q.
(>
can cover their short positions quickly and at relatively low £ 200
transaction costs. <u
Q.
WO
Investors and traders who are long an OTR bond for 100 -

liquidity reasons require compensation if they are to sac­

rifice that liquidity by lending that bond in the repo mar­ 0

ket. At the same time, investors and traders wanting to Jul-97 Jul-98 Jul-99 Jul-00 Jul-01
short the OTR securities are willing to pay for the liquid­ Fiqure 14.4 On-the-run 10-year special spread, July 1997
ity of shorting these particular bonds when borrowing to July 2010, Part I.
them in the repo market. As a result, OTR securities tend
to trade special.
The auction cycle is an important determinant not only of
which bonds trade special, but also of how special individ­
ual bonds trade over the course of the auction cycle. This
will be illustrated first by examining the history of special
spreads for the OTR 10-year Treasury and then by exam­
ining the term structure of special spreads for the OTR
10-year Treasury as of May 28, 2010.

Figures 14.4 through 14.6 show the history of the OTR

10-year Treasury special spread from July 1997 to July
2 0 1 0 : the 13-year history is broken up into three graphs for

better readability. 1 3 The vertical lines indicate 10-year

Treasury auctions. These are either auctions of new OTR Nov-01 Nov-02 Nov-03 Oct-04 Nov-05
securities, in which case the OTR security changes over the Fiqure 14.5 On-the-run 10-year special spread, July 1997
vertical line, or re-openings of existing OTR securities (i.e., to July 2010, Part II.
auctions that increase the size of an already existing issue),
in which case the same security is featured on both sides
of the vertical line.

Several lessons may be drawn from these graphs. First,

special spreads are quite volatile on a daily basis, reflecting
supply and demand for special collateral each day. Second,
special spreads can be quite large: spreads of hundreds
of basis points are quite common. Third, special spreads
do attain higher levels over some periods rather than oth­
ers, a feature that will be discussed in the next subsection.
Fourth, and the main theme of this subsection, while the
cycle of OTR special spreads is far from regular, these

Mar-06 Mar-07 Mar-08 Mar-09 Mar-10

13 Note that data from the aftermath of the Lehman bankruptcy,
from November 2008 to February 2009, is missing from Figure 14.5. Fiqure 14.6 On-the-run 10-year special spread, July 1997
Events at that time will be discussed in the next subsection. to July 2010, Part

282 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
spreads tend to be small immediately after auctions and
to peak before auctions. It takes some time for a short
base to develop. Immediately after an auction of a new
OTR security, shorts can stay in the previous OTR secu­
rity or shift to the new OTR. This substitutability tends
to depress special spreads. Also, the extra supply of the
OTR security immediately following a re-opening auction
tends to depress special spreads. In fact, a more detailed
examination of special spreads indicates that re-opened
issues do not get as special as do new issues. In any case,
as time passes after an auction, shorts tend to migrate
toward the OTR security, and its special spread tends to Days Since Issue / Days Between Previous and Next Issues
rise. Furthermore, as many market participants short the Figure 14.7 Average OTR 10-year special spread as a
OTR to hedge purchases of the to-be-issued next OTR, function of the auction cycle, July 1997 to July 2010.
the demand to short the OTR and, therefore, its special
spread, can increase dramatically o=r spike going into
Because special spreads in Figures 14.4 through 14.6 are so vol­
the subsequent auction.
atile, Figure 14.7 reports the average special spread as a func­
tion of the auction cycle. The horizontal axis represents time into
While not shown in these figures, the special spread of the
an auction cycle, measured as the days since the issue of the
5-year OTR behaves quite similarly to the 10-year. The pat­
10-year OTR divided by the total number of days between issue
tern of spreads of shorter-maturity OTRs is similar although
dates. The curve gives the average of the special spread across
these spreads tend not to be nearly so wide. This difference
cycles of the 13-year history depicted in Figures 14.4 through
is primarily due to the more frequent issuance of shorter-
14.6. As expected, the average special spread increases over
maturity Treasuries that prevents a particular issue from
the cycle, spiking as the subsequent auction approaches.
becoming far and away the most liquid bond or most-favored
short. Finally, the 30-year had historically been as liquid and The auction-driven pattern of special spreads can be seen not
its special spreads as large and volatile as that of the 1 0 -year, only from historical data but also from the term structure of spe­
but this has not been the case since the years leading up to cial spreads of an individual issue. Table 14.2 gives the spot and
a discontinuation of 30-year bond issuance in 2001. Subse­ forward term structure of special spreads for the OTR 10-year
quently, apart from some very active specials trading sur­ Treasury as of May 28, 2010. The terms listed are representa­
rounding the announcement of the re-introduction of "the tive of commonly-traded terms for OTR issues. These typically
bond" in 2005 and its sale in 2006, the specials spread of include fixed terms from the pricing date (e.g., one month) and
the OTR 30-year has been quite muted relative to those of expiration dates of the relevant futures contracts. The latter
shorter maturities. trade because many market participants are interested in OTR

Table 14.2 Term Structure of Special Rates and Spreads for the 10-Year, On-the-Run U.S. Treasury as of May 28,
2010. TYM0, TYU0, and TYZ0 Are the Tickers of the Relevant 10-Year Futures Contracts
Term Term Date Term Days Term Rate Term GC Term Spread Forward Spread

Overnight 6 /1 / 1 0 4 .09% .23% . 14% . 14%

1 Week 6/4/10 7 .0 0 % .23% .23% .35%
TYM0 6/30/10 33 - .1 0 % .2 2 % .32% .34%
2 Months 7/28/10 61 -.05% .23% .28% .23%
3 Months 8/30/10 94 .0 0 % .25% .25% .2 0 %
TYU0 9/30/10 125 .04% .26% .2 2 % .13%
TYZ0 12/31/10 217 .17% .30% .13% .0 1 %

C hap ter 14 Repurchase A greem ents and Financing ■ 283

basis trades, that is, trading the OTR against the futures
contract into which it is deliverable. Note that the over­
night rate is the business day following the pricing date.
The term spreads in Table 14.2 are simply the differences
between the term GC rates and the respective term
special rates. For this table the forward spreads are com­
puted from the term spreads, but forward repo trades do
exist. In any case, to illustrate the calculation, the forward
special spread from June 30, 2010, to July 28, 2010, is
such that investing at the spread to June 30 and then at
forward spread from June 30 to July 28 is equivalent to
investing to July 28. Let sfwd be this forward spread. Then,
using the numbers supplied in the table, sfwd is approxi­
mated by
33 x .32% + (61 - 33) x s ™ 61 x .28%
s ^d .23% (14.2)
The projected (and realized) 10-year auction schedule as of
May 28, 2010, was a re-opening of the current 3 1/2 S of May 15,
2020, both in the middle of June and July, to be followed by
the issue of a new OTR in the middle of August 2010. In light
of the discussion in this subsection and the historical evidence,
the special spread would be expected to increase into these
auctions. According to the implied forward spreads, the spread
is projected to increase into the June re-opening. The 3 1/2 S are
projected to stay special into and somewhat past the July and
August auctions as well, but, for the period September 30 to
December 31, the forward special spread is only one basis point.
In other words, by the time the then-current 10-year has been
around for a month, the specialness of the 3 1/2 S is projected to
have dissipated.
Special Spreads in the United States
and the Level of Rates
By graphing special spreads rather than special rates, Fig­
ures 14.4 through 14.6 hide a factor that has historically limited
special spreads. Until very recently, there was no explicit pen­
alty for a fail, i.e., for failing to deliver a bond that had been
sold. This has implied that the special rate could not fall below
0%. Reason as follows. If a trader had shorted the OTR 10-year
and failed to deliver upon settlement, the trader would not
receive the cash from the sale and, consequently, would lose
one day of interest on that cash. But what if the trader could
borrow the bond overnight in the repo market at 0 %, i.e., lend
money at 0%, so as to be able to make delivery? The econom­
ics of that borrow to the trader is the same as failing: in both
cases no interest is earned on the proceeds from selling the
bond. Therefore, because no trader would borrow the bond if
284 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
7 -|
Jul-99 Jul-01 Jul-03 Jul-05 Jul-07 Jul-09
10-Year Special Spread Fed Funds Target
Fiaure 14.8 OTR 10-year special spread and the Fed funds
target rate, July 1997 to July 2010.
the special rate were 0 % or less, the special rate should never
be less than 0%. Equivalently, the special spread should not
exceed the GC rate . 1 4
Figure 14.8 superimposes the Fed's target rate for fed funds on
the overnight, 10-year special spread. Clearly, over all but the
most recent period, the special spread has been limited by the
level of rates. The level of rates, therefore, is part of the expla­
nation for the periods of relatively high and relatively low special
spreads observed in this figure and in Figures 14.4 through 14.6.
In 2009, however, the treatment of fails changed. In October
and November 2008, as part of the reaction to the Lehman
bankruptcy that September, fails to deliver the 10-year OTR
climbed to record levels, $5.311 trillion in the week ending
October 22, relative to a pre-crisis average of $165 billion. 1 5
Regulators were extremely unhappy with the situation as it was
viewed as a threat to the liquidity and efficiency of the U.S. Trea­
sury market. With their prodding, an industry group called the
Treasury Market Practices Group adopted a penalty rate for fails,
which took effect on May 1, 2009, equal to the greater of 3%
minus the fed funds target rate or zero. Essentially, when the fed
funds rate is near zero, the penalty is near 3%, i.e., failing to
deliver $100 million of a bond costs $100mm X 3%/360 or
$8,333 per day. As the fed funds rate increases, the penalty falls.
The logic there is that since higher interest rates are typically
1A
This is not strictly true because there are such non-monetary costs of
fails as regulatory capital requirements. For a case study on negative
OTR 10-year special rates in the second half of 2003, see "Repurchase
Agreements with Negative Interest Rates," by Michael Fleming and
Kenneth Garbade, Current Issues in Economics and Finance, Volume 10,
Number 5, April 2004. www.newyorkfed.orglresearch/currentjssues/
ci 10-5/ci 10-5.html
15 Liz Capo McCormick, "Treasury Traders Paid to Borrow as Fed Exam­
ines Repos," Bloomberg, November 24, 2008.
associated with higher opportunity costs of failing, high penal­
ties are not necessary in high-rate environments to prevent epi­
sodes of system-wide fails.
In light of the imposition of a penalty for failing to deliver, the
new upper limit for the special spread is the penalty rate rather
than the GC rate. In fact, soon after the imposition of the pen­
alty, demand to short the OTR Treasury in June 2009 drove the
special spread up to this limit. This episode can be seen to the
far right of Figure 14.8.
Valuing the Financing Advantage
of a Bond Trading Special in Repo
The OTR 10-year, the 3 1/2 S of May 15, 2020, was trading
extremely rich on May 28, 2010, slightly more than 2 per 100
face value, relative to the C-STRIPS curve. OTR bonds often
trade at a premium that is in part due to their liquidity advan­
tages, i.e., the ability to turn positions in these bonds back into
cash with minimum effort, even in a crisis, and in part due to
their financing advantages, i.e., the ability to lend these bonds
and borrow cash at a relatively low rate. It is obvious from
Table 14.2 that, in the case of the 3 1/2 S , almost all of the premium
is due to liquidity. Nevertheless, it is useful here and even more
so in other situations to translate special spreads into price or
yield premiums.
The financing value of a bond is the value, over the entire life
of the bond, of lending it in repo, borrowing cash at its special
C hap ter 14
rate, and investing that cash at the higher GC rate. The key
assumption then, is how special the bond will trade and for how
long. Professional repo traders have an opinion about how the
special spreads of particular issues will evolve over time that can
be used in this analysis. Another approach is to accept the mar­
ket's view as expressed in the term structure of special spreads.
According to Table 14.2, it is reasonable to assume that the 3 1/2 S
will trade as GC past September 30, 2010: the forward special
rate from then to December 31 is only one basis point. Also,
there is no reason to expect that the issue will ever in its life
trade special again. Hence, the financing value of the bond is its
financing value over the 125 days from the pricing date, May 28,
2010, to September 30, 2010. But, as will now be shown, this
financing value can be easily calculated from the term special
spread of .22 % to September 30, 2010.
The value of lending 100 of cash at a spread of .22% for 125
days is simply
^ 25 X .22 % ^
100 X ----------------- = .076 (14.3)
360
or 7.6 cents per 100 market value of the bond. At a price of
101.90, therefore, assuming no haircuts, the financing advan­
tage of the 3 1 4 s is worth only about 7.7 cents per 1 0 0 face
amount, a very small part of its total premium of over 2 dollars.
Finally, to translate the dollar value of specialness into a yield
value, simply divide by the DV01. In this case, with the DV01 of
the 3 1 4 s approximately equal to .085, the value of the special
spread is ^ or only about .9 basis points.
Repurchase A greem ents and Financing 285
 Learning Objectives
After completing this reading you should be able to:

Discuss the process of liquidity transfer pricing (LTP) and Compare the various approaches to liquidity trans­
identify best practices for the governance and implemen­ fer pricing (zero cost, average cost, matched maturity
tation of an LTP process. marginal cost).

Discuss challenges that may arise for banks during the Describe the contingent liquidity risk pricing process and
implementation of LTP calculate the cost of contingent liquidity risk.

Excerpt is Financial Stability Institute Occasional Paper No. 10, by Joel Grant.

287
15.1 INTRODUCTION
Internal transfer pricing is an extremely important manage­
ment tool for banks. This paper observes that until the global
financial crisis (GFC), many banks treated liquidity as a free
good for transfer pricing purposes, and this was one cause for
the very poor liquidity outcomes experienced during the GFC.
Furthermore, although liquidity transfer pricing (LTP) practices
are improving, there is little guidance publicly available to
banks, regulators, and other stakeholders on what constitutes
good practice. This paper makes a start on filling that gap.
LTP is a process that attributes the costs, benefits and risks of
liquidity to respective business units within a bank. 1 LTP has
gained considerable attention since the onset of the GFC with
some reports linking poor LTP practices to the funding and
liquidity issues witnessed at several banks (Senior Supervisors
Group (SSG), 2008; 2009).
The purpose of LTP is to transfer liquidity costs and benefits from
business units to a centrally managed pool. To achieve this, LTP
charges users of funds (assets/loans) for the cost of liquidity, and
credits providers of funds (liabilities/deposits) for the benefit of
liquidity. LTP also recoups the cost of carrying a liquidity cushion by
charging contingent commitments, such as lines of credit, based
on their predicted (expected) use of liquidity. This is depicted in
Figure 15.1 below. Banks with poor LTP practices typically under­
price or (even worse) fail to price liquidity. Such banks are more
likely to accrue illiquid assets and contingent exposures, and
under-value stable sources of funding. This outcome applied to
many banks and other financial institutions prior to the GFC.
In the years preceding the GFC, liquidity was plentiful and
cheap, and as we now know, unsustainably plentiful and cheap.
Some of the larger and more creditworthy banks could obtain
long-term funding at only the slightest margins above swap
rates. Such ideal funding conditions proved fruitful for banks,
widely encouraging leverage and maturity transformation,
which underpinned their record profits. At the same time these
conditions led many to believe that funding would always be
available, and at permanently cheap rates. One consequence
of this belief was that it provided little incentive for banks to
devote attention to liquidity risk management. As a result,
many banks failed to recognise the true nature of the liquidity
risk embedded in their business activities. 12
1 In this regard, LTP forms part of the funds transfer pricing (FTP) process.
2 This claim is supported by the Basel Committee on Banking Supervi­
sion (BCBS), which reported that many of the basic yet fundamental
principles of liquidity risk management were neglected by banks. For
more information, see Liquidity Risk: Management and Supervisory
Challenges, BCBS, (February 2008).
288 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
One principle of liquidity risk management that lacked attention
was LTP. In 2009, a group of prudential regulators conducted
an international survey to assess the progress banks are making
to enhance LTP. The survey covered 38 banks from nine coun­
tries. Total assets of the banks surveyed ranged from less than
US$250 billion to greater than US$1 trillion.
The survey responses revealed that many of the LTP practices
employed by banks were short of good practice. This paper
extracts the lessons learned from the survey, and makes a first
attempt at establishing better LTP practice. For confidential­
ity reasons, however, it is not possible to quote or reference
directly from any of the survey responses.
15.1.1 A Summary of the Major Lessons
Learned
15.1.1.1 Governance of the LTP process
Most banks included in the survey lacked an LTP policy. As
such, LTP was not defined nor were there any rules or principles
in regard to how LTP should operate. Typically, this outcome
meant that liquidity generators (such as retail branches raising
deposits) were underpaid for their liquidity creation, and liquid­
ity users (such as lending, investment, and trading portfolios)
received free or unduly cheap liquidity.
Where banks in the survey were operating with decentralised
funding centres, most had inconsistent LTP regimes. In addition,
these banks relied on manual off-line processes to intervene and
to update relevant funding costs, and were more prone to arbi­
trage between business units and internal treasuries.
For many of the banks in the survey with large trading businesses,
internal treasuries often lacked visibility over individual business
balance sheets, limiting their understanding of individual fund­
ing requirements and contingent liquidity exposures. Most of the
time this resulted in treasuries charging all trading businesses
based on their net funding requirement, with no add-ons for the
implicit risk of a blow-out in liquidity needs.
Oversight of the LTP process at nearly all banks that partici­
pated in the survey was poor to nonexistent, especially by risk
and financial control functions. This was one of the factors that
resulted in the accumulation of highly illiquid (and often corre­
lated) assets and the excessive reliance upon short-term (often
overnight) funding.
Liquidity Management Information Systems (LMIS) employed
by most of the banks surveyed were simplistic and inflexible.
Many of the systems were unable to attribute the costs, bene­
fits, and risks of liquidity appropriately to respective businesses,
and at a sufficiently granular level. This resulted in product mis­
pricing, which distorted profit and performance assessments.
For a large proportion of banks included in the survey, their LTP the same charge for the cost of liquidity and, conversely, short-
process failed to account for the costs, benefits and risks of and long-term liabilities receiving the same credit for the benefit
liquidity in the pricing and performance assessment of various of liquidity.
products and business units. As a result, profit measures used as
a basis for determining business unit performance and executive 15.1.1.3 Sizing and Attributing the Costs
remuneration were distorted. Profit pools, for example, which of Liquidity Cushions
are generally used to determine short-term incentives (bonuses)
For a large majority of the banks surveyed, liquidity cushions
for employees, were derived from a simple percentage of
were derived from stress assumptions stemming mainly from
accrued revenues without any regard for the liquidity risk taken
idiosyncratic funding scenarios, revolving around a single bank's
to generate such profits. 3 This encouraged revenue and risk
sudden inability to raise funds. Having little or no regard to sys­
maximisation rather than risk-adjusted earnings.
temic funding scenarios, most cushions were too small to with­
stand prolonged or deep market disruptions.
15.1.1.2 The Application of LTP
In addition, cushions comprised liquid assets that were them­
Probably the most striking example of poor LTP practice was
selves funded short-term. This meant that the cost of carrying
how some of the banks that were surveyed treated liquidity as a
the liquidity cushion was quite small, but the real value of the
"free" good, completely ignoring the costs, benefits and risks of
cushion in addressing sudden (contingent) liquidity risks was
liquidity. These banks neglected to charge or credit respective
also minimal. This costing and funding arrangement provided
businesses, products and/or transactions accordingly. This was
insufficient incentive for banks to attribute true costs back to
particularly the case for much of the contingent or unfunded
business units on an expected or predicted usage basis but,
business that was written. Examples included trading and invest­
rather, to opt for the simpler but incorrect method of averaging
ment banking activities, lines of credit, the need to prepare
the cost across all assets.
for collateral calls, and variable-rate (adjustable-rate) products
including home mortgages.

Most of the banks surveyed recognised the need to attribute
the costs, benefits and risks of liquidity to respective businesses.
However, a large majority of these banks employed a pooled
average cost of funds approach to derive the costs and benefits
of liquidity. This resulted in short- and long-term assets receiving
3 Bonus pools often neglected other risks, not just liquidity, and the
cost of capital employed to generate such profits. This is the subject of
another paper.
15.1.2 Regulatory Developments
The Basel Committee on Banking Supervision (BCBS) has been
central to regulatory developments in liquidity, first publishing
Sound Practices for Managing Liquidity in Banking Organisa­
tions in February 2000. Following this, in 2006, the BCBS
established the Working Group on Liquidity (WGL) to "serve
as a forum for information exchange on national approaches
to liquidity supervision and regulation". The group's initial
mandate was to review and evaluate liquidity supervision

C h ap ter 15 Liquidity Transfer Pricing: A Guide to B etter Practice ■ 289

practices, and banks' approaches to liquidity risk manage­
ment, with respect to the sound practices already established.
This work was the first to highlight the basic yet fundamental
elements that were missing from bank liquidity management.
These findings formed the basis of the report Liquidity Risk:
Management and Supervisory Challenges (February 2008) and
sparked a review of the February 2000 sound practices. An
updated version of these practices, articulating 17 principles,
was released as Principles on Sound Liquidity Risk Manage­
ment and Supervision (September 2008). Since 2008 the BCBS
has released Principles for Sound Stress Testing Practices and
Supervision (May 2009) and more recently, Basel III: Interna­
tional Framework for Liquidity Risk Measurement, Standards
and Monitoring, aimed at improving the resilience of the
financial system (December 2010 ) . 4 As part of this, two global
standards for liquidity risk were developed. First, a Liquidity
Coverage Ratio (LCR) to ensure banks have sufficient high
quality liquid assets to survive an idiosyncratic shock and,
second, a Net Stable Funding Ratio (NSFR) to encourage
banks to fund their business activities using more stable
sources of funding.
15.1.3 The Need for More Guidance on LTP
The scale and extent of liquidity reform is large. But, given
the weaknesses in bank liquidity risk management approaches
unveiled by the recent crisis, it is not surprising that certain
principles require further guidance. This is particularly the case
for LTP.
Extant guidance is broad but merely encourages banks to
include liquidity risk in their internal pricing mechanisms, with­
out providing specific help . 5 For example, Principle 4 of the
BCBS Principles on Sound Liquidity Risk Management and
Supervision states that: "a bank should incorporate liquidity
costs, benefits and risks in the internal pricing, performance
measurement and new product approval process for all signifi­
cant business activities (both on- and off-balance sheet),
thereby aligning the risk-taking incentives of individual busi­
ness units with the liquidity risk exposures their activities create
for the bank as a whole" (p 3).
The Committee of European Banking Supervisors (CEBS)
(now the European Banking Authority) has also highlighted the
importance of banks having "an effective allocation mechanism
4 These papers can be accessed via http://www.bis.org/list/bcbs/sac_1/
index.htm.
5 A complete list of principles and/or recommendations provided by
various regulatory and non-regulatory bodies is included in Appendix 1.
290 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
for liquidity costs, benefits and risks". Recommendations pro­
vided in the Second Part of CEBS's Technical Advice to the
European Commission (EC) on Liquidity Risk Management6,
and Point 14 in Annex V of the amendments to the Capital
Requirements Directive (Directive 2009/111/EC of the European
Parliament and of the Council of 16 September 2009)7, led to
the development of CEBS's, Guidelines on Liquidity Cost Benefit
Allocation (October 2010) . 8
Efforts by the BCBS and others to improve LTP are acknowl­
edged, but a lack of detailed supporting guidance has left
some supervisors and banks asking: "what exactly constitutes
better practice?" This paper seeks to assist with this question.
It focuses on some of the more widespread poor LTP practices
that were identified via the international survey with the aim of
drawing out better practices. This more detailed guidance is
intended to support and supplement the principles already pro­
mulgated, and assist supervisors and banks in achieving better
LTP practices.
15.2 G O VERN IN G LTP
Broadly speaking, all policies, processes and practices require
governing. This is normally achieved through a combination of
external control factors, such as regulation and competition, and
internal control factors, such as board oversight and risk man­
agement. 9 Because external control factors affect institutions in
much the same way, governance is differentiated largely by the
internal control factors that are employed.
How well an institution is governed can bear heavily on whether
group-wide objectives are met. While institutions with strong
internal controls are more likely to achieve their goals, institu­
tions with weak internal controls are more prone to the
6 See Recommendation 2 in Second Part of CEBS's Technical Advice to
the European Commission on Liquidity Risk Management, September
2008, which is available at http://www.eba.europa.eu/getdoc/bcadd66
4-d06b-42bb-b6d5-67c8ff48d11d/20081809CEBS_2008_147_(Advice-
on-liquidity_2nd-par.aspx.
7 Available at http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:
L:2009:302:0097:0119:EN:PDF.
8 Guidelines on Liquidity Cost Benefit Allocation, CEBS, October
2010, can be accessed via http://www.eba.europa.eu/cebs/media/
Publications/Standards%20and%20Guidelines/2010/Liquidity%20
cost%20benefit%20allocation/Guidelines.pdf.
9 The Committee of Sponsoring Organisations of the Treadway Com­
mission (COSO) defines internal control as "a process, effected by an
entity's board of directors, management and other personnel, designed
to provide "reasonable assurance" regarding the achievement of
objectives in the effectiveness and efficiency of operations, reliability
of financial reporting, and compliance with applicable laws and regula­
tions" (http://www.coso.org/resources.htm).
problems of moral hazard and adverse selection. 1 0 This is likely
to weigh on performance.
Many of the poor LTP practices that were identified across
banks that participated in the survey were the direct result of
weak internal controls. Some of these are discussed in more
detail below.
15.2.1 Management of the LTP Process
Broadly speaking, there were severe deficiencies in how the LTP
process was managed.
15.2.1.1 LTP Policies
Few banks in the survey had an effective LTP policy. As a result,
LTP was not defined, nor were there any principles and/or rules
in place to assist businesses understand how LTP should oper­
ate. Having no LTP policy is clearly poor practice, given what we
now know about liquidity risk. Banks have traditionally relied on
internal transfer pricing to manage interest rate risk in the bank­
ing book, and to assess and monitor the performance of products
and business units, but with no or only minimal adjustments for
liquidity costs, benefits and risks. For most banks in the survey,
the internal pricing of liquidity risk is a relatively new concept,
brought to light by the recent breakdown in wholesale funding
markets, and the consequent increase in funding costs. It will take
time for banks to establish adequate LTP policies and procedures,
but this is a necessary first step towards better LTP practice.
15.2.1.2 Internal Funding Structure - Centralised
vs Decentralised
There is substantial debate surrounding the optimal internal
structure of banks - is it better to have a centralised funding
centre, whereby wholesale funding is restricted to a group or
subsidiary treasury or, alternatively, decentralised funding cen­
tres, whereby certain business units are able to raise funding
themselves from their own sources to cover their own liquidity
needs? There are reasonable academic and economic argu­
ments that provide support for both approaches. However,
the survey identified that banks with decentralised funding
centres, particularly those with large prime brokerage business
activities, were more susceptible to poor LTP practices. For
10 Moral hazard occurs when a party, insulated from risk, behaves
differently than they would if they were fully exposed to the risk (www
.wikipedia.com). For example, a bank might be more inclined to engage
in risky behaviour, knowing that it will be bailed out if the risks turn bad.
Adverse selection, on the other hand, is a process whereby bad results
occur because of information asymmetries between buyers and sellers.
For example, a used car salesman might sell a car, which he knows has
mechanical problems, to a buyer that is less informed.
C h ap ter 15
example, some business units that were able to raise wholesale
funds from external sources then sold the funds to treasury
and in some cases to other business units, at a higher rate. This
resulted in a "risk-free" profit to the business unit at the cost of
more and possibly badly managed risk for the bank as a whole.
It is clear, however, that decentralised funding structures were
not the sole cause of internal arbitrage. Poor oversight and inad­
equate risk controls also played a role. Jointly, these factors lim­
ited the ability of treasury and business units to know what price
other business units had paid for funds from external sources
and thus provided a basis for arbitrage. In addition to this, most
of the banks with decentralised funding structures employed
inconsistent LTP regimes and relied on manual off-line processes
to update funding costs.
15.2.1.3 Trading Book Funding Policies
and Identifying Funding Requirements
Probably the worst LTP practices identified in the survey were in
relation to trading and investment banking activities. A combi­
nation of poorly designed trading book policies, inadequate risk
controls and limits, as well as a lack of oversight were to blame.
For example, some banks that took part in the survey lacked
trading book funding policies and procedures, which allowed for
over-aggressive trading behaviour and the accumulation of illiq­
uid assets in search of revenues, not risk-adjusted profit. Most of
the banks included in the survey did have trading book funding
policies, but nearly all of these policies assumed that assets were
only held short-term (ie for 180 days or less). One problem with
this approach is that, irrespective of whether assets are likely to
be held for more than the 180-day threshold, long-term fund­
ing charges only apply when assets roll from the trading book
to the banking book. This provided little incentive for banks to
develop risk controls and limits to adequately measure, monitor
and assess the liquidity risk in traded assets, and was evident
through the build-up of positions that were highly illiquid.
Many of the larger banks included in the survey, particularly
those with substantial trading businesses, lacked a line of sight
to individual business balance sheets, and thus could not iden­
tify the funding requirements of individual trading desks. As a
result, trading and investment banking activities were funded
based on the total net funding requirement across all related
business units. This method essentially provides a line of credit
to the trading book, and gives no regard to the liquidity risk
embedded in business activities. This approach is therefore
considered to be poor practice. On a separate but related issue,
banks with large trading businesses that participated in the
survey also applied insufficient haircuts to many of the traded
assets they held. These banks clearly underestimated the likeli­
hood of a market disruption, and the extent to which market
Liquidity Transfer Pricing: A Guide to B etter Practice ■ 291
liquidity could evaporate. The severe drop in market prices
led to calls on margin positions and placed severe pressure on
banks' abilities to meet funding requirements. Part of the reason
this occurred was because no one had previously thought of the
need to price the liquidity costs of potential margin calls.
15.2.1.4 Oversight
Ineffective oversight of the LTP process contributed to many of
the problems that were identified at banks that took part in the
survey. For example, the accrual of long-term illiquid assets and
short-term volatile liabilities created a large and poorly under­
stood mismatch between the maturities of assets and liabilities,
and therefore exposed banks to greater structural liquidity risk.
Probably the most striking example highlighting the implications
of poor oversight was how some of the banks' LTP processes
enabled them to accumulate significant amounts of highly rated,
yet highly illiquid, tranches of collateralised debt obligations
(CDOs) in their respective trading accounts. These portfolios
were assumed to be safely funded with much shorter-term liabil­
ities, typically in the order of overnight to 90-day funds.
15.2.1.5 Towards Better LTP Practice
In one form or another, all of the banks included in the survey
are enhancing the way LTP is managed. A large portion of the
banks surveyed, for example, are creating LTP policies for the
first time to outline the purpose of LTP and, to provide some
principles and/or rules to ensure business units understand
the reasoning behind charges relating to the use of liquidity.
For the small proportion of banks in the survey that were oper­
ating with decentralised funding centres, they are all moving
towards having wholesale funding managed centrally by a trea­
sury function. In part, this is to restrict arbitrage between busi­
ness units and treasury, and between business units themselves.
The survey also identified a small number of banks that are
developing trading book policies and procedures for the first
time. To complement this change, these banks are also develop­
ing risk controls and limits for trading activities to properly mea­
sure, monitor and assess the liquidity risk embedded in products
and business units.
Most of the banks included in the survey, however, were found
to be updating existing policies. The most notable enhancement
includes the application of higher funding charges to trading
positions that are more likely to become "stale" (ie positions that
have a higher probability of rolling from the trading book to the
banking book). Banks in this category are also enhancing existing
risk controls and limits to better manage liquidity risk exposures.
The follow-on effects from these enhancements are improving
risk-adjusted profit measures, and this is prompting business
292 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
units to consider the cost of liquidity as part of their decision
to book certain assets. Haircuts on traded assets are also being
widened to account for more severe and prolonged market
disruptions, and to ensure that assumptions surrounding the
amount of liquidity that can be generated during a crisis are
appropriately conservative.
Banks that were included in the survey whose trading book
exposures are small relative to their main business activities, are
attempting to curb over-trading behaviour by imposing higher
funding charges on net funding requirements when certain
funding limits are breached. Other banks in the survey, whose
trading book exposures are large relative to their main business
activities, are devoting more attention to understanding the
funding requirements of individual trading desks, and are look­
ing to apply charges on a more granular basis.
Across all banks in the survey, there is an emphasis on improving
oversight. Management at all levels, treasury functions, as well
as independent risk and financial control personnel are becom­
ing more engaged in the LTP process. In addition, meetings to
discuss changes in funding costs are being held more regularly,
for example, monthly instead of quarterly or semi-annually, as
they were prior to the financial crisis.
In one form or another, all of the banks included in the survey
are enhancing the way their LTP process is managed. One posi­
tive stemming from these enhancements is that related parties
involved in the management of LTP are being forced to better
understand the LTP process. Broadly, banks are encouraged to
continue with similar changes.
15.2.2 Liquidity Management Information
Systems (LMIS)
LMIS are widely used by management as a primary source
of measuring and monitoring the performance of businesses.
LMIS provide information that assists management in liquidity
strategic decision-making. In this regard, LMIS play a pivotal role
in helping management achieve group-wide goals. Weak LMIS
could easily distort the information for decision-making and
prevent the bank from achieving its objectives.
One application of LMIS is to support internal pricing mecha­
nisms. In relation to LTP, LMIS enable the costs, benefits and
risks of liquidity to be attributed to appropriate business
activities. Many of the pre-2009 LMIS employed by banks that
were included in the survey were too basic, and this limited the
effectiveness and efficiency of the LTP process. In some cases,
for example, the basic and rigid nature of LMIS meant that
certain business activities failed to receive a charge for the cost
of liquidity or, conversely, a credit for the benefit of liquidity.
Another weakness in many of the LMIS that were employed by
banks in the survey was that they prevented the costs, ben­
efits and risks of liquidity from being attributed at a sufficiently
granular level.
The SSG (2009) also report similar findings. "Many firms
acknowledged shortcomings in their LMIS infrastructure and in
their ability to produce useful reports during the crisis, recog­
nizing that better-quality and more timely liquidity reporting
was essential to effective management of liquidity and funding
issues during a crisis" (p 15). In light of these shortcomings, the
SSG recommended that banks improve their LMIS.
One implication of the weakness in LMIS and the poor LTP prac­
tices that resulted is that businesses reported performance (and
employees claimed bonuses) on a basis that might not have
reflected their actual performance. Essentially, this would limit
management's ability to monitor performance, accurately dis­
tinguish good performing businesses from those that were not
performing so well, and make reliable decisions pertaining to
their objectives.
A large proportion of the banks included in the survey are in
the process of upgrading LMIS after their short-comings were
unmasked by the GFC. From a supervisory perspective, it is essen­
tial that this upgrading continues. As outlined above, LMIS are
an essential part of the decision-making process so it is vital that
the information they provide is accurate and reliable. Upgrading
LMIS in a large bank is a costly and long-term process. But the
benefits of appropriately charging business activities for the cost,
benefits and risk of liquidity, and at a sufficiently granular level,
will far outweigh the costs and limitations of the basic LMIS that
were previously employed. LMIS that are sufficiently advanced to
achieve these outcomes will promote better LTP practice.
15.2.3 Remuneration Practices
If designed well, incentive pay can have enormous benefits. It
encourages behaviour that is consistent with the culture of an
institution, and assists management in achieving group-wide
objectives. On the other hand, poorly designed remunera­
tion can promote perverse behaviours such as excessive risk­
taking, which could severely impact the performance of an
institution.
In 2009, the Financial Stability Board (FSB) reported that poor
remuneration practices were one of the factors that contributed
to the GFC. "High short-term profits led to generous bonus
payments to employees without adequate regard to the longer-
term risks they imposed on their firms.
These perverse incentives amplified the excessive risk-taking
that severely threatened the global financial system and left
C h ap ter 15 Liquidity Transfer Pricing: A Guide to B etter Practice
firms with fewer resources to absorb losses as risks materi­
alised" (p 1 ) . 11
The SSG also identified poor remuneration practices as one of
the factors that contributed to the funding and liquidity prob­
lems witnessed at some banks during the recent crisis. Following
their survey of firms, the SSG reported that remuneration was
largely insensitive to the risks taken to generate income, and to
costs associated with long-term funding commitments that were
required to hold illiquid assets (p 24).
Similarly, many of the banks that participated in the survey on
LTP failed to adequately account for the costs, benefits and
risks of liquidity in the pricing and performance assessment of
various products and business units. As a result, profit mea­
sures used as a basis for determining remuneration were often
distorted. Profit pools, for example, which are generally used
to determine short-term incentives, or bonuses for employees,
were derived from a simple percentage of accrued revenues,
without any regard to the cost of liquidity (or capital). This
placed more emphasis on maximising revenues rather than
risk-adjusted earnings.
Another reason the costs, benefits and risk of liquidity were
poorly allocated through the LTP process for most of the
banks in the survey, was because of the way remuneration
was structured, particularly for those employees responsible
for oversight. For many staff in these areas, remuneration was
designed such that it largely depended on the performance
of front-line businesses they were responsible for oversee­
ing. Thus, including the actual costs for liquidity would have
impacted negatively upon business unit performance, which
inevitably would have reduced personal remuneration and ben­
efits for employees. Clearly, this would have also impacted the
independence of their role.
Recognising these weaknesses, many of the banks that
took part in the survey are developing their respective LTP
processes to ensure that profit and performance measures
include the relevant costs for liquidity (and capital, although
this is a separate issue). Under the new regime, assets will
receive a charge for the cost of liquidity consistent with the
positions that are funded. In addition to this, many of the
larger banks in the survey are moving towards re-designing
remuneration for persons in risk control positions consistent
with Principle 3 of the FSB's Principles for Sound Compensa­
tion Practices. Principle 3 states that, "staff engaged in finan­
cial and risk control should be compensated in a manner that
11 Principles for Sound Compensation Practices, FSB, (April 2009) is
available at http://www.financialstabilityboard.org/list/fsb_publications/
tid 123/index.htm.
■ 293
is independent of the business areas they oversee and com­
mensurate with their key role in the firm" (p 2). It is envisaged
that this will also promote a more appropriate attribution of
liquidity costs to business activities and restore independence
in these vital roles.
15.3 LTP IN PRACTICE: M ANAGING
O N -BALAN CE SH EET FUNDING
LIQUIDITY RISK
15.3.1 Why Banks Need LTP
In their daily operations, banks make money by funding long­
term loans (assets) with short-term deposits (liabilities), a pro­
cess that is commonly referred to as maturity transformation. As
pointed out by the BCBS (September 2008), this "makes banks
inherently vulnerable to liquidity risk, both of an institution-
specific nature and that which affects markets as a whole" (p 3).
But provided banks use LTP to account for the costs, benefits
and risks of liquidity in product pricing, new product approval
processes and profit and performance assessments, they should
not be discouraged from engaging in maturity transformation.
Banks with poor LTP practices are more likely to accrue larger
amounts of long-term illiquid assets, contingent commitments
and shorter-dated volatile liabilities, substantially increasing their
vulnerability to funding shortfalls.
15.3.2 An Example of What Can Go
Wrong with Poor LTP
In October 2009, the SSG revealed that firms that encoun­
tered the most severe funding and liquidity problems through
the financial crisis were those that relied excessively on
short-term financing of longer-term illiquid assets. That
is, those that engaged most in maturity transformation. The
SSG highlighted that one of the drivers behind the devel­
opment of these business models was poor LTP practices,
which failed to penalise businesses for the liquidity risk
embedded in the assets that were booked, and which also
allowed banks to build up significant amounts of contingent
liquidity risk in off-balance sheet exposures. These banks
made large apparent profits before the GFC, but failed to
recognise that these profits were based upon what proved
to be extraordinarily fragile liquidity arrangements.
15.3.3 "Zero" Cost of Funds Approach -
Liquidity as a "Free" Good
Probably the most striking example of poor practice identified in
the survey was that some banks failed to account for the costs,
benefits and risks of liquidity in all or some aspects of their busi­
ness activities. These banks came to view funding liquidity as
essentially free, and funding liquidity risk as essentially zero. As
a result, there was simply no charge attributed to some assets
for the cost of using funding liquidity, and conversely no credit
attributed to some liabilities for the benefit of providing funding
liquidity. This was undoubtedly the worst practice identified in
the survey. Figure 15.2 below provides a graphical representa­
tion of what this would look like in practice. Note that the rate
charged to users of funds in this instance would have been
derived from the swap curve only. If we assume that interest rate
risk is properly accounted for using the swap curve, then a zero
spread above the swap curve implies a zero charge for the cost
of funding liquidity.
A zero charge for the cost of liquidity and, conversely, a zero credit
for the benefit of liquidity exacerbated maturity transformation to
the largest degree possible. This approach resulted in the hoarding
of long-term highly illiquid assets, and very few long-term stable
liabilities to meet funding demands as they became due.
15.3.3.1 Why Did Some Banks Choose This
Approach ?
Ideal funding conditions in the years preceding the crisis could
provide one explanation of why some banks viewed liquidity
as a free good, and funding liquidity risk as essentially zero.
Figure 15.3 below shows how the spread between one-year
LIBOR and the one-year swap rate changed during the period
June 2005 to October 2010.

The international survey identified many poor LTP practices,

which reflected weaknesses in the LTP methods/approaches that
were used to manage funding liquidity risk. These are discussed
in more detail below.

294 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 140 rate calculated, all assets irrespective of their maturity are
charged the same rate for their use of funds (cost of liquidity), as
depicted in Figure 15.4 below.
To illustrate how charges and credits for the use and benefit
of funds would be allocated under an average cost of funds
approach, consider the following example. If the average rate
across all funding sources was 1 0 bps, all loans would receive
a charge of $ 1 , 0 0 0 on a principal amount of $ 1 million, irre­
spective of their maturity. Assuming this rate was also used to
1.06.2005 1.06.2006 1.06.2007 1.06.2008 1.06.2009 1.06.2010 reward fund providers, then all deposits would receive a credit
D ate of $ 1 , 0 0 0 on a principal amount of $ 1 million, irrespective of
Figure 15.3 1-year LIBOR/Swap spread their maturity. This can be seen in Table 15.1.
(Currency = USD).
15.3.4.1 Problems with the Pooled "Average"
Source: Bloomberg.
Cost of Funds Approach
Despite its simplicity there are two major weaknesses with
In June 2005, at the peak of robust share market growth, the
this approach. First, it ignores the heightened liquidity
spread was only 0.5 basis points (bps). With funding conditions
risk embedded in longer-term assets. Charging one "aver­
so easy, it is likely that banks viewed spreads as pure credit risk
age" rate for the use of funds inherently assumes that all
adjustments and neglected (ignored) funding liquidity risk alto­
assets, irrespective of their maturity, pose the same liquidity
gether. If banks believed funding would always be available and
risk. Moreover, if this "average" rate is also used to credit
at permanently cheap rates, this simply could have masked the
fund providers, then an incentive to write loans will be met
need to charge assets for the cost of liquidity, and conversely,
with a direct disincentive to gather deposits. For example,
credit liabilities for the benefit of liquidity.

15.3.4 Pooled "Average" Cost Spread=

of Funds Approach to LTP average cost/
benefit of funds

Some banks recognised the need to charge users and

credit providers of funding liquidity and employed a
pooled approach to LTP, where an average rate was
calculated based on the interest expense (cost of
funds) across all existing funding sources. For exam­
ple, if deposits were a bank's only source of funding
the average rate would be based on the total inter­
est expense for all deposits divided by average total
deposits, adjusted for floats and reserve requirements.
This approach is much better than the zero cost of funds
approach, but because there is only one "average"
Figure 15.4 Single average for the cost and benefit of funds.

Table 15.1 Costs and Benefits of Funds Under an Average Cost Approach
Term in years 1 2 3 4 5

Loan/deposit principal $1 million $1 million $1 million $1 million $1 million

Average cost of funds (bps) 10 10 10 10 10

Charge for use of funds $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0

Credit for benefit of funds $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0

C h ap ter 15 Liquidity Transfer Pricing: A Guide to B etter Practice ■ 295


Yield
Maturity
Figure 15.5 Separate averages for the cost and benefit
of funds.
decreasing the rate charged to fund users from 1 0 bps to
five bps will encourage loan generation, but at the same
time, this will provide less incentive for business units to
raise deposits.
Having separate "average" rates for the costs and benefits of
funds is a better approach. This is depicted in Figure 15.5 below.
To illustrate the effect of having separate average rates for the
cost and benefit of funds, consider the following example. If the
average cost of funds is 1 0 bps, as in the example presented
above, all loans would be charged $ 1 , 0 0 0 on a principal of
$1 million, irrespective of their maturity. Further, if the average
benefit of funds is four bps, all deposits would be credited $400
on a principal of $1 million, irrespective of their maturity. Under
this approach, lowering the average cost of funds from 1 0 bps
to five bps will encourage loan generation. However, because of
the separate rate for the average benefit of funds, this change
will not directly discourage business units from raising deposits.
This information is presented in Table 15.2.
However, in much the same way as one "average" rate for
fund users ignores the heightened liquidity risk in longer-term
assets, having one "average" rate for fund providers ignores the
increased benefits of liquidity in longer-term liabilities. That is,
Table 15.2 Costs and Benefits of Funds Under a Separate Average Cost Approach
Term in years 1 2
Loan/deposit principal $1 million $1
Average cost of funds (bps) 10
Average benefit of funds 4 4
Charge for use of funds $1 , 0 0 0
Credit for benefit of funds $400
296 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
all deposits irrespective of their maturity receive the
same credit for the benefit of funds, as can be seen in
Table 15.2.
Second, using an average cost of funds reflects his­
torical rates and prices, but does not appropriately
reflect the actual market cost of funds. If five-year
funding was to increase by 2 0 bps, for example, the
respective change in the average (cost of funds) rate
would be much less. Changes in the actual market
cost of funds would need to be sustained for a period
of time for the effect to be fully integrated into the
average cost of funds. Because the average cost of
funds lags changes in the actual market cost of funds,
it does not appropriately reflect market perceptions
of risk for new business entering a bank's books.
15.3.4.2 Implications of Pooled "Average" Cost
of Funds Approach
Promotes Maturity Transformation One implication of
employing a pooled "average" cost of funds approach to LTP is
that it promotes unhealthy as well as healthy maturity transfor­
mation. Business units will be unduly encouraged to write long­
term assets because they do not receive higher charges for their
use of funds over a longer period. Conversely, business units will
be discouraged from raising long-term liabilities because there
is no premium credited to liabilities that provide funding for lon­
ger periods of time. The net effect of this is a larger mismatch
between the maturities of assets and liabilities on banks' bal­
ance sheets, which inherently exposes them to greater structural
liquidity risk. This point is supported by the SSG (2009), which
claims that "borrowers had taken advantage of the opportu­
nity the market afforded to obtain short-term (often overnight)
financing for assets that should more appropriately have been
funded with long-term, stable funding" (p 2 ).
Moreover, some institutions ignored maturity mismatch
liquidity risk by not appropriately match-funding originated
transactions in their funds transfer pricing (FTP) systems on
a cash-flow basis. When combined with average costs of
3 4 5
million $1 million $1 million $1 million
10 10 10 10
4 4 4
$1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0 $1 , 0 0 0
$400 $400 $400 $400
existing funds across all funding sources to banks' balance Marginal cost of funds curve
sheets, the lack of reference to term cash-flow matched Yield
funding entailed the cross-subsidisation of longer-dated
Term liquidity premium
liquidity risk at the expense of shorter-dated risk. Such
subsidisation skewed business incentives and behaviours
to the detriment of bank soundness.
Other factors, such as remuneration and information asym­
metries, naturally encourage long-term asset generation,
but under an average cost of funds approach the incentive Charges (credits) to short-term assets (liabilities) higher
under "pooled" average cost-of-funds approach
is exacerbated. For example, if remuneration is based on
performance, which is measured via net interest income, Charges (credits) to long-term assets (liabilities) higher
under matched-maturity marginal cost-of-funds approach
businesses will ordinarily be encouraged to write long-term
loans because they generate more interest income, with less Maturity
effort, over several years. Where an average cost of funds Fiaure 15.6 Matched-maturity marginal cost of funds
approach is employed, this incentive becomes even more approach to LTP.
attractive for business units because assets that require fund­
ing for longer periods of time are not charged more for the of business unit managers and provides central management
cost of liquidity. In regard to information asymmetries, business with more control over group-wide objectives.
unit managers are likely to know more about their businesses'
activities than treasury. Hence, if business unit managers believe
treasury is under-charging for the use of long-term funds, it will 15.3.5 Matched-Maturity Marginal Cost
naturally encourage them to write long-term assets. But since all of Funds Approach to LTP
funds are charged the same rate for the use of funds under an
average cost of funds approach, where information symmetries A matched-maturity marginal cost of funds approach to LTP is
exist, this incentive will be magnified. A similar but opposite current best practice for assets and liabilities on the balance
effect will exist for liabilities. sheet. From banks' actual market cost of funding, this approach
calculates the portion of the cost that is attributable to liquidity.
D istorts Profit Assessm ent Another implication of the pooled
It seeks to achieve this by converting fixed-rate borrowing costs
average cost of funds approach to LTP is that it distorts profit
to floating-rate borrowing costs through an internal swap trans­
assessment. As outlined above, the average cost of funds lags
action and observing the spread over the reference rate, which
changes in banks' actual market cost of funds, especially in vola­
is depicted from the swap curve. This spread is usually referred
tile markets. Banks employing this approach found that their
to as a term liquidity premium and is the rate that charges
pricing methodologies resulted in the mispricing of and accu­
assets for the use of funds, and credits liabilities for the benefit
mulation of assets on significantly distorted risk-adjusted terms.
of funds. This is presented graphically in Figure 15.6.
This made it difficult to identify poor performing products and
business units on a risk-adjusted basis. To explain this process more fully, banks incur fixed-rate costs
when issuing unsecured wholesale term debt. Using these costs
There are several reasons why some of the banks included in
alone it is difficult to strip out the portion that is attributable to
the survey might have chosen to adapt a pooled average cost
liquidity. But swapping fixed rate costs to floating rates provides
approach to LTP. First, averaging funding costs across all assets
a solution. The process generally involves stripping structured
is much simpler than having to charge individual assets, prod­
debt issuances into embedded derivatives and floating rate cash
ucts or transactions based on their contractual or behavioural
instruments, which are pegged to a reference rate. 1 2 The spread
(expected) maturities. Second, the simplicity of the average
above the reference rate is the rate that values the internal swap
cost of funds approach makes it easier for business units to
transaction at par. This is the term liquidity premium. It reflects
understand the LTP process and therefore provides more incen­
both idiosyncratic credit risks and market access premiums and
tive for them to comply. Third, under this approach, the LTP
is considered to be a much better measure of the cost of liquid­
process could be managed efficiently using basic LMIS. Fourth,
ity than an average cost of funds.
the average cost of funds is less susceptible to intermedi­
ate changes in banks' actual market cost of funding, thereby
reducing net interest income volatility across businesses. This is
advantageous because it limits the subjective decision-making This process is described in detail in Matz and Neu (2007).

C h ap ter 15 Liquidity Transfer Pricing: A Guide to B etter Practice ■ 297

Reference rates are generally depicted from a swap curve,
which is constructed from a combination of LIBOR or
Euribor rates for funding up to one year, and interest rate
swaps for funding above one year. This curve reflects a term
structure of interbank lending rates. Although credit risk is
somewhat mitigated by the fact that principal amounts are not
exchanged between respective parties in a swap agreement,
swap curves are still considered to provide better estimates of
"base" reference rates for the purpose of teasing out liquid­
ity than, say, government curves. This is because swap curves
more closely reflect the risks to which banks are exposed when
borrowing and lending money in the interbank market. Swap
curves also capture changes in general market conditions.
15.3.5.1 How are Rates for Users and Providers
of Funds Determined?
Under the matched-maturity marginal cost of funds approach,
rates charged for the use of funds and, conversely, rates cred­
ited for the benefit of funds are based on the term liquidity
premiums corresponding to the maturity of the transaction, or
in the case of amortising or indeterminate-maturity products,
blended term liquidity premiums consistent with their known or
estimated cash-flow profiles.
Even though the matched-maturity marginal cost of funds approach
to LTP is considered to be better practice, some of the more
advanced banks surveyed that had employed this method failed to
actively update term liquidity premiums. As a result, assets were mis­
priced and risk-adjusted profit assessments were distorted, especially
as market volatility increased in the early stages of the GFC.
15.3.6 Examples of Pricing Funding
Liquidity Risk
To illustrate how the matched-maturity marginal cost of funds
approach should be applied in practice, and to compare it to
the average cost of funds approach, assume the following term
liquidity premiums and average cost of funds were recorded by
a bank at a point in time prior to the crisis (pre-GFC), and more
recently (current).
Some examples of how LTP should apply to various transactions
are presented below.
15.3.6.1 Non-Amortising Bullet Loans
As the name implies, non-amortising bullet loans provide no
repayments (cash flows) throughout the life of the loan. Since
all principal and interest is repaid at maturity, a funding com­
mitment is required for the entire life (term) of the loan. Hence,
using a matched-maturity marginal cost of funds approach,
298 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Table 15.3 Pre-GFC and Current Term Liquidity
Premiums and Average Cost of Funds
In basis points
Term in years 1 2 3 4 5
Panel A: pre-GFC
Term liquidity 1 2 3 6 10
premium
Average cost of 2 2 2 2 2
funds
Panel B: current
Term liquidity 5 10 18 28 40
premium
Average cost of 8 8 8 8 8
funds
a one-year non-amortising bullet loan should have received
a charge of one bp (Panel A), if originated pre-crisis, and five
bps (Panel B) if originated more recently. For simplicity, if the
principal of the loan was $ 1 million, this should have translated
to charges of $100 and $500, respectively to the business
unit(s) writing the loans. In much the same way, a five-year
non-amortising bullet loan should have received a charge of
10 bps (Panel A) if originated pre-crisis, and 40 bps (Panel B) if
originated more recently. Assuming the same loan principal of
$ 1 million, this should have translated to charges of $ 1 , 0 0 0 and
$4,000, respectively, to the business unit(s) writing the loans.
In contrast, had an average cost of funds approach been applied,
both the one- and five-year non-amortising loans would have
been charged two bps (Panel A) if originated pre-crisis, and eight
bps (Panel B) if originated more recently. Table 15.4 below pres­
ents the differences in the charges for the uses of funding for
each of the non-amortising bullet loans in this example.
Table 15.4 shows that non-amortising bullet loans with a term
of one-year would have received a higher charge for the use of
funding if banks applied an average cost of funds approach rather
than a matched-maturity marginal cost of funds. However, for all
other maturities, the opposite is true. Using an average cost of
funds approach in the pre-crisis period, a five-year loan would
have been undercharged eight bps ($800 on a loan of $ 1 million).
If the same loan was originated more recently it would have been
undercharged 32 bps ($3,200 per $1 million). This example high­
lights one of the major weaknesses of the average cost of funds
method, viz., its inability to immediately reflect changes in the
actual market cost of funds. For banks in the survey employing
this approach, it would have encouraged business units to write
long-term loans at the expense of short-term deposits.
Table 15.4 Differences in Funding Charges In both cases, the charge for the use of funds indicates that a
funding commitment is required for somewhere between three
Basis points
and four years and not the entire term of the loan, which was
Term in years 1 2 3 4 5 five years.

Panel A: pre-GFC If an average cost of funds approach had been employed, the
Term liquidity 1 2 3 6 10
loan originated pre-crisis would have received a charge of two
premium bps (Panel A). This would have resulted in an undercharge
of 3.9 bps (5.9 — 2). If the loan had been originated more
Average cost of 2 2 2 2 2

funds recently, it would have received a charge of eight bps, which

would have resulted in an undercharge of 18.1 bps (26.1 - 8 ).
Difference - 1 0 1 4 8
Although the differences in the funding charges are not as
Panel B: current severe as in the non-amortising bullet loan example above,
Term liquidity 5 10 18 28 40 it still highlights the weakness of the average cost of funds
premium approach in reflecting changes in the actual market cost of
funding. Once again, this would have encouraged long-term
Average cost of 8 8 8 8 8

funds loan (asset) generation.

Difference -3 2 10 2 0
15.3.6.2 Amortising Loans
Unlike non-amortising bullet loans, amortising loans do provide
repayments (cash flows) throughout the life of the loan. Since a
portion of principal (and interest) is repaid prior to maturity, a
funding commitment is not normally required for the entire life
(term) of the loan. This is because, at some point between origi­
nation and maturity, the loan becomes self-funding.
Consider the simplest loan type in this category, a five-year
linearly amortising bullet loan with a principal amount of
$1 million. If you think of this as five separate annual loans,
each of $2 0 0 , 0 0 0 , using a matched-maturity marginal cost of
funds approach, this loan (assuming it was originated pre-crisis)
should have received a charge of:
1(1)+ 2 (2 )+ 3 (3 )+ 4 (6 )+ 5 (10)
1+2 +3 +4+5 '
P '
32 Not all amortising loans provide known cash flows for the entire
life of the loan. Take standard variable- (adjustable-) rate mort­
gages, for example. Often their contractual maturity will be
25 or 30 years at origination, but their actual maturity will vary
depending on factors such as repayment frequency and repay­
ment amount.
The uncertainty surrounding future cash flows makes it more
difficult to calculate an appropriate charge for the commit­
ment of funds required to service these types of loans. For
example, a simple tenor-weighted (blended) term liquidity
premium cannot be derived because of the unknown timing
of future cash flows.
Consider a standard $500,000 variable rate mortgage, with
a contractual term of 25 years. Attributing a 25-year term
liquidity premium essentially overcharges the loan for the
cost of funding liquidity and could discourage asset growth.
A better approach is to bundle mortgages into monthly
vintages, based on their origination date, and model the
repayment history (decay) over time as depicted in

This is a tenor-weighted (blended) term liquidity premium, Figure 15.7 below.

derived from what is commonly referred to as the tranching
If mortgages tend to behave similarly, as highlighted in the
approach. Following this same approach, if the loan was origi­
figure above, irrespective of the vintage to which they belong,
nated recently it should have received a charge of:
then a single charge for funding liquidity can be attributed to
1(5) + 2(10) + 3(18) + 4(28) + 5(40) the entire portfolio, instead of to each individual transaction.
26.1b p s.
1+2+3+4+53
1 This charge is based on the behavioural maturity of the port­
folio, which is often calculated by banks using the weighted-
13 Another method used by banks to calculate the charge for the use
average life (WAL) method.
of funds is the internal rate of return (IRR) approach. This involves
calculating an IRR using the rates depicted from the swap curve, and an WAL = ^ t i
IRR using the rates depicted from the marginal cost of funds curve. The m P (15.1)
difference between the resulting rates is the rate used to charge busi­
ness units for the use of funds. For more detail, and an example of this where P(- = principal amount in distribution /, P = amount of
approach, see Matz and Neu (2007). loan, and t,- = time (in years) of payment /.

C h ap ter 15 Liquidity Transfer Pricing: A Guide to B etter Practice ■ 299


WAL can be interpreted as the weighted-average time it takes
to recoup $ 1 of principal (ie the time it takes for the loan to start
paying for itself) . 1 4
As an example, suppose a large bank writes around $2 billion
of mortgage loans on average, per month, and upon examining
the decay of its loans finds the behavioural maturity (WAL) of the
mortgage portfolio to be approximately four years. If a matched-
maturity marginal cost of funds approach is employed, then all
mortgage loans should receive a charge, at point of origination,
based on the four-year term liquidity premium. Using the figures
from Table 15.3, this would be six bps (Panel A) or 28 bps (Panel
B) depending on when the loan was originated.
Across the entire portfolio, this would translate into dollar
charges of $1.2 million or $5.6 million, respectively. In contrast,
if an average cost of funds approach is employed, mortgage
loans should receive a charge of two bps (Panel A) if originated
pre-crisis, and eight bps (Panel B) if originated more recently.
Collectively, for all mortgage loans, this would translate into
dollar charges of $400,000 or $1 . 6 million, respectively.
This example further demonstrates how the average cost of
funds lags changes in banks actual market cost of funds and, at
the same time, highlights how costly this could be, especially
when products are priced at the portfolio level and comprise a
large portion of bank assets.
15.3.6.3 Deposits
Because deposits are a source of funding for banks, busi­
ness units responsible for raising retail, and in some cases
14 The WAL is not the time it takes to repay 50 per cent of the loan.
That would be a median calculation. The WAL is an average. Only in the
special case of when the interest rate on the loan is zero, will 50 per cent
be repaid at the WAL. As the interest rate increases from zero, less than
50 per cent of the loan will be paid at the WAL. This is because most of
the initial repayments comprise interest and not principal.
300 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
wholesale, deposits should be credited for the benefit of
liquidity they provide.
Deposits should be categorised as "sticky" or "hot/volatile"
and credited based on their likelihood of withdrawal. As a
general rule, sticky money, such as term deposits, are less
likely to be withdrawn and should therefore receive larger
credits than hot/volatile money, such as demand deposits,
savings and transaction accounts, which are more likely to be
withdrawn at any time.
Using a matched-maturity marginal cost of funds approach,
term deposits should receive a credit based on their matu­
rity. For example, using the same figures as presented
in Table 15.3, a one-year term deposit should have been
credited one bp if originated pre-crisis and five bps if origi­
nated more recently. Similarly, a five-year term deposit should
have received a credit of 10 bps if originated pre-crisis and 40
bps if originated more recently.
Had an average cost of funds approach been employed, all
term deposits would have received a credit of two bps if origi­
nated pre-crisis and eight bps if originated more recently, irre­
spective of their maturities. In the pre-crisis period, this would
have resulted in over compensating the one-year term deposit
by one bp (2 - 1), and by three bps ( 8 - 5) if originated
more recently. The five-year term deposit on the other hand
would have been under compensated by eight bps ( 2 - 1 0 ) if
originated pre-crisis and a staggering 32 bps ( 8 - 40) if origi­
nated more recently. As above, this example highlights the
limitations of the average cost of funds approach. For banks
employing this approach, it would have encouraged business
units to raise short-term deposits rather than long-term, more
stable sources of funding. Collectively, with the finding from
above, this would have led to more structural liquidity risk on
the balance sheet.
Hot/volatile sources of deposits are often referred to as inde­
terminate maturity products, given the uncertainty surround­
ing their cash flows. However, despite being categorised as
hot or volatile, these types of deposits sometimes provide
stable sources of funding. Demand deposits, for example,
can be withdrawn at any time without notice. But, if all similar
accounts were to be pooled and the behaviour of the cash
flows modelled over time, there would be a proportion that is
rarely withdrawn (stable or core part) and a proportion that is
more often withdrawn (hot or volatile part). Making this dis­
tinction is important, because if a bank were to simply apply
a matched-maturity marginal cost of funding approach, all
demand deposits would only receive a credit based on the
overnight term liquidity premium. Given this is likely to be very
close to zero, which translates to a cheap funding source for
banks, business units would be discouraged from raising
demand deposits. A better approach would be to assign
larger credits to core parts of funding, based on the mod­
elled behavioural maturity, and smaller credits to hot/vola-
tile parts of funding.
Banks employing an average cost of funds approach would
have no incentive to make the distinction between core and
volatile parts of funding since, under this approach, the same
credit for the benefit of funding is applied to all deposits,
irrespective of their maturity.
15.3.7 Summary
Failing to price liquidity is unacceptably poor LTP practice for a
bank, and supervisors should not tolerate this failing.
The average cost approach to LTP is simple, but has two major
defects. First, it neglects the varying maturity of assets and
liabilities by applying a single charge for the use and benefit of
funds and, second, it lags changes in banks' actual market cost
of funding. These defects essentially promote maturity trans­
formation, which inherently exposes banks to more structural
(mismatch/funding) liquidity risk.
Overall, a matched-maturity marginal cost of funds approach
promotes better LTP practice. It is more complex than the
pooled average cost of funds approach, but it has some sig­
nificant advantages. First, it recognises that the costs and
benefits of liquidity are related to the maturities of assets and
liabilities, and therefore allows higher rates to be assigned to
products that use or provide liquidity for longer periods of
time. Second, it recognises the importance of having changes
in market conditions incorporated quickly and efficiently into
the rate used to charge and credit users and providers of
funds, and therefore relies on the actual market cost of funds.
Banks should be encouraged to move towards this approach,
if they are not already doing so.
15.4 LTP IN PRACTICE: M ANAGING
CO N TIN G EN T LIQUIDITY RISK
For many on-balance sheet items, calculating the charge for
using, or the credit for providing, funding liquidity is quite
straightforward. However, the same cannot be said about
contingent commitments such as lines of credit, collateral
postings for derivatives and other financial contracts, and liquid­
ity facilities to name a few. In these cases, the best approach is
to impose a scenario model, determine a reasonable low prob­
ability worst-case outcome and charge at the most granular
C h ap ter 15
for a liquidity cushion.
level the transaction, product, or business unit for the costs of
covering this outcome.
Banks carry a liquidity cushion, a "buffer" of highly liquid assets
or, alternatively, stand-by liquidity to help them survive periods
of unexpected funding outflows. A graphical illustration of this
is depicted in Figure 15.8.
In December 2010, the BCBS published two global standards for
liquidity risk. First, a Liquidity Coverage Ratio (LCR) to ensure
banks have sufficient high quality liquid assets to meet their daily
net cumulative cash outflows during an idiosyncratic shock, for a
period of one calendar month. Second, a net stable funding ratio
(NSFR) aimed at reducing banks structural liquidity risk by
encouraging the use of longer-term funding of assets and other
business activities. 1 5 The move to make banks more self-suffi­
cient and stable over a longer period is in part to reduce the
burden of central banks having to act as the lender-of-last-resort,
and the potential implications of moral hazard as a result of
these actions.
15.4.1 Liquidity Cushions: A Principle
of Liquidity Risk Management
Liquidity cushions are considered a fundamental principle
for the management of liquidity risk. This is clearly outlined
in Principle 1 of the BCBS Principles for Sound Liquidity
Risk Management and Supervision (September 2008), and
also reinforced by Principle 12, which states that "a bank
should maintain a cushion of unencumbered, high quality liquid
assets to be held as insurance against a range of liquidity stress
scenarios, including those that involve the loss or impairment
of unsecured and typically available secured funding sources.
There should be no legal, regulatory or operational impedi­
ment to using these assets to obtain funding" (p 4).
15 For more details, see Basel III: International Framework for Liquidity
Risk Measurement, Standards and Monitoring, BCBS, (December 2010).
Liquidity Transfer Pricing: A Guide to B etter Practice ■ 301
15.4.2 Extant Guidance Focuses on Size,
Composition and Marketability
Extant guidance provided in association with liquidity cushions
focuses mainly on size, composition and marketability of the
assets contained within the cushion. To ensure banks' liquid­
ity cushions are adequately sized, the BCBS recommends they
be aligned with stress-testing outcomes that consider both
idiosyncratic and systemic scenarios, plus a combination of
the two. The level of stress assumed in the tests should reflect
a bank's overall risk tolerance. To assess their risk tolerance,
banks should consider factors such as structural liquidity risk
(ie the liquidity gap between the weighted average maturities
of assets and liabilities) and the complexities of both on- and
off-balance sheet business activities, which affect the frequency
and irregularities of cash flows.
According to the BCBS, liquidity cushions should comprise "a
core of the most reliably liquid assets, such as cash and high
quality government bonds or similar instruments, to guard
against the most severe stress scenarios" (p 30). Banks should
also consider the marketability of these assets. Although this is
likely to vary in relation to the stress scenario and survival period
(ie assets will generally remain more marketable throughout less
severe market disruptions), there are some generic characteris­
tics that tend to improve asset liquidity. For example, assets that
are more transparent are generally also easier to value, and the
certainty surrounding this will inherently improve marketability.
In addition, assets that are central bank-eligible and/or have
good market depth will generally be more marketable. A bank's
reputation, credit rating and active participation in certain mar­
kets will also impact asset marketability (p 30).
15.4.3 Problems with Banks Liquidity
Cushions Unveiled by the GFC
The recent crisis exposed some fundamental problems with
banks' liquidity cushions. First, for the banks that participated in
the survey, very few used the results of stress-testing to deter­
mine the size of their liquidity cushion. For the few banks that
did consider the results of stress-tests, the size of their liquidity
cushion was based on outcomes stemming from idiosyncratic
funding scenarios only. Having little or no regard for prolonged
market-wide disruptions meant that cushions were inadequately
sized to protect the banks from larger-scale unexpected (contin­
gent) outflows. On a separate but related issue, one of the flaws
with many of the banks' stress-testing processes was that the
parameters used were too narrow, and were based purely on
historical data. This meant that events that had not previously
occurred were neglected.
302 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Second, most of the banks that were surveyed had liquidity
cushions comprised of assets that were thought to be highly
liquid, but were found to be highly illiquid and highly corre­
lated. There were instances where some assets held as stand­
by liquidity were not unencumbered, meaning that the bank
did not have legal claim over the asset or that the asset was
not entirely free from debt.
Third, nearly all of the banks included in the survey funded their
liquidity cushions short-term (e.g. overnight), consistent with the
perception that funding could be easily accessed and any mar­
ket disruption would only be short-lived. While this minimised
negative carry costs, it also provided banks little incentive to
attribute the relevant costs back to the businesses that created
the need to carry additional liquidity. When assets in the cushion
could not be sold to generate funding, it became apparent that
the real cost of carrying stand-by liquidity was much greater
than what the banks had assumed.
15.4.4 LTP and Liquidity Cushions - Both
Principles, Both Treated Separately
To date, there has been limited guidance about how to attribute
the cost of carrying liquidity cushions, but this paper offers some
ideas. Even though it is common practice for banks to attribute
this cost via LTP, no link between LTP and liquidity cushions is
established in extant material. In fact, LTP and liquidity cushions
are very much treated as mutually exclusive principles for sound
liquidity risk management.
15.4.5 Poor Attribution of Cost
of Carrying a Liquidity Cushion
Carrying a "buffer" of highly liquid assets is costly for banks
because the cost of funding assets comprising the cushion
generally outweighs the return they generate . 1 6 As such, banks
often seek to minimise the size of their liquidity cushion so that
the negative carry does not drag on profits.
Most of the banks included in the survey consider the cost of
carrying additional liquidity a cost of doing business, rather than
an opportunity cost. In this regard, the cost of carry should not
be borne by central management (ie treasury). It should instead
be attributed back to businesses via the LTP process. While this
appears common practice amongst banks participating in the
survey, generally through incorporating a liquidity premium in
the LTP process, most simply averaged the cost across all assets
16 The survey identified that this is the typical method banks use to cal­
culate the cost of carry.
without giving specific attention to those businesses and prod­
ucts that generate the need to carry additional liquidity.
As a simple example, if it costs a bank $30 million to carry
a buffer of liquid assets and total assets of the bank equate
to $300 billion, then under the approach described above,
all assets would receive a charge of one bp through the LTP
process. This is depicted in Figure 15.9. Note that the one bp
charge is in addition to the term liquidity premium, which is
charged to assets based on their commitment of funds. This is
highlighted in equation 2 .
One explanation of why this approach might have been adopted
by most of the banks surveyed is because they underestimated
the "actual" cost of carrying additional liquidity. As mentioned
above, assets in the cushion most often incurred short-term
(overnight) funding charges on the premise that funding could
be easily accessed and that any market disruption would be
short-lived. This minimised the negative cost of carry, making
it easy for banks to recoup the cost by simply adding a small
spread (liquidity premium) to the funding cost that was charged
to assets, as depicted in Equation 2.
FTP = base rate + term liquidity premium + liquidity premium
(15.2)
where FTP = funds transfer price, base rate = rate depicted
from the swap curve corresponding to the asset's contractual/
behavioural maturity or repricing term, whichever is less, term
liquidity premium = spread between the swap curve and the
bank's marginal cost of funds curve based on the contractual/
behavioural maturity of the asset, and liquidity premium = cost
of carrying liquidity cushion averaged over total assets of the bank.
Generally speaking, banks would not have believed this would
create problems despite the fact that only assets were being
charged because the spread charged to recoup the cost of
carrying the liquidity cushion was so small. But there are some
recoup the cost of carry charge via LTP for the cost of
carry
Fiqure 15.9 Recouping the cost of carrying a liquidity
cushion via LTP.
C h ap ter 15 Liquidity Transfer Pricing: A Guide to B etter Practice
serious implications associated with this poor practice. First, it
inherently assumes that all assets expose the bank to the same
unexpected (contingent) liquidity risk. Second, it completely
neglects the contingent liquidity risk embedded in liabilities, for
example, deposit run-off during stress environments, and off-
balance sheet activities such as drawdowns on lines of credit.
Third, it makes no attempt to charge businesses based on their
predicted liquidity usage during stress environments. Fourth,
the attribution of charges is not granular enough to discour­
age businesses from writing or buying products that pose more
contingent liquidity risk than others.
Although some banks that were surveyed did attempt to charge
the negative cost of carry back to businesses on a predicted
usage basis, the attribution was generally at a very high level.
One problem with not having a granular charge is that it encour­
ages businesses to deal in products that are not being charged
for the contingent liquidity risk they actually present. The impli­
cation of distorting behaviour by not charging products for the
risks they present was discussed in Section 2.
15.4.6 Towards Better Management
of Contingent Liquidity Risk
In one form or another, all banks that participated in the survey
are enhancing the way they manage contingent liquidity risk.
Many are incorporating a wider variety of scenarios as part of
their stress-testing processes to account for different types of
market disruptions that might occur. These are largely in con­
junction with BCBS recommendations and include idiosyncratic
and systemic funding shocks and a combination of the two. In
another step forward, senior management are becoming more
engaged with stress-testing results and using them as a basis
for deriving the size of the liquidity cushion. The composition
of assets in liquidity cushions is broadly improving, once again
in line with BCBS recommendations. For example, many of the
larger banks are now holding a larger proportion of cash
and government securities than previously. This is most
likely due to the development of the LCR.
Probably the most substantial enhancement that is occurring
is the application of higher funding costs to liquid assets.
Before the GFC, banks believed funding could be accessed
almost immediately and always. But the recent market tur­
moil has demonstrated that funding markets can remain
disrupted for a significant period of time. As such, banks are
applying higher funding charges to assets held as part of
the liquidity cushion on the premise that it could take lon­
ger than expected to generate liquidity when needed. The
charges applied depend on banks' assumptions surrounding
the length and severity of potential market disruptions. If,
■ 303
for example, a bank assumes funding markets for a particular 1. Identify contingent commitments that are likely to create unexpected
asset could remain stressed for two years, then the cost of hold­
ing that asset as additional liquidity should be based on the
two-year term liquidity premium.

The move to apply higher funding costs to liquid assets is con­

sidered significant for banks because carrying a more costly 2. Perform stress tests under various
scenarios to approximate the funding
liquidity cushion creates more profit drag. As described above, that might be required.
banks previously recouped this cost by charging all assets
equally, a small liquidity premium via LTP. Following the same
approach now, however, is likely to cause conjecture amongst
3. Net approximations from above against inflows
business units and distort business unit behaviour given generated, for example, through the sale of
the larger costs. As such, this method is no longer feasible marketable securities to derive the size of the
liquidity cushion.
for banks. A better approach is to examine the contingent f----------------------------- \
liquidity risk embedded in various business activities and to
L iq u id ity cu sh io n
attribute charges based on their predicted, or expected, use k____________________________
of funding liquidity. Higher contingent liquidity charges should
be applied to business activities that pose more threat to large
and unexpected funding outflows. This process is depicted 4. Calculate the cost of
carry as the cost of
in Figure 15.10. funding liquid assets 5. Recoup cost of
minus the return they carry by charging
Some examples of pricing contingent liquidity risk are presented generate. Ensure that a liquidity
in the following section. appropriate haircuts and premium, at the
unsecured term funding most granular
charges have been level, to the
applied to assets. business unit,
15.4.7 Example of Pricing Contingent product or
transaction that
Liquidity Risk creates the need
for the bank to
The uncertainty surrounding future cash-flow demands stem­ carry such liquid
assets.
ming from contingent commitments makes it particularly difficult
for banks to assess and price contingent liquidity risk. This is one
of the reasons why it was neglected prior to the GFC. Some of
the products that received little attention but then warranted
significant funding included: credit card loans and investments, FSI Occasional Paper No 10
trading positions and derivatives, revolving lines of credit, and Fiaure 15.10 Toward better management
liquidity lines. contingent liquidity risk.
The first step towards better management of contingent liquidity
risk is not to address the question of how much should be charged
but, rather, for banks to understand that all contingent commit­ The likelihood of drawdown (sometimes referred to as a draw­
ments need to be charged. Once this is clear, then methods for down factor) should be assessed using behavioural modelling
pricing contingent liquidity risk can be refined and improved. and should depend on factors such as customer drawdown his­
tory, credit rating of the customer, and other factors the bank
At the most basic level of what is considered to be better prac­ deems important in making this prediction. In the example
tice, all banks should be charging contingent commitments above, assume there is a 60 per cent chance the customer will
based on their likelihood of drawdown. For example, suppose draw on the remaining credit and that the cost of term fund­
a line of credit with a limit of $10 million has $4 million already ing assets in the liquidity cushion is 18 bps (depicted from
drawn. The rate charged for contingent liquidity risk should be the three-year term liquidity premium in Table 15.3). The rate
derived as: charged for the cost of contingent liquidity risk should be
limit - drawn amount equal to:
x likelihood of drawdown
limit
($10m-$4m)x0 6x0 0018 =Q000648o/oor 6.48bps
x cost of funding liquidity cushion $10m

304 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Multiplying this by the limit of $10 million on the line of credit
yields a dollar charge of $6,480.
As explained earlier, prior to the crisis, banks applied short-term
and often overnight funding charges to assets comprising their
liquidity cushions on the belief that funding was abundant and
permanently cheap. If the overnight funding rate was 0.5 bp and
banks had applied the same approach as in this example, the
dollar charge for the contingent liquidity risk would have been
$1,800. However, banks did not follow this approach. Instead
they averaged the cost of funding their liquidity cushions across
all of their assets. By doing this it is likely that the lines of credit
such as the one in this example did not even receive a charge
for the cost of contingent liquidity risk. This would have encour­
aged business units to grant lines of credit and other contingent
commitments.
A similar approach to that in the example above can be
applied to other types of contingent commitments. For exam­
ple, credit card accounts will generally have a proportion of the
limit that is undrawn. With some behavioural analysis the likeli­
hood of drawdown can be estimated and contingent funding
liquidity costs can be attributed accordingly. More advanced
banks might assess the behaviour of individual customers and
assign a weighted probability of drawdown. All banks, how­
ever, are encouraged to at least examine and attribute charges
based on the behaviour of a portfolio of like- contingent
commitments.
15.5 CO N CLU SIO N *•
The international survey identified some badly deficient LTP
practices. The worst practices are summarised below.
• Management of the LTP process was poor. There were a lack
of LTP policies, decentralised funding structures accompa­
nied by weak internal risk controls and limits, inconsistent LTP
regimes, off-line and manually adjusted LTP processes, a lack
of trading book funding policies, as well as poor independent
oversight by risk and financial control personnel.
• LMIS were often not advanced enough to incorporate
the costs, benefits and risks of liquidity at a sufficiently
granular level.
• Profit pools, which were used to determine bonuses to
employees, were derived from unadjusted revenues, without
any regard to the risks (liquidity and capital) taken to gener­
ate such profits.
• Probably the most striking example of poor practice was that
some banks applied a zero charge for the cost of funding
liquidity based on the premise that liquidity was a free good.
C h ap ter 15
• Other banks applied a single pooled approach to LTP,
whereby one average rate was used to charge users of funds
and to credit providers of funds.
• Liquidity cushions were not linked to stress-testing outcomes,
and scenario analyses were not severe enough to account for
prolonged market-wide disruptions.
• Charges applied to fund liquid assets were often based on
short-term rates, reflecting the belief that funding was abun­
dant and would remain permanently cheap.
• To recoup the cost of carrying a liquidity cushion, most
banks simply charged all assets an equal and small liquidity
premium, which failed to account for the varying amounts
of contingent liquidity risk embedded in different business
activities.
Collectively, these poor LTP practices encouraged long-term
illiquid asset creation and discouraged long-term stable liability
creation, with obvious consequences.
By and large, banks have realised that many of their LTP prac­
tices were insufficient. As a result, banks are now working
towards enhancing their LTP processes to ensure their business
activities adequately account for the costs, benefits and risks of
liquidity. To assist banks and supervisors throughout this pro­
cess, below is a compilation of what is considered to be better
LTP practices.
Governing LTP
• Banks should have an LTP policy that defines LTP, states the
purpose of LTP and provides some principles and/or rules
to ensure LTP achieves its intended purpose. The LTP policy
should apply to all business units that are material users or
providers of funding liquidity.
• LTP should be managed centrally, within group treasury or a
subsidiary treasury, and applied consistently across the group.
Wholesale funding should be confined to this function.
• Trading book funding policies should exist and, where appro­
priate, funding should be provided at the most granular level
e.g., at the trading desk level as opposed to the trading
book level. This requires treasury to have a full line of sight
to individual business balance sheets. Banks are also encour­
aged to examine individual positions and apply higher fund­
ing charges to those that are more likely to become stale, or
that present significantly greater amounts of funding liquidity
risk. Finally, banks should have in place limits and adequate
controls to curb over-trading behaviour.
• Oversight of the LTP process should be provided by indepen­
dent risk and financial control personnel. Senior management
should also be involved in the LTP process. Meetings should
be held regularly, and include various stakeholders such as
Liquidity Transfer Pricing: A Guide to B etter Practice ■ 305
 ALCO, senior management and treasury functions to discuss
changes in funding costs.
• To assist with performance assessments and decision-making,
LMIS should be advanced enough to attribute, at a suffi­
ciently granular level, all of the relevant costs, benefits and
risks of liquidity to the appropriate business activities.
• Remuneration practices should be more sensitive to the risks
taken to generate profits. For example, profit pools, which
are used to derive short-term incentives such as bonuses,
should be adjusted for the cost of liquidity through the LTP
process.
Using LTP to manage on-balance sheet funding liquidity
risk
• When applying LTP in practice, banks should by now have
come to the realisation that liquidity is not a free good.
Hence, employing a zero cost of funds approach to LTP is
extremely poor practice and should not be tolerated by
supervisors.
• Banks should instead be moving towards incorporating a
matched-maturity marginal cost of funding approach to LTP
This approach is superior to any other established. First, it
recognises the need to charge more for the cost of liquidity
for assets that require funding for longer periods of time.
Conversely, it recognises the need to credit more for the
benefit of liquidity for liabilities that provide funding for lon­
ger periods of time. Second, the rate charged for the use
and for the benefit of funds is based on banks' actual market
costs of funds. This rate incorporates both idiosyncratic credit
risk adjustments and market access premiums.
306 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
• Charges for the use of liquidity and credits for the benefit of
liquidity should not be borne by central management (ie trea­
sury), but should instead be attributed, at a sufficiently granu­
lar level, to the business activities using or providing liquidity.
Managing contingent liquidity risk
• The size of liquidity cushions should be derived from stress­
testing outcomes and scenario analyses that at a minimum
account for idiosyncratic and systemic scenarios, including
prolonged market disruptions, and a combination of the two.
• Assets held as part of the liquidity cushion should be of the
highest form of liquidity.
• Funding charges applied to assets in the liquidity cush­
ion should not be based on short-term overnight rates
but should instead be derived from longer-term rates to
account for the possibility of longer than expected market
disruptions.
• The cost of carrying a liquidity cushion is a cost of doing
business and should thus be recouped from the business
activities that require the bank to carry such liquid assets. The
charge attributed to business activities should not be equal
and based on the assumption that the contingent liquid­
ity risk is the same for all types of business. Instead, indi­
vidual business activities should be charged based on their
expected, or predicted, use of contingent liquidity.
To conclude, one size does not fit all. Banks vary in size and
complexity, and the LTP process employed should reflect these
factors. While banks should, at least, consider all better practices
promoted through this paper, only those that are appropriate and
will most likely improve their own LTP process should be adopted.
A PPEN D IX
LTP Principles and Recommendations
W o rk in g G ro u p
B asel C o m m itte e on Banking
S u p e rv isio n (B C B S)
Principle 4 of "Principles for Sound Liquid­
ity Risk Management and Supervision"
(September, 2008).1
E u ro p e a n C o m m issio n (EC)
Point 14 in Annex V of "Directive
2009/111/EC of the European Parliament
and of the Council of 16 Septem ber".2
C o m m itte e fo r E u ro p e a n Banking
S u p e rv iso rs (C E B S )
Recommendation 2 in "Second Part
of CEBS' Technical Advice to the
European Commission on Liquidity Risk
Management" (September, 2008).3
T h e In stitu te fo r In tern atio n al
F in a n ce (IIF)
Recommendation III.4 of "Final Report
of the IIF Committee on Market Best
Practices: Principles of Conduct and Best
Practice Recommendations" (July, 2008).4
C o u n te rp a rty Risk M a n a g e m e n t Policy
G ro u p III (C R M PG III)
Recommendation IV-17 of "Contain­
ing Systemic Risk: The Road to Reform"
(August, 2008).5
1 Available at http://www.bis.org/publ/bcbs144.pdf.
2 Available at http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0097:0119:EN:PDF.
3 Available at http://www.eba.europa.eu/getdoc/bcadd664-d06b-42bb-b6d5-67c8ff48d11d/20081809CEBS_2008_147_(Advice-on-liquidity_2nd-par.aspx.
4 Available at http://www.iif.com/press/press+releases+2008/press+75.php.
5 Available at http://www.crmpolicygroup.org/.
C h ap ter 15
P rin c ip le s/R e c o m m e n d a tio n s
"A bank should incorporate liquidity costs, benefits and risks in the internal pric­
ing, performance measurement and new product approval process for all significant
business activities (both on- and off-balance sheet), thereby aligning the risk-taking
incentives of individual business lines with the liquidity risk exposures their activities
create for the bank as a whole" (p 3).
"Robust strategies, policies, processes and systems shall exist for the identification,
measurement, management and monitoring of liquidity risk over an appropriate set
of time horizons, including intra-day, so as to ensure that credit institutions main­
tain adequate levels of liquidity cushions. Those strategies, policies, processes and
systems shall be tailored to business lines, currencies and entities and shall include
adequate allocation mechanisms of liquidity costs, benefits and risks" (L302/116).
"Institutions should have in place an adequate internal mechanism - supported
where appropriate by a transfer pricing mechanism - which provides appropriate
incentives regarding the contribution to liquidity risk of the different business activi­
ties. This mechanism should incorporate all costs of liquidity (from short to long­
term, including contingent risk)" (p 8).
"Firms should ensure that they have in place effective internal transfer pricing poli­
cies to reflect implied or incurred actual or potential costs related to reasonably
anticipated liquidity demands from both on- and off-balance sheet business. Transfer
pricing should take closely into account the liquidity of relevant underlying assets;
the structure of underlying liabilities, and any legal or reasonably anticipated repu­
tational contingent liquidity risk exposures. Transfer pricing should be designed to
ensure that lines of business within the firm that create liquidity exposures are pro­
portionately charged for the cost to the firm of maintaining corresponding prudent
liquidity positions" (p 56).
"The Policy Group recommends that all large integrated financial intermediaries
incorporate appropriate pricing-based incentives for the full spectrum of their fund­
ing activities. This includes a funds transfer pricing policy that assigns the cost of
funding to businesses that use funding and credits the benefits of funding to busi­
nesses that provide it. This must encompass both on- and off-balance sheet activi­
ties (for example, contingent funding), as well as potential funding needs related to
actions that might be taken to preserve the institution's reputation. The funds trans­
fer pricing process should be informed by stress testing efforts that identify potential
vulnerabilities and assign the related costs to the businesses that create them. The
methodology should provide direct economic incentives factoring in the related
liquidity value of assets and behavioral patterns of liabilities. The costs and benefits
identified should be assigned to specific businesses and, under all circumstances,
used in evaluating the businesses' performance" (p 30).
Liquidity Transfer Pricing: A Guide to B etter Practice ■ 307
The US Dollar
Shortage in Global
Banking and the
International Policy
Response
Learning Objectives
After completing this reading you should be able to:

Identify the causes of the US Dollar shortage during the Discuss how central bank swap agreements overcame
Great Financial Crisis. challenges commonly associated with international lenders
of last resort.
Evaluate the importance of assessing maturity/currency
mismatch across the balance sheets of consolidated
entities.

Excerpt is BIS Working Paper No. 291, by Patrick McGuire and Gotz von Peter.
16.1 INTRODUCTION
The global financial crisis has shown just how unstable banks'
sources of funding can become. Throughout the crisis, but
particularly following the collapse of Lehman Brothers in
September 2008, many banks faced severe difficulties securing
short-term US dollar funding. In response, central banks around
the world adopted extraordinary policy measures, including
international swap arrangements with the US Federal Reserve,
to enable them to provide US dollars to commercial banks in
their respective jurisdictions. What caused this global shortage
of US dollars? Which banking systems have been most affected?
How could a shortage develop so quickly after dollar liquidity
had been viewed as plentiful?
This paper provides a systematic analysis of the build-up of
stresses on banks' international balance sheets which set the
stage for the shortage of US dollars. 1 It relies on the BIS interna­
tional banking statistics to reconstruct the global balance sheet
positions for each of the major national banking systems.1 2 These
data provide information on both the currency and the counter­
party of banks' foreign assets and liabilities, facilitating an analy­
sis of how banks funded their foreign currency investments. With
this dataset, the dynamics of the crisis can be analysed along
the contours of banks' consolidated global balance sheets, argu­
ably the most appropriate framework for assessing funding pres­
sures, rather than along geographical (ie residency-based) lines.
Understanding the global US dollar shortage requires a depar­
ture from the familiar domestic bank run story. In the open
economy version of the traditional bank run model, depositors
run the bank and convert their domestic deposits to foreign cur­
rency (Chang and Velasco (2000, 2001)) or, in the case of liability
dollarization, directly withdraw dollars (Rajan and Tokatlidis
(2005)). The resulting demand for foreign currency, being pro­
portional to domestic bank liabilities, can easily exhaust the
country's FX reserves (Obstfeld et al (2009)). While the domestic
run story remains relevant in the emerging market context, this
paper traces the origins of the US dollar shortage to the inter­
national operations of the major banking systems and to the
global funding and swap markets on which they rely. Previous
1 The historical usage of the term "dollar shortage" (notably by Kindle-
berger (1950), and Triffin (1957)) refers to the main structural monetary
problem of the postwar period, namely the global scarcity of gold and
dollar assets which resulted from chronic US current account surpluses.
The use of the term here refers to the difficulty banks face in securing
short-term US dollar funding.
2 "National banking system", the primary unit of analysis in this paper,
refers to the set of large internationally active banks headquartered
in a particular country (eg US banks, German banks, Swiss banks), as
opposed to banks located in a particular country.
310 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
episodes with similar international dimensions include the
lengthening of the maturity of Latin American dollar debt in the
early 1980s, which raised concerns about a maturity mismatch
on European banks' balance sheets (McCauley (1984)). Another
case is the "Japan Premium" faced in the 1990's by Japanese
banks, which had financed their global expansion in the eurodol­
lar and euroyen markets (Peek and Rosengren (2001)).
The funding difficulties which arose during the crisis are directly
linked to the remarkable expansion in banks' global balance
sheets over the past decade. Reflecting in part the rapid pace
of financial innovation, banks' (particularly European banks')
foreign positions have surged since 2 0 0 0 , even when scaled by
measures of underlying economic activity. As banks' balance
sheets grew, so did their appetite for foreign currency assets,
notably US dollar-denominated claims on non-bank entities.
These assets include retail and corporate lending, loans to
hedge funds, and holdings of structured finance products
based on US mortgages and other underlying assets. During
the build-up, the low perceived risk (high ratings) of these
instruments appeared to offer attractive return opportuni­
ties; during the crisis they became the main source of mark
to market losses.
The accumulation of US dollar assets saddled banks with sig­
nificant funding requirements, which they scrambled to meet
during the crisis, particularly in the weeks following the Lehman
bankruptcy. To better understand these financing needs, we
break down banks' assets and liabilities by currency to examine
cross-currency funding, or the extent to which banks fund in
one currency and invest in another. We find that, since 2000,
the Japanese and the major European banking systems took on
increasingly large net (assets minus liabilities) on-balance sheet
positions in foreign currencies, particularly in US dollars. While
the associated currency exposures were presumably hedged
off-balance sheet, the build-up of net foreign currency positions
exposed these banks to foreign currency funding risk, or the risk
that their funding positions (FX swaps) could not be rolled over.
The magnitude of this risk is gauged in a second step, where
we attempt to quantify banks' total short-term US dollar financ­
ing needs at the onset of the crisis. This requires breaking down
banks' US dollar-denominated assets and liabilities further, by
residual maturity, to quantify the degree of maturity transfor­
mation embedded in banks' balance sheets. Although data
limitations make direct measurement of the maturity of banks'
positions impossible, we argue that information on counterparty
type (bank, non-bank or central bank) can serve as a proxy since
the average maturity of positions is likely to vary systematically
with the sector of the counterparty, with interbank positions
having a shorter maturity than positions vis-a-vis non-bank enti­
ties. This yields a lower-bound estimate of banks' US dollar
funding gap—the amount of short-term US dollar funding banks
require—measured here as the net amount of US dollars chan­
nelled to non-banks. By this estimate, European banks' need for
short-term US dollar funding was substantial at the onset of the
crisis, at least $1.0-1.2 trillion by mid-2007.
Events during the crisis led to severe disruptions in banks'
sources of short-term funding. Interbank markets seized up, and
dislocations in FX swap markets made it even more expensive
to obtain US dollars via swaps. Banks' funding pressures were
compounded by instability in non-bank sources of funds as well,
notably dollar money market funds and dollar-holding central
banks. The market stress meant that the effective maturity of
banks' US dollar funding shortened just as that of their US dol­
lar assets lengthened, since many assets became difficult to sell
in illiquid markets. This endogenous rise in maturity mismatch,
difficult to hedge ex ante, generated the global US dollar short­
age. Our estimate of the size of banks' US dollar funding gaps
at the onset of the crisis shed light on why the international pol­
icy response was necessary, and why it took the form of a global
network of central bank swap lines.
One point highlighted throughout this analysis is the importance
of taking banks' worldwide consolidated positions as the unit
of analysis. Banks have become so globalised, with offices in
many countries around the world, that it is impossible to iden­
tify vulnerabilities in their balance sheets using residency-based
statistics alone (eg, domestic credit data, balance of payments
data, the BIS locational banking statistics by residency). Stresses
build up across the global balance sheet, as mismatches in the
currency or maturity of assets and liabilities, and thus can be
understood only by looking at banks' worldwide positions con­
solidated across all office locations. In some cases, banks' cross-
border assets booked by offices in a particular host country can
account for the bulk of that country's external asset position,
and yet still represent a relatively small part of the consoli­
dated banking systems' worldwide assets. This fact clouds the
interpretation of the "national balance sheet" for many host
countries, since banks' long or short currency positions booked
in one office location and offset in another may signal a "mis­
match" in the host country's net external position when none
may, in fact, exist.
The remainder of the paper is organised as follows. The next
section introduces concepts related to banks' international
investment and funding choices, from which we derive the data
requirements. Section 3 examines banks' investment and fund­
ing patterns since 2000 which set the stage for the US dollar
shortage and policy responses examined in Sections 4 and 5.
The final section concludes, and the data appendix provides
detail on the BIS international banking statistics and the con­
struction of the dataset.
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response
16.2 BAN KS' INTERNATIONAL
POSITIONS: CO N CEPTS AN D DATA
We first introduce concepts related to an internationally active
bank's investment and funding choices. Consider a bank that
seeks to diversify internationally, or expand its presence in a
specific market abroad. This bank will have to finance a particu­
lar portfolio of loans and securities, some of which are denomi­
nated in foreign currencies (eg a German bank's investment in
US dollar-denominated structured finance products). The bank
can finance these foreign currency positions in several ways:
1. The bank can borrow domestic currency, and convert it in a
straight FX spot transaction to purchase the foreign asset in
that currency.
2. It can also use FX swaps to convert its domestic currency
liabilities into foreign currency and purchase the foreign
assets. 3
3. Alternatively, the bank can borrow foreign currency, either
from the interbank market, from non-bank market partici­
pants or from central banks.
The first option produces no subsequent foreign currency
needs, but exposes the bank to currency risk, as the on-balance
sheet mismatch between foreign currency assets and domestic
currency liabilities remains unhedged. Our working assumption
is that banks employ FX swaps and forwards to hedge any on-
balance sheet currency mismatch. 4 That is, a bank funding in
domestic currency (option 1 or 2 ) is likely to do so as described
in option 2. Importantly, the second leg of the swap in option 2
is not that different from funding a position through foreign cur­
rency borrowing in the first place (option 3): in both cases, the
bank needs to "deliver" foreign currency when the contractual
liability comes due.
For concreteness, let A, denote the bank's claims (assets)
denominated in currency /, with / = 0 representing the domes­
tic currency. The assets are financed by liabilities L; (where L0
includes equity). The net position in currency / equals ( A - L(),
where the term "long" ("short") is used to denote a positive
(negative) net on-balance sheet position. Funding option 1
above produces a long foreign currency position of A (>0
3 An FX swap is an exchange of two currencies at the current spot
exchange rate today, coupled with the promise to exchange back at a
future date at a fixed exchange rate.
4 Stigum and Crescenzi (2007) describe in detail how banks use deriva­
tives to hedge their international operations. In some circumstances,
banks may find it advantageous to maintain open foreign currency posi­
tions (eg to insulate capital/asset ratios against a depreciation of the
domestic currency (Fukao (1991)).
■ 311
financed by Lq = A r Option 2 couples the same on-balance sheet
positions with a(n off-balance sheet) promise to repay A, when
the swap comes due, to be met by the proceeds from, or sale
of, A,. Option 3 matches foreign currency funding to foreign
assets, leaving a zero net position {A-,—L,=0). The balance sheet
identity implies that net foreign currency positions (if positive)
are mirrored in net borrowing in domestic currency. That is,
(16.1)
The various funding options expose the bank to funding risk, or
the risk that funding liabilities cannot be rolled over. The magni­
tude of this risk depends on the degree of maturity transforma­
tion embedded in the bank's balance sheet. The bank is said to
face a foreign currency funding gap if the investment horizon of
its foreign currency assets A, exceeds the maturity of its foreign
currency funding or FX swaps. The portfolio's investment hori­
zon depends on the desired holding period, on the maturity of
the underlying assets and on market liquidity. If the contractual
liabilities (Ljt or swaps) cannot be rolled over for some reason,
then foreign currency assets that were intended to be held have
to be sold instead, possibly in distressed market conditions.
Suppose the bank finances its foreign currency assets A, by fully
hedging currency risk, ie by a combination of foreign currency
borrowing L, and FX swaps S, such that A; = L(- + S,. Denote by
A 7 7 (L,lt) the foreign currency assets (liabilities) with a long
investment horizon or long effective maturity. Ideally, one
would measure short-term funding liabilities (including FX
swaps) in currency i directly, as (L, — Lj-T) + S,. However, since
FX swaps are typically (unobserved) off-balance sheet transac­
tions, we use the hedging equality to replace S, and express
short-term funding liabilities as (A,- — U[T). These short-term for­
eign currency liabilities can be met with banks' liquid or matur­
ing assets, worth (A; — A--7). The difference yields the foreign
currency funding gap : 5
Why is funding risk in foreign currencies of special interest?
Banks also face the risks inherent in transforming maturities in
their domestic currency market, of course. Indeed, maturity
transformation is an essential function of banking, and banks
5 If a bank borrows more than it invests in currency /, it can swap the
proceeds into domestic currency to increase A0. The resulting swap
position, S, —A, - L, < 0, represents a short-term claim on currency /,
but to realise this claim the bank must come up with as much domestic
currency at short notice. If the proceeds were channelled into long-term
domestic assets, then the foreign currency funding gap is measured
as (A--7 - Lj-T) + (Li — A ;) — ( L; — L[t) — (A, - A--7). In the extreme
case where A, = 0, the qap simply equals foreiqn currency short-term
liabilities, (L, - Lj-7).
312 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
would find it unprofitable to eliminate maturity mismatch alto­
gether (Morgan and Smith (1987), Goodhart (1995), Diamond
and Rajan (2001), Stigum and Crescenzi (2007)). However, in a
purely domestic banking context, the central bank can act as
lender of last resort and provide sufficient liquidity to eliminate
a domestic funding shortage; doing so is both time-honoured
practice (Bagehot (1873), Goodhart (1995)) as well as optimal
policy (Allen and Gale (1998), Diamond and Rajan (2006)). By
contrast, central banks cannot create foreign currencies; their
ability to meet banks' demand for foreign currencies is con­
strained by the exchange rate regime or limited to available FX
reserves (Chang and Velasco (2000, 2001), Obstfeld et al (2009)).
Banks' foreign currency requirements may therefore have to be
met from international sources (Fischer (1999), Mishkin (1999)).
Funding risk is inherently tied to stresses across the global
balance sheet: mismatches between the maturity, currency
and counterparty of assets and liabilities. Quantifying this risk
requires measurement of banking activity on a consolidated
basis, preferably at the level of the decision-making economic
unit (ie individual banks). Data designed to identify vulnerabili­
ties in banks' funding patterns would ideally include, for both
assets and liabilities, a complete breakdown of positions by cur­
rency, maturity and counterparty type, along with the relevant
risk characteristics and off-balance sheet positions.
The publicly available information on banks' international positions
typically falls far short of this ideal. Published accounts (collected
in BankScope and Bloomberg) are available at the level of individ­
ual (consolidated) banks, but lack the essential breakdowns (coun­
terparty, maturity and currency) needed here. Such information
may be collected by bank examiners in the course of their supervi­
sory activity, but is not included in publicly available data sources. 6 6
Statistics compiled at the national level (from national authorities,
the IMF and the OECD) generally do not provide a complete
picture either. As shown in Section 16.3.1, banks have become so
globalised that residency-based data are insufficient for identifying
vulnerabilities in any particular national banking system.
The analysis in this paper relies on the BIS international bank­
ing statistics, the most comprehensive source of information
on banks' international balance sheet positions. 7 With these
6 Also, their focus on individual banks may mean that macroprudential
issues, such as the extent to which different banks rely on the same fund­
ing patterns or trade and invest in the same direction, can be overlooked.
7 The Bank for International Settlements disseminates four sets of inter­
national banking statistics compiled from underlying data reported by
monetary authorities in over 40 countries, including the major offshore
centres. As described in the appendix, the analysis in this paper relies
(primarily) on two of these: the BIS consolidated banking statistics on an
immediate borrower basis (CBS) and the BIS locational banking statistics
by residency (LBSN).
data, it is possible to reconstruct the consolidated global banks' total assets (row 2) and more than 70% of Canadian,
balance sheets for the major national banking systems. This Italian and UK banks' assets. Across all banks in BankScope, the
effectively involves adding up the cross-border and local top 50 institutions account for some 80% of total bank assets in
(ie vis-a-vis residents of the host country) balance sheet posi­ the database. Banks' foreign positions (row 4) is even more
tions reported by banks' home offices and their offices in host concentrated in the familiar names.
countries around the world into a consolidated whole for each
banking system. The end result is a dataset with the consoli­
dated balance sheet positions for 19 banking systems for the 16.3 THE LONG AND SHORT O F BANKS'
Q2 1999-Q1 2009 period at a quarterly frequency. It is impor­ G LO B A L BA LA N CE SH EETS
tant to note that the constructed positions are estimates
based on imperfect underlying data, and in places require 16.3.1 The Structure of Banks' Operations
assumptions to address known data limitations. More informa­
tion on these assumptions and the construction of the dataset Internationally active banks have offices in many countries
is provided in the appendix. around the world. Their currency and maturity positions are
managed across the consolidated global entity rather than
We use this dataset to investigate how banks fund their
office by office. Thus, large measured "mismatches" on the
foreign currency investments, and to derive their funding
balance sheet of an office in one location may be hedged off-
requirements across currencies and counterparties. While not
balance sheet or offset by on-balance sheet positions booked
at the individual bank level, the advantages of these data are
by offices elsewhere, leaving a matched book for the bank as
that they provide (i) the consolidated foreign assets and liabil­
a whole. This section provides some simple measures of how
ities for each banking system, (ii) estimates of the gross and
banks' offices are organised across countries, and highlights the
net positions by currency, and (iii) information on the sources
importance of measuring stresses across the balance sheets of
of financing (ie interbank market, central banks and non-bank
consolidated entities.
counterparties).
Overall, foreign offices account for a significant share of banks'
Table 16.1 presents summary statistics on the 11 banking sys­
worldwide consolidated balance sheets. The bottom five rows of
tems analysed in later sections. Row 1 lists the number of inter­
Table 16.1 show the share of banks' total foreign claims (assets)
nationally active banks which are headquartered in the country
which are booked by their offices in various countries/regions. 9
listed in the column heading, and whose foreign claims (row 4)
In most cases, /ess than half of banks' foreign claims are booked
are thus included in the BIS consolidated banking statistics. 8
by their home offices, with French and Japanese banks being
Row 2 provides the total assets for this select group of banks in
exceptions. At the extreme are Swiss banks, with more than
each banking system. For some banking systems (eg Germany,
$3 trillion in foreign claims, accounting for over 80% of their
France and Italy), the number of individual reporting institutions
total balance sheet assets. Only 18% of their foreign claims are
is large since it includes many banks that hold small foreign
booked by offices in Switzerland. Banks' offices in the United
exposures. However, international banking is highly concen­
Kingdom tend to be the largest outside the home country, fol­
trated. Estimated concentration ratios (row 3) for each banking
lowed by offices in the United States; combined, US and UK
system, calculated using bank-level information on total assets
offices account for roughly one third of German, Spanish and
from BankScope, indicate that the five largest institutions
Dutch banks' foreign claims.
account for more than 90% of Belgian, Swiss, French and Dutch
Looking at these data from the perspective of host countries
shows just how large banks' international operations really
8 A banking system's foreign positions (assets or liabilities) are com­
are. Table 16.2, where the column headings now indicate host
posed of four components: (i) cross-border positions booked by all countries, shows the gross and net international asset position
offices worldwide and in all currencies; (ii) "local positions", or claims of each country, and compares these to banks' cross-border
booked by banks' foreign offices vis-a-vis residents of the host country
claims (here, including banks' cross-border inter-office positions
(in either the local currency or a foreign currency); (iii) positions booked
by the home office vis-a-vis residents of the home country in foreign as well). The table distinguishes between positions booked by
currencies; and (iv) cross-border positions booked by banks' foreign
offices vis-a-vis residents of the home country. Only by splicing the CBS
and the LBSN can these four components be assembled into a consoli­ 9 For banks' home offices, the figures in Table 16.1 include cross-border
dated whole for each banking system (see Table A in the appendix). lending in all currencies and lending to residents of the home country in
The remaining component, banks' "strictly domestic" activity, or posi­ foreign currencies. For banks' foreign offices, the figures include cross-
tions booked by home offices vis-a-vis residents of the home country in border and local claims in all currencies, ie the complete balance sheet
the domestic currency, is not included in the BIS banking statistics. of the foreign office. See footnote 8.

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 313
Table 16.1 Size and Structure of Banks' Foreign O perations
Positions at end-2007

Banking system BE CA CH DE ES FR IT JP NL UK US

Number of banks1 18 17 23 1,801 96 135 724 106 49 17 33

Total assets ($bn) 2 2,218 2,437 3,810 10,585 4,541 8,359 4,180 9,845 4,649 10,008 9,904
Asset concentration3 94.9 72.4 89.3 53.5 62.9 96.1 70.6 62.3 93.6 75.3 50.5
Foreign claims($bn) 4 1,608 912 3,390 5,177 1,416 4,456 1,543 2,571 2,962 4,378 2,285
over total assets (%) 72 37 89 49 31 53 37 26 64 44 23
over annual GDP (%) 348 63 776 155 98 171 18 58 378 157 16
US dollar share (%) 23 70 60 33 36 31 10 48 31 42 52
Home entry6 42 23 18 44 27 51 39 75 27 44 2 2
office location ( % ) 5
Foreign claims, by

UK 6 18 30 2 2 28 6 5 6 2 0 25
US 6 41 23 6 9 12 3 9 12 16
Euro Area 37 2 4 16 10 15 35 2 23 11 7
OFC 7 3 9 21 7 2 6 2 6 6 14 24
Other 6 7 4 4 24 10 17 3 13 15 2 2

Assets booked by 42 26 80 27 2 2 27 19 7 47 29 21

foreign offices ( % ) 8
1 Number of banking groups (headquartered in the country shown in the columns) that report in the BIS consolidated banking statistics.
2 Total assets (including "strictly domestic assets") aggregated across BIS reporting banks. For reporting jurisdictions which do not provide this aggre­
gate (DE, ES, FR, IT, JP), total assets are estimated by aggregating the worldwide consolidated balance sheets (from BankScope) for a similar set of
arge banks headquartered in the country.
3 Share of total assets accounted for by the five largest reporting institutions.
4 Foreign claims as reported in the BIS consolidated banking statistics (immediate borrower basis) plus foreign currency claims vis-a-vis residents of
the home country booked by home offices (taken from the BIS locational banking statistics by nationality). See footnote 8 in the main text. Excludes
inter-office claims.
5 Total claims (cross-border claims plus claims on residents of the host country) booked by offices in each location over total worldwide consolidated
foreign claims.
6 Excludes banks' "strictly domestic" claims, or their claims on residents of the home country in the domestic currency.
7 Offshore financial centres: here Bahamas, Bahrain, Bermuda, the Cayman Islands, Guernsey, Hong Kong SAR, the Isle of Man, Jersey, Macao SAR,
Panama and Singapore.
8 Share of total assets (row 2) booked by offices outside the home country.
Sources: IMF IFS; BankScope; BIS consolidated statistics (immediate borrower basis); BIS locational banking statistics by nationality.

offices of "domestic" and "foreign" banks in each host country.
In five countries (BE, CH, DE, JP and UK), banks' cross-border
positions accounted for almost half of that country's external
assets at end-2007, and as much as a quarter in five other
countries (CA, ES, FR, IT and NL). The offices of foreign banks
alone accounted for nearly 40% of the United Kingdom's exter­
nal assets. In contrast, positions booked by the home offices
of domestic banks were much larger in the case of Belgium,
Germany, Japan and Switzerland.
What Tables 16.1 and 16.2 make clear is that "bank nationality"
and "bank residency" are fundamentally different concepts.
Positions booked by offices in any one country are generally a
small part of that banking system's global consolidated balance
sheet (Table 16.1), yet cross-border positions booked by banks'
offices in any one country can be large relative to that host
country's external asset position (Table 16.2). This has implica­
tions for how one should interpret a "national balance sheet",
the unit of analysis used in a growing literature on international

314 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Table 16.2 Bank Assets in Total External Assets 3
4
Positions at end-2007

Country BE CA CH DE ES FR IT JP NL UK2 US

Gross external 2,407 1,199 3,231 7,367 2,091 7,758 2,827 5,355 3,795 12,777 17,640
assets ($bn)1
Net external 141 -127 635 949 -1,081 375 -119 2,195 14 -586 -2,442
assets ($bn)
Cross-border bank claims ($bn)3
All banks 1,162 303 1,539 3,561 613 2,821 648 2,402 1,342 6,844 2,961
Domestic banks 881 282 1,235 2,953 471 2,497 478 2,169 1,133 1,966 1,113
Foreign banks 280 21 304 608 141 324 169 233 209 4,878 1,848
Cross-border bank claims / external assets (%)4
All banks 48 25 48 48 29 36 23 45 25 54 17
Domestic banks 37 24 38 40 23 32 17 41 30 15 6

Foreign banks 12 2 9 8 7 4 6 4 5 38 10

Net cross-border bank claims ($bn)

All banks 191 40 146 1,568 -8 9 11 -294 1,690 149 -1,274 -754
Domestic banks 160 64 117 1,339 6 8 123 -130 1,623 207 -400 -814
Foreign banks 32 -2 4 30 229 -157 - 1 1 1 -165 67 -5 9 -874 60
Pre-crisis: change in net positions Q4 2000-Q2 2007 ($bn)
External assets 3 36 221 882 -729 145 -143 844 21 -488 -1,003
All banks 126 24 50 1,276 18 89 -176 771 109 -680 -573
Domestic banks 97 32 48 986 124 172 -6 3 631 161 -190 -420
Foreign banks 30 - 8 2 290 -106 -8 4 -113 140 -51 -490 -152
During crisis: change in net positions Q2 2007-Q4 2007 ($bn)
External assets -5 -2 3 128 5 - 2 0 2 111 -1 6 193 53 46 -108
All banks 51 17 25 277 -18 -32 -41 284 49 -269 7
Domestic banks 47 24 14 327 10 -4 6 -1 8 301 39 -107 -194
Foreign banks 3 - 6 10 -5 0 -2 9 14 -2 3 -1 6 10 -162 2 0 0

1 Stock of international assets held by residents (banks and non-banks) of the country listed in the column heading.
2 The calculations in the bottom half of the table on banks' net cross-border positions should be interpreted with caution. Banks located in the United
Kingdom reported roughly $800 billion in liabilities for which the residency of the counterparty is unknown (see data appendix). The calculation in the
table assumes that these "unallocated" liabilities are held by non-residents. Were we to assume that they were held by residents, then the net cross-
border claims of domestic (foreign) banks would change from -$400 billion (-$874 billion) to -$48 billion (-$412 billion).
3 Cross-border claims (including inter-office claims) booked by banks' offices located in the country in the column heading.
4 Ratio of cross-border bank claims to gross external assets (row 1).
Sources: IMF IFS; BIS locational statistics by nationality.

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 315
investment and capital mobility. 1 0 For at least two reasons, the banks, at 6 %). Therefore, vulnerabilities in these banks' balance
national balance sheet may be a poor indicator of vulnerabilities sheets may not be visible in the home country's external posi­
(eg currency or maturity mismatches) faced by residents of a tion, even when combined with data on these banks' domestic
particular country. positions (eg domestic credit and other such aggregates).
Vulnerabilities can only be measured by taking into account the
First, changes in a country's external position can be driven to
entire balance sheet of the consolidated global entity. More­
a large extent by the activity of foreign banks' offices, and thus
over, these vulnerabilities relate to domestic residents only to
be only loosely related to vulnerabilities in residents' portfo­
the extent that the residents hold exposures in the national
lios. For instance, suppose banks headquartered in country A
banking system.
double their balance sheet size through greater cross-border
lending and/or acquisition of foreign banks. If the balance sheet
adjustment occurs in these banks' foreign offices, it can gener­ 16.3.2 Balance Sheet Expansion since 2000
ate large swings in other countries' external positions without
The origins of the US dollar shortage during the crisis are
necessarily affecting country A's external position. For instance,
linked to the expansion since 2 0 0 0 in banks' international bal­
the expansion in the global balance sheets of Swiss, German
ance sheets. The outstanding stock of banks' foreign claims
and Dutch banks since 2000 was driven to a large extent by
grew from $10 trillion at the beginning of 2000 to $34 trillion
greater cross-border positions booked by their offices in the
by end-2007, a significant expansion even when scaled by
United Kingdom (see next section). Indeed, as shown in the
global economic activity (Figure 16.1, left panel). The year-on-
bottom rows of Table 16.2, the offices of foreign banks located
year growth in foreign claims approached 30% by mid-2007,
there saw larger changes in their net cross-border balance sheet
up from around 10% in 2001. This acceleration took place
positions in the pre-crisis period than did UK headquartered
during a period of financial innovation, which included the
banks (-$490 billion compared to -$190 billion). Over this
emergence of structured finance, the spread of "universal
same period, foreign banks' offices contributed significantly to
banking", which combines commercial and investment bank­
the change in the net external position in Italy and Spain as well.
ing and proprietary trading activities, and significant growth in
In any particular host country, a long or short net cross-border
the hedge fund industry to which banks offer prime brokerage
positions in a particular currency booked by the offices of for­
and other services.
eign banks there may be offset or hedged elsewhere on those
banks' global balance sheet. How, then, should we interpret the At the level of individual banking systems, the growth in
associated "mismatches" on the national balance sheet of the European banks' global positions is most noteworthy (Figure 16.1,
host country? And to what extent do they reflect vulnerabilities centre panel). For example, Swiss banks' foreign claims jumped
faced by the host country residents? from roughly five times Swiss nominal GDP in 2000 to more
than seven times in mid-2007 (Table 16.1). Dutch, French,
The converse of this point is that it is generally difficult to
German and UK banks' foreign claims expanded considerably
identify a particular banking system's vulnerabilities by looking
as well. In contrast, Canadian, Japanese and US banks' foreign
at the home country's domestic and external positions data.
claims grew in absolute terms over the same period, but did
For example, in at least six countries (BE, CH, DE, FR, JP and
not significantly outpace the growth in domestic or world GDP
NL), domestic banks' cross-border positions account for a third
(Figure 16.1, right panel). While much of the increase for some
or more of the home country's external position (Table 16.2).
European banking systems reflected their greater intra-euro area
Yet, Table 16.1 (bottom row) indicates that assets booked by
lending following the introduction of the single currency in 1999,
offices outside the home country account for a significant share
their estimated US dollar- (and other non-euro-) denominated
(a quarter or more) of each of these countries' national banking
positions accounted for more than half of the overall increase in
systems' total worldwide assets (with the exception of Japanese
their foreign assets between end-2000 and mid-2007.

10 Lane and Shambaugh (2009a) construct estimates of the currency

composition of the external asset and liability positions for a large sam­
ple of countries, and show that the effect of exchange rate movements
is sizeable. Lane and Shambaugh (2009b) and Faria and Mauro (2009)
build on this by investigating the determinants of countries' long and
short currency positions. See Lane and Milesi-Ferretti (2001) for back­
ground, Forbes (2008) for an analysis of capital flows into the United
States, and Tille and van Wincoop (2007) and Devereux and Sutherland
(2009) for recent models of international portfolio choice.
16.3.3 Cross-Currency Funding Positions
How did banks finance this expansion, especially their foreign
currency asset positions? This section examines cross-currency
funding, or the extent to which banks invest in one currency
and fund in another. This requires a breakdown by currency of
banks' gross foreign positions, as shown in Figure 16.2, where
positive (negative) positions represent foreign claims (liabilities).

316 ■ Financial Risk M anager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Foreign claim s scaled by world G D P
In per cent
A
All banks, by currency European banks (all currencies)
German
Swiss
00 01 02 03 04 05 06 07 08
A r\
Estimated totals for 19 banking systems (see data appendix).
booked by banks' foreign offices.
Sources: IMF; BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality.
For some European banking systems, foreign claims are primar­
ily denominated in the home country (or "domestic") currency,
typically representing intra-euro area crossborder positions
(eg Belgian, Dutch, French and German banks). For others
(eg Japanese, Swiss and UK banks), foreign claims are predomi­
nantly in foreign currencies, mainly US dollars.
Foreign currency assets often exceed the extent of funding in
the same currency. This is shown in Figure 16.3, where, in each
panel, the lines indicate the overall net position (foreign assets
minus liabilities) in each of the major currencies. 11 If we assume
that banks' on-balance sheet open currency positions are small,
these cross-currency net positions are a measure of banks' reli­
ance on FX swaps. Many banking systems maintain long posi­
tions in foreign currencies, where "long" ("short") denotes a
positive (negative) net position. These long foreign currency
positions are mirrored in net borrowing in domestic currency
from home country residents (recall equation (16.1)).1 12
1 This is consistent with European universal banks using their retai
11 The "unknown" liabilities in Figure 16.2 have been allocated (by
currency) in Figures 16.3-16.5 using information on the currency split
from the BIS International Debt Securities database (see the appendix
for explanation).
12 As mentioned in footnote 8, banks' "strictly domestic" positions are
not reported in the BIS banking statistics. Their gross positions in their
domestic currency booked by their home offices vis-a-vis home country
residents are therefore unknown, but their net position (shown as the
shaded area in Figure 16.3) can be inferred as a residual from the bal­
ance sheet identity (see equation (16.1) and data appendix). German
banks' foreign claims in Figure 16.2, for example, comprise all of their
foreign currency positions, but their euro positions only vis-a-vis counter­
parties outside Germany.
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response
Other banks (all currencies)
Belgian
Dutch 4
2
o
00 01 02 03 04 05 06 07 08
Foreign claims excluding claims on residents of the home country
Figure 16.1
UK banks, for example, borrowed (net) in sterling (some
$550 billion in mid-2007, both cross-border and from UK resi­
dents) in order to finance their corresponding long positions in
US dollars, euros and other foreign currencies. By mid-2007,
their long US dollar positions stood at $200 billion, on an esti­
mated $2 trillion in gross US dollar claims. Similarly, German
and Swiss banks' net US dollar books approached $300 billion
by mid-2007, while that of Dutch banks surpassed $150 billion.
In comparison, Belgian and French banks maintained a relatively
neutral overall US dollar position prior to the crisis, while
Spanish banks had borrowed US dollars to finance euro lending
at home, at least until mid-2006.13
Taken together, Figures 16.2 and 16.3 thus show that several
European banking systems expanded their long US dollar posi­
tions significantly since 2 0 0 0 , and funded them primarily by bor­
rowing in their domestic currency from home country residents.
banking arms to fund the expansion of investment banking
activities, which have a large dollar component and are concen­
trated in major financial centres. In aggregate, European banks'
combined long US dollar positions grew to roughly $700 billion
by mid-2007 (Figure 16.5, top left panel), funded by short
13 The long net foreign claims of Japanese banks and the short net
foreign claims of US banks mirror the (cumulative) current account posi­
tions of their respective home countries, reflecting the degree to which
domestic banks' home offices accommodate international capital trans­
fers. However, for the reasons elaborated in Section 16.3.1, the relation­
ship between a country's external position and the foreign assets of the
banks headquartered there is tenuous.
■ 317
 G ross foreign assets and liabilities, by currency1
In trillions of US dollars

UK banks Swiss banks German banks

USD
EUR
JPY
Domestic2
Other 2
Unknown

0 0

-2 -2

-4 -4

Spanish banks French banks Belgian banks

1.0 1.4

0.5 -_ 0.7

0 .0 0 .0

- -0.5 -0.7

- 1.0 -1.4

-1.5

Dutch banks' Japanese banks US banks

3.0 1.5

L. 1.5 1 0 .0

0 .0 o -1.5

. -1.5 - -1 -3.0

-3.0 -2 -4.5
00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
1 o
Positive (negative) values are assets (liabilities). For UK banks, gross positions in domestic currency booked by these banks'
home offices. Prior to Q4 2005, local liabilities in local currency (LLLC) vis-a-vis some large European countries are estimated. The
contraction in positions in Q4 2008 in part reflects the sale of some business units of Fortis. 4 Local positions (LCLC and LLLC) vis-
a-vis advanced economies are available from Q4 2002. The contraction in positions in Q3 2008 in part reflects the sale of some
business units of ABN AMRO.

Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure 16.2

318 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 A

Net foreign positions, by currency

In billions of US dollars

UK banks Swiss banks German banks

500

-250

-500 1,200
Dom (residents)
-

Dom (crossborder)
J___ L -750 -1,800

Spanish banks French banks Belgian banks

600

300

-300

-900

Dutch banks1 Japanese banks US banks

V 1,200 800

. 600 400

o 0

-600 -400

- 1,200 -800

J__ I__ I__ L -1,800 - 1,200

00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
A r\
Net foreign positions are assets minus liabilities. Implied net positions in domestic currency vis-a-vis residents of the home
country, inferred from the balance sheet identity (see data appendix). For UK banks, net cross-border positions in domestic
currency booked by these banks' home offices. 4 Prior to Q4 2005, local liabilities in local currency (LLLC) vis-a-vis some large
European countries are estimated. The contraction in positions in Q4 2008 in part reflects the sale of some business units
of Fortis. 5 Local positions (LCLC and LLLC) vis-a-vis advanced economies are available from Q4 2002. The contraction in positions
in Q3 2008 in part reflects the sale of some business units of ABN AMRO.
Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure 16.3

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 319
positions in sterling, euros and Swiss francs. 1 4 As banks' cross­
currency funding grew, so did their hedging requirements and
FX swap transactions, which are subject to funding risk when
these contracts have to be rolled over.
16.3.4 Maturity Transformation across
Banks' Balance Sheets
As discussed in Section 2, funding risk hinges on the degree of
maturity transformation embedded in banks' balance sheets.
Unfortunately, data limitations make it difficult to obtain an
aggregate maturity profile of banks' foreign assets and liabili­
ties. In this section, we argue that the counterparty sector break­
down available in the BIS banking statistics can serve as a proxy
for maturity transformation, and hence funding risk, since the
maturity of positions is likely to vary systematically with the type
of counterparty. 1 5 We use this counterparty information to con­
struct a measure of banks' US dollar funding gap, the amount of
US dollars invested in longer-term assets which is not supported
by longer-term US dollar liabilities, this gap being the amount
that banks must roll over before their investments mature (equa­
tion (16.2)). We build up this argument in several steps.
The counterparty sector breakdown for European banks' gross
US dollar assets and liabilities is shown in Figure 16.5 (top right
panel). Interbank claims, which include interbank loans and debt
securities claims, tend to be shorter-term or can be realised at
shorter notice than claims on non-banks. We think of US dollar
claims on non-banks as banks' desired US dollar investment
portfolio. This portfolio of non-bank assets includes banks' retail
and corporate lending, lending to hedge funds, and holdings of
securities ranging from US Treasury and agency securities to
structured finance products. 1 6 Whether these non-bank assets
14 Adding in Japanese banks' $600 billion long US dollar position
(Figure 16.3) brings the estimated total to $1.3 trillion.
15 Using the counterparty sector also addresses the common problem that
the effective maturity may differ from the maturity stated on bank balance
sheets (Flannery and James (1984)). Demand deposits held by households,
for instance, are a stable source of funding with a long effective maturity.
16 No counterparty sector breakdown is available for banks' US dollar
claims on US residents booked by their offices in the United States ("Local
US positions" in Figure 16.5, top right panel), since these positions are
taken from the CBS (see Table A in appendix). Overlaying our data set with
the BIS consolidated banking statistics (ultimate risk basis) suggests that
over 70% of these positions are vis-a-vis non-bank private entities. Alterna­
tive sources of data also indicate that the bulk of these positions is likely
to be transactions with nonbank counterparties. For instance, BankScope
data suggest that European bank subsidiaries in the United States book
a small share (below 5%) of their total assets as interbank assets. Data on
foreign banks' offices in the United States from the Federal Reserve H.8
release point in the same direction. Thus, our estimate of US dollar posi­
tions vis-a-vis non-banks (in Figures 16.4 and 16.5) is the sum of banks'
international US dollar positions in non-banks and their local US positions.
320 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
can be readily converted to cash depends upon the maturity of
the underlying positions as well as on their market liquidity.
These US dollar investments are funded by liabilities to various
counterparties. Banks can borrow US dollars directly from the
interbank market, typically short-term. They can also raise US
dollars via FX swaps (with bank or non-bank counterparties), which
are even shorter-term on average. 1 7 18 In contrast, US dollar funding
provided directly by non-banks includes corporate and retail
deposits, deposits from central banks, and financing from money
1Q
market funds, and is thus of varying maturities. As described in
Baba et al (2009), money market funds had become an important
source of short-term US dollar financing, providing an estimated
$1 trillion to European banks in 2007. If the effective maturity of
liabilities to non-banks matches that of their investments in non­
banks (ie is "longer-term"), then a lower-bound estimate of their
US dollar funding gap is the net US dollar position vis-a-vis non­
banks. If, on the other hand, banks' liabilities to non-banks were all
short-term, then an upper-bound estimate of their funding gap is
their gross US dollar position in non-banks. Figure 16.4, which
focuses on the lower-bound measure, shows the considerable het­
erogeneity in the way European banks met their US dollar funding
requirements. For example, Dutch, German, Swiss and UK banks
had the largest funding gaps (green lines) by mid-2007.
However, their reliance on the interbank market (blue line), cen­
tral bank deposits (red line) and FX swaps (shaded area) differed
markedly. 1 9 UK banks maintained largely balanced net interbank
US dollar positions, thus implying cross-currency funding, while
German banks relied relatively more on interbank funding.
Taken together, these estimates suggest that European banks'
US dollar investments in non-banks were subject to considerable
funding risk at the onset of the crisis. The net US dollar book,
aggregated across the major European banking systems, is por­
trayed in Figure 16.5 (bottom left panel), with the non-bank com­
ponent tracked by the green line. By this measure, the major
European banks' US dollar funding gap had reached $1.0-1.2
trillion by mid-2007. Until the onset of the crisis, European banks
17 Evidence from the BIS Triennial Central Bank Survey (of 2007) indi­
cates that 78% of FX swap turnover is accounted for by contracts with a
maturity of less than seven days.
18 In the BIS banking statistics, reporting banks' liabilities to official
monetary authorities mostly reflect international deposits of foreign
exchange reserves.
19 The figures on net interbank lending to other (unaffiliated) banks should
be interpreted with caution. Incomplete reporting of inter-office positions
makes it impossible to precisely pin down banks' net position visa-vis
other banks, and hence their net FX swap position, which is backed out
as a residual. In Figures 16.4 and 16.5, the solid blue lines and the corre­
sponding shaded areas are the primary set of estimates; the dashed blue
lines and corresponding dashed black lines are alternative estimates (see
data appendix). This problem is particularly severe for Swiss banks.
 Net US dollar-denom inated foreign positions, by counterparty sector
In billions of US dollars

UK banks Swiss banks German banks

Monetary authorities
Other banks 300
Non-banks
Cross currency

^ W \

-300

Spanish banks French banks Belgian banks

Dutch banks' Japanese banks US banks

00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
1 Cross-border positions in all currencies and local positions in foreign currencies vis-a-vis official monetary authorities. Excluding
liabilities to Japanese monetary authorities placed in banks located in Japan. The solid blue line tracks net interbank lending to
other (unaffiliated) banks. The dashed blue line is an alternative measure of interbank positions which makes use of the available
information on inter-office positions (see data appendix). The estimated net position vis-a-vis non-banks is the sum of net
international claims on non-banks and net local claims on US residents (vis-a-vis all sectors) booked by the US offices of the reporting
bank. See footnote 16 in the main text. 4 Implied cross-currency funding (ie FX swaps) which equates gross US dollar assets and
liabilities. The dashed black line is an alternative measure of cross-currency funding which makes use of the available information on
inter-office positions (see data appendix). 5 Prior to Q4 2005, local liabilities in local currency (LLLC) vis-a-vis some large European
countries are estimated. The contraction in positions in Q4 2008 in part reflects the sale of some business units of Fortis. 6 Local
positions (LCLC and LLLC) vis-a-vis advanced economies are available from Q4 2002. The contraction in positions in Q3 2008 in part
reflects the sale of some business units of ABN AMRO.
Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure 16.4

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 321
 A

European banks' balance sheet positions

In trillions of US dollars

Net positions, by currency Gross US dollar positions, by counterparty sector

Local US positions3
Interbank 8
Non-banks (international)
Monetary authorities
Unknown r

-4

-8

-12

Net USD positions, by counterparty sector Net USD positions vis-a-vis non-banks

Monetary authorities Lower bound6

Other banks5 Lower bound (incl MMF) 8
Non-banks6 Upper bound9
Cross currency7 Vis-a-vis
public sector10

V—
I -1.0
00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08
A
Estimates are constructed by aggregating the on-balance sheet cross-border and local positions reported by Belgian, Dutch, French,
German, Italian, Spanish, Swiss and UK banks' offices. Positions booked by offices located in Switzerland (for CHF) and in the
United Kingdom (for GBP). CHF and GBP positions reported by offices located elsewhere are included in "Other".3 US dollar
positions vis-a-vis US residents booked by banks' offices in the United States (LCLC and LLLC). No sectoral breakdown is available
for these positions. See footnote 16 in the main text. 4 Cross-border positions in all currencies and local positions in foreign
currencies vis-a-vis official monetary authorities. Excluding liabilities to Japanese monetary authorities placed in banks located in
Japan. 5 The solid blue line tracks net interbank lending to other (unaffiliated) banks. The dashed blue line is an alternative measure
of interbank positions which makes use of the available information on inter-office positions (see data appendix). 6 The net position
vis-a-vis non-banks is estimated as the sum of net international positions vis-a-vis non-banks and net local US positions (vis-a-vis all
sectors). The dashed green line is the estimate of the US dollar funding gap when (cumulative) writedowns are incorporated (see
text). 7 Implied cross-currency funding (ie FX swaps) which equates gross US dollar assets and liabilities. The dashed black line is
an alternative measure of cross-currency funding which makes use of the available information on inter-office positions (see data
appendix). 8 Lower bound estimate plus estimated US dollar liabilities to money market funds. 9 Consolidated gross claims on
AA
non-banks. Consolidated gross claims (ultimate risk basis) on the US public sector.
Sources: BIS consolidated statistics (immediate borrower and ultimate risk basis); BIS locational statistics by nationality. Figure 16.5

had met this need by tappinq the interbank market ($432 billion)
and by borrowing from central banks ($386 billion) , 2 0 and used
FX swaps ($315 billion) to convert (primarily) domestic currency
20 In the BIS locational banking statistics, several countries (eg
Germany, Japan and the United States) do not report liabilities (in for­
eign currency) vis-a-vis domestic official monetary authorities, which
makes it difficult to identify precisely total liabilities to these coun­
terparties. For example, data on foreign exchange reserve holdings
reported to the IMF indicate that Japanese monetary authorities held
roughly $118 billion in banks located in Japan in mid-2007 ($26 billion
in Japanese banks and $92 billion in foreign banks in Japan). To the
extent that these reserves are US dollar-denominated, the red lines in
Figure 16.4 understate liabilities to official monetary authorities for all
those banking systems which have offices in Japan, and which receive
deposits from Japanese monetary authorities.

322 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
funding into dollars. 21 If we assume that these banks' liabilities
to money market funds (roughly $1 trillion, Baba et al (2009))
are also short-term liabilities, then the estimate of their US dollar
funding gap in mid-2007 would be $2.0-2.2 trillion. Were all
liabilities to non-banks treated as short-term funding, the
upper-bound estimate would be $6.5 trillion (Figure 16.5,
bottom right panel).
The funding patterns for Japanese and US banks in Figure 16.4
deserve comment as well. Japanese banks' estimated net US
dollar claims on non-banks had risen beyond $600 billion by
end-2007 and, compared with other banking systems, were
skewed towards holdings of US government securities. 2 2
They financed these holdings primarily by borrowing in yen from
Japanese residents. In contrast to Japanese banks, the data
show that US banks borrowed roughly $750 billion internation­
ally by end-2007, and channelled these funds to US residents
(as implied by the shaded area in Figure 16.3). A closer look at
the underlying data suggests that a large portion of their inter­
national liabilities to non-banks were booked by their offices in
Caribbean offshore centres as liabilities to non-bank counterpar­
ties located in the United States (eg firms or money market
mutual funds). This could be regarded as an extension of US
banks' domestic activity since it does not reflect (direct) funding
from non-banks outside the United States. Netting these posi­
tions would imply that their US dollar net borrowing from non­
banks in the rest of the world is smaller than the green line in
Figure 16.4 suggests (some $500 billion at end-2007).
16.4 THE US DOLLAR SHORTAGE
The implied maturity transformation in Figure 16.5 became unsus­
tainable as banks' major sources of short-term funding turned
out to be less stable than expected. Beginning in August 2007,
heightened counterparty risk and liquidity concerns compromised
short-term interbank funding (Taylor and Williams (2009)), vis­
ible in the rise of the blue line in the lower left panel. The related
dislocations in FX swap markets made it even more expensive to
obtain US dollars via currency swaps (Baba and Packer (2009a)),
as European banks' US dollar funding requirements exceeded
other entities' funding needs in other currencies.
01
The alternative estimates in Figure 16.5 (bottom left panel) for net
interbank borrowing (dashed blue line) and cross-currency financing
(dashed black line) were $127 billion and $620 billion, respectively, in
mid-2007.
22 Japanese banks' foreign claims on the public sector stood at $627
billion at end-2007, or 29% of their foreign claims. These public sector
shares are higher than for any other banking system.
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response
European banks' funding difficulties were compounded by insta­
bility in the non-bank sources of funds as well. Money market
funds, facing large redemptions following the failure of Lehman
Brothers, withdrew from bank-issued paper, threatening a
wholesale run on banks (Baba et al (2009)). Less abruptly, a por­
tion of the US dollar foreign exchange reserves that central
banks had placed with commercial banks was withdrawn during
the course of the crisis. 2 3 In particular, some monetary authori­
ties in emerging markets reportedly withdrew placements in
support of their own banking systems in need of US dollars.
Market conditions during the crisis have made it difficult for
banks to respond to these funding pressures by reducing their
US dollar assets. While European banks held a sizeable share of
their net US dollar investments as (liquid) US government securi­
ties (Figure 16.5, bottom right panel), other claims on non-bank
entities—such as structured finance products—have been harder
to sell into illiquid markets without realising large losses. Other
factors also hampered deleveraging of US dollar assets: banks
brought off-balance sheet vehicles back onto their balance
sheets and prearranged credit commitments were drawn. 2 4
Indeed, as shown in Figure 16.5 (top right panel), the estimated
outstanding stock of European banks' US dollar claims actually
rose slightly (by $248 billion or 3%) between Q2 2007 and Q3
2008.25 It was not until the fourth quarter of 2008 that signs of
deleveraging emerged. 2 6
The frequency of rollovers required to support European
banks' US dollar investments in non-banks became difficult
to maintain as suppliers of funds withdrew from the market.
Banks were thus forced to come up with US dollars, given their
reliance on wholesale funding and short-term FX swaps. Essen­
tially, the effective holding period of assets lengthened just
as the maturity of funding shortened. This endogenous rise in
23 Data complied from the 63 monetary authorities which report details
on their foreign exchange holdings to the IMF indicate that central
bank deposits with commercial banks dropped by $257 billion between
mid-2007 and end-2008. See BIS (2009a) for discussion.
24 Consistent with lines being drawn (or discontinued), unused credit
commitments reported by European banks declined by $657 billion
(18%) between mid-2007 and Q1 2009, primarily vis-a-vis US entities
(down 29%).
25 This is despite substantial asset writedowns of $280 billion by end-Q3
2008; by Q1 2009, the writedowns of European banks and brokers had
reached $441 billion (Bloomberg).
26 Between end-Q3 2007 and end-Q1 2009, the outstanding stock of
European banks' US dollar claims fell by $1.5 trillion (17%). It is difficult
to distinguish reductions in lending and asset disposal from writedowns
of assets still on bank balance sheets (see BIS (2009a) for discussion).
In addition, part of the overall reduction reflects the restructuring of
several major European banks.
■ 323
 US dollar positions of European banks' US offices
In billions
A
Vis-a-vis residents of the United States Vis-a-vis non-US residents, by counterparty sector

00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
1 9
Vis-a-vis counterparties in all sectors. Net positions.
Sources: BIS consolidated banking statistics (immediate borrower basis); BIS locational banking statistics by nationality. Figure 16.6

maturity mismatch, difficult to hedge ex ante, generated the nearly 50% (Figure 16.5, bottom panels). Flowever, writedowns
US dollar shortage. of securities and other mark-to-market losses during the crisis
make this observed decline difficult to interpret. Specifically,
Banks reacted to the dollar shortage in various ways, supported
writedowns of assets lead to decreases in the reported stock of
by actions taken by central banks to alleviate the funding pres­
US dollar claims, and thus a decline in net claims on non-banks.
sures. 2 7 Prior to the collapse of Lehman Brothers (up to end-Q2
Ideally, we would measure the US dollar funding gap directly, as
2008), European banks tapped funds in the United States; their
the sum of net interbank funding, net FX swap transactions and
local US dollar liabilities booked by their US offices, which
(possibly) net liabilities to official monetary authorities, in order
included their borrowing from Federal Reserve facilities, 2 8 grew
to pick up the changes in actual net short-term funding liabilities
by $329 billion (13%) between Q2 2007 and Q3 2008, while
(see equation (16.2)). However, in this analysis, the net FX swap
their local assets remained largely unchanged (Figure 16.6, left
positions are backed out as a residual. Thus, any writedown on
panel). This allowed European banks to channel funds out of the
the asset side is automatically reflected in a reduction in the esti-
United States via inter-office transfers (right panel), presumably __ OA

mated net FX swap positions.

to help their head offices replace US dollar funding previously
obtained from the market. 2 9
From the onset of the crisis to end-Q1 2009, the lower bound
estimate of European banks' US dollar funding gap declined by
27 The range of rescue programmes and their effects are reviewed in BIS
(2009b) and ECB (2009).
28 European banks with an established presence in the United States can
borrow against collateral from the facilities the Federal Reserve makes
available to depository institutions. A number of European banks have
access to additional facilities in their capacity as primary dealers. The
borrowing of US dollars by European banks' US offices from the Federal
Reserve is captured in banks' local liabilities in local currency vis-a-vis
the United States. This is not captured in their international liabilities to
official monetary authorities (as in Figures 16.4 and 16.5), as it is neither
in foreign currency nor cross-border.
29 Similarly, Cetorelli and Goldberg (2008) present evidence that inter­
nationally active US banks often rely on internal markets, ie borrow from
foreign affiliates to smooth liquidity shortages.
When asset writedowns are positive, the accuracy of the esti­
mated US dollar funding gap thus depends on the extent to
which banks actually unwound the funding positions supporting
these written-down assets. If banks closed out all these funding
positions by, for example, buying US dollars in the spot market,
then the original estimate of the US dollar funding gap (solid
green line in Figure 16.5, lower left panel) is correct through
end-Q1 2009. If, on the other hand, banks have not closed out
their funding positions, but rather rolled them over, then the
observed measure will underestimate the true funding gap
by the amount of the writedowns. In this case, if we assume
that the bulk of European banks' writedowns (estimated by
30 Only in the period prior to the crisis, when asset writedowns were
zero, will the sum of the three components of net short-term liabilities
be identically equal to the (negative of) the US dollar funding gap (net
claims on non-banks).

324 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Bloomberg at $423 billion between Q2 2007 and Q1 2009) were
related to their US dollar-denominated non-bank assets, then
their US dollar funding gap at end-Q1 2009 would be in the
neighbourhood of $880 billion (dashed green line)—still down
from the pre-crisis peak, but considerably higher than the esti­
mated $583 billion gap which results when the funding positions
are assumed to have been closed.
16.5 THE INTERNATIONAL PO LICY
RESPO N SE
The severity of the US dollar shortage among banks outside the
United States called for an international policy response. While
European central banks adopted measures to alleviate banks'
funding pressures in their domestic currencies, they could not
provide sufficient US dollar liquidity. Thus they entered into
temporary reciprocal currency arrangements (swap lines) with
the Federal Reserve in order to channel US dollars to banks in
their respective jurisdictions (Figure 16.7). Swap lines with the
ECB and the Swiss National Bank were announced as early as
December 2007. Following the failure of Lehman Brothers in
September 2008, however, the existing swap lines were doubled
in size, and new lines were arranged with the Bank of Canada,
the Bank of England and the Bank of Japan, bringing the swap
lines total to $247 billion. As the funding disruptions spread to
banks around the world, swap arrangements were extended
across continents to central banks in Australia and New Zealand,
Scandinavia, and several countries in Asia and Latin America,
forming a global network (Figure 16.7). Various central banks

Central bank netw ork of swap lines

Bank of Canada Reserve Bank of Australia

Bank of Mexico Reserve Bank of New Zealand

Central Bank of Brazil Monetary Authority of Singapore

US Federal Reserve

Bank of England Bank of Japan People's Bank of China

Sveriges Riksbank Bank of Korea

Eurosystem

National Bank of Denmark

Central Bank of Iceland

National Bank of Poland Magyar Nemzeti Bank

The arrows indicate the direction of flows (where known); light shaded arrows represent US dollars
provided to other central banks, dark arrows represent other currencies (evaluated at the average
exchange rate during Q4 2008). The thickness of the arrows is proportional to the size of central bank swap
lines, as announced; where swap lines are unlimited, the figure shows maximum usage instead, derived
from auction allotments (Figure 16.8). The ASEAN swap network is not shown.
Source: Central banks. Figure 16.7

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 325
 A
Central banks' US dollar swap lines
In billions
Eurosystem Bank of England
Q1 08 Q3 08 Q1 09 Q3 09 Q4 08 Q1 09
A
Amounts outstanding are constructed by cumulating US dollar auction allotments, taking into account the term to maturity.
The shaded area indicates the period of unlimited swap lines (as of 13 October 2008).
Source: Central banks.
also entered regional swap arrangements to distribute their
respective currencies across borders.
On 13 October 2008, the swap lines between the Federal
Reserve and the Bank of England, the ECB and the Swiss
National Bank became unlimited to accommodate any quantity
of US dollar funding demanded. The swap lines provided these
central banks with ammunition beyond their existing foreign
exchange reserves (Obstfeld et al (2009)), which in mid-2007
amounted to $294 billion for the euro area, Switzerland and the
United Kingdom combined, an order of magnitude smaller than
Oi
our lower-bound estimate of the US dollar funding gap.
In providing US dollars on a global scale, the Federal Reserve
effectively engaged in international lending of last resort.
The swap network can be understood as a mechanism by which
the Federal Reserve extends loans, collateralised by foreign
currencies, to other central banks, which in turn make these
funds available through US dollar auctions in their respective
jurisdictions. 13 2 This made US dollar liquidity accessible to com­
31 Line "Foreign currency reserves (in convertible foreign currencies)" from
the IMF Template on International Reserves and Foreign Currency Liquid­
ity, which includes reserves disclosed by central government and mon­
etary authorities (Eurosystem, Swiss National Bank and Bank of England).
32 The Federal Reserve press release of 13 October 2008 explicitly
stated that the swap lines are to provide US dollar funding via the
central banks to financial institutions abroad. The foreign currencies
pledged to the Federal Reserve in exchange are best regarded as collat­
eral. A new set of swap arrangements (announced on 6 April 2009) was
necessary to authorise the Federal Reserve, should the need arise, to
obtain and disburse the foreign currencies to US banks.
326 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Swiss National Bank
Q2 09 Q3 09 Q1 08 Q3 08 Q1 09 Q3 09
Figure 16.8
mercial banks around the world, including those that have no US
subsidiaries or insufficient eligible collateral to borrow directly
from the Federal Reserve System.
The quantities of US dollars actually allotted through US dollar
auctions in Europe provide an indication of European banks' US
dollar funding shortfall at any point in time (Figure 16.8). Most
of the Federal Reserve's international provision of US dollars was
indeed channelled through central banks in Europe, consistent
with the finding that the funding pressures were particularly
acute among European banks. Once the swap lines became
unlimited, the share provided through the Eurosystem, the Bank
of England and the Swiss National Bank combined was 81%
(15 October 2008), and it has remained in the range of 50-60%
since December 2008.
How successful has the international policy response been?
While it is too soon for conclusive answers, the immediate
effects have been largely positive. Reflecting considerable
demand in the aftermath of the Lehman bankruptcy, the amount
of US dollars provided globally through international dollar swap
lines surged in October 2008, and peaked at $583 billion in
December 2008 (Federal Reserve Statistical Release H.4.1).
Since then, the use of swap lines has gradually subsided, to $50
billion by early October 2009. In tandem, the level and spreads
of US dollar interest rates, notably Libor, have receded from
their historical peak in autumn 2008. Baba and Packer (2009b)
find evidence that the US dollar auctions reduced the level and
volatility of swap spreads. The policy also helped avert more
extensive distress-selling of dollar-denominated assets, and
possibly mitigated interbank rate volatility and upward pressure
on the US dollar. 3 3
Beyond addressing the immediate exigencies, however, the
international swap arrangements are of broader interest from
an institutional perspective. 3 4 The structure of the arrange­
ments appears to overcome two challenges commonly associ­
ated with international lending of last resort. First, the Federal
Reserve and its foreign counterparts have the power, in princi­
ple, to create any amount of money, in contrast with interna­
tional financial institutions administering limited resources. 3 5
Demands in other currencies can similarly be met by including
the respective currency-issuing central banks in the network of
swap lines. Second, the swap network does not compound the
informational problems that can give rise to moral hazard. By
lending against collateral to foreign central banks that interme­
diate those funds to banks in their jurisdictions, the Federal
Reserve assumes no credit risk vis-a-vis the ultimate borrowers,
and delegates the task of monitoring the banks (or collateralis­
ing the loans) to the national authorities closer to the bank
supervision process. 3 6
16.6 CO N CLU D IN G REM ARKS
The recent financial crisis has highlighted just how little is
known about the structure of banks' international balance
sheets and their interconnectedness. The globalisation of
banking over the past decade and the increasing complex­
ity of banks' international positions have made it harder to
construct measures of funding vulnerabilities that take into
33 At the same time, banks' increased reliance on the public availability
of US dollar funding may have delayed the necessary restructuring of
their balance sheets.
34 The international swap arrangements are not unprecedented. A net­
work of swap lines, also centred on the Federal Reserve Bank of New
York, was set up in 1962 to support dollar parities in the Bretton Woods
system of fixed exchange rates (Kindleberger (1996)).
or
Effective lending of last resort requires sufficient resources to reassure
markets that the means of payment will remain available in all circum­
stances (Bagehot (1873)). As the ultimate issuers of currencies, central
banks are the natural lenders of last resort, which some take to imply that
an international financial institution cannot play an analogous role interna­
tionally (Capie (1998), Schwartz (1999)). The recent literature on the design
of the IMF or its lending policies takes into account its limited resources and
focuses on moral hazard issues (Fischer (1999), Lerrick and Meltzer (2003)).
O
The regulation and supervision of banks remains decentralised, and
vested with domestic authorities at the national level. An international
institution may find it difficult to contain moral hazard when lending to
banks outside its regulatory and supervisory reach (Jeanne and Wyplosz
(2003)).
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response
account currency and maturity mismatches. This paper par­
tially fills this void, investigating how banks funded their inter­
national positions across currencies and counterparties. The
analysis shows that between 2000 and mid-2007, the major
European banking systems built up long US dollar positions
vis-a-vis non-banks and funded them by interbank borrow­
ing, borrowing from central banks and FX swaps. We argue
that this greater transformation across counterparties in fact
reflected greater maturity transformation across these banks'
balance sheets, exposing them to considerable funding risk.
When heightened credit risk compromised sources of short­
term funding during the crisis, the chronic US dollar funding
needs became acute, particularly in the wake of the Lehman
Brothers bankruptcy.
In contrast to many previous international financial crises, it
was banks' international exposures to other industrialised
countries that deteriorated, and the global interbank and FX
swap funding structure which seized up. The build-up of such
stresses at the global level can only be identified by track­
ing the extent of cross-currency funding, and by implication,
banks' reliance on short-term interbank and FX swap positions.
What pushed the system to the brink was not cross-currency
funding per se, but rather too many large banks employing
funding strategies in the same direction, the funding equiva­
lent of a "crowded trade". Only when examined at the aggre­
gate level can such vulnerabilities be identified. By quantifying
the US dollar overhang on non-US banks' global balance
sheets, this paper contributes to a better understanding of
why the extraordinary international policy response was neces­
sary, and why it took the form of a global network of central
bank swap lines.
A broader message of this paper is that vulnerabilities in the
international financial system are best measured along the con­
tours of banks' consolidated balance sheets, rather than along
national borders. This is because (i) stresses build up across the
balance sheet—as mismatches between the maturity, currency
and counterparty of assets and liabilities—and (ii) the consoli­
dated balance sheets of the relevant decision-making units
(ie banks) transcend national borders. The dataset constructed
for this paper provides a fairly comprehensive picture of banks'
funding patterns at the level of national banking systems. The
macroprudential perspective afforded by these data shows
that (i) stresses can build up in a national banking system that
cannot be identified with the home country's residency-based
statistics alone, and (ii) banks' cross-border positions are large
relative to countries' external positions, clouding the interpre­
tation of what the "national balance sheet" implies for domes­
tic residents.
■ 327
DATA A PPEN D IX
Reconstructing Banks' Global Balance
Sheets
The analysis in this paper requires estimates of banks' consoli­
dated asset and liability positions broken down by currency and
counterparty sector. This data appendix describes how we con­
struct these estimates, and highlights known data limitations.
The BIS International Banking Statistics
Table A shows the relevant balance sheet components (first col­
umn) and how the required breakdowns are captured in the BIS
international banking statistics. The underlying data are taken
from the BIS consolidated banking statistics on an immediate
borrower basis (CBS) and the BIS locational banking statistics by
nationality (LBSN).
The CBS are organised on the principle of bank nationality.
They provide reporting banks' worldwide consolidated foreign
claims (PC), which comprise cross-border claims (XBC) booked
by all offices worldwide, and local claims (LC), or positions
booked by banks' foreign offices vis-a-vis residents of the host
country. Local claims are denominated in either "local curren­
cies" (LCLQ , ie the domestic currency of the host country, or
in foreign currencies (LC FQ . The statistics record cross-border
claims and local claims in foreign currencies as a joint item called
international claims (INTC = XBC + LCFQ. These claims can be
broken down by the country of residence of the counterparty.
Therefore, banking system b's foreign claims on borrowers in
country c are
FC bc = LC LC bc + INTCbc=> FC b = Y .c FCbc
While the counterparty sector (bank, non-bank private sec­
tor and public sector) is known for international claims, there
is no currency breakdown for these positions nor information
about the location of the booking office. Moreover, the CBS
data contain no information on international liabilities (INTL). In
contrast to international positions, both the currency and the
location of the booking office are known for LCLC by definition.
In addition, banks report their locally booked liabilities in local
currencies (LLLC).
In contrast to the CBS, the LBSN are collected on the principle
of bank residence. The "reporting unit" in the LBSN is any bank
office (head office, branch or subsidiary) in a particular country
or jurisdiction—including major offshore financial centres. Each
bank office reports its cross-border claims and liabilities (XBC
and XBL) as well as foreign currency claims and liabilities vis-a-vis
328 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
residents of that country (LCFC and LCFL, if a foreign office;
DCFC and DLFC if the home office). Importantly, these positions
are broken down by bank nationality (ie the parent country of
the booking office) as well as by currency and counterparty sec­
tor. 3 7 For instance, X B C re p re se n ts US dollar cross-border
claims booked in reporting country r by banks headquartered in
parent country b. The LBSN do not include information on the
location (country) of the counterparty, nor do they include local
claims and liabilities (ie vis-a-vis residents) in the domestic cur­
rency of the reporting country (LCLC and LLLC).
Construction of the Dataset
The two sets of statistics contain complementary information
on banks' global balance sheets. We merge these statistics to
construct the required balance sheet components as shown
in Table A. The key step is to aggregate the LBSN data across
the 40 reporting countries to obtain total international claims
and international liabilities for each bank nationality (ie bank­
ing system), along with the currency and counterparty sector
breakdowns that are unavailable in the CBS. As shown in the last
column of Table A, combining these pieces from the LBSN with
those from the CBS splice yields a complete breakdown by cur­
rency of all foreign positions. The only remaining missing pieces
of the balance sheet are banks' "strictly domestic" positions, or
their domestic currency assets and liabilities booked by home
offices vis-a-vis residents of the home country (DCLC and DLLC).
While their gross "strictly domestic" positions are unknown,
their net position can be inferred as a residual from the balance
sheet identity, as illustrated in equation (16.1) in the main text.
Consider, for example, UK-headquartered banks. Summing
across all reporting countries (indexed by r) in the LBSN where
UK banks have offices gives UK banks' international claims and
liabilities on a global consolidated basis, or
INTCb =-Zr(XBCrb+ L C F C j.
This aggregate compares to INTC in the CBS, but now comes
with detailed breakdowns by currency and counterparty sector.
To match worldwide consolidated foreign claims (PC from the
CBS), the only missing balance sheet components are UK banks'
local claims and liabilities in the domestic currencies of various
host countries (LCLC and LLLC). This information is available in
the CBS reported by the United Kingdom.
37 The sectoral breakdown distinguishes positions vis-a-vis non-banks,
vis-a-vis official monetary authorities and vis-a-vis banks. The interbank
positions are further divided into inter-office positions (within the same
bank group) and positions vis-a-vis other (unaffiliated) banks.
Table A A Breakdown of Banks' Consolidated W orldwide Positions

Breakdowns by

Booking office Residence of Sector of Currency of

Totals location counterparty counterparty positions

Domestic claims (DC ) 1

in foreign currency (DCFC) LBSN LBSN LBSN LBSN LBSN
in local currency (DCLC)
Foreign claims (FC) CBS CBS
ASSETS

Cross-border claims (XBC) LBSN LBSN LBSN LBSN

International claims (INTC) 2 CBS LBSN LBSN CBS CBS LBSN LBSN
Local claims (LC ) 3
in foreign currency (LCFC) LBSN LBSN LBSN LBSN LBSN
in local currency (LCLC) CBS CBS CBS CBS
Domestic liabilities (DL) 1
in foreign currency (DLFC) LBSN LBSN LBSN LBSN LBSN
in local currency (DLLC)
Foreign liabilities (FL)
LIABILITIES

Cross-border liabilities (XBL) LBSN LBSN LBSN LBSN

International liabilities (INTL) 2 LBSN LBSN LBSN LBSN
Local liabilities (LL) 3
in foreign currency (LLFC) LBSN LBSN LBSN LBSN LBSN
in local currency (LLLC) CBS CBS CBS CBS
CBS = consolidated banking statistics on an immediate borrower basis; LBSN = locational banking statistics by nationality.
1 Domestic claims (liabilities including equity) in the home country.
2 International claims INTC = XBC + LCFC, and international liabilities INTL = XBL + LLFC.
3 Local positions booked by banks' foreign offices outside the home country.

The combined dataset thus yields, for 19 banking systems,
foreign claims and liabilities on a worldwide consolidated basis
both broken down by (i) the currency of the position, (ii) the
location of the booking office and (iii) the counterparty type
(bank, non-bank, central bank), and with partial information
on the residency (country) of the counterparty (ie for local
positions, the residency of the counterparty is known by con­
struction; for cross-border positions, the residency of the coun­
terparty is unknown).
across borrowing countries in the CBS) should correspond to
total foreign claims reported in the CBS. That is,
£ r(XBCrb+L C F C j+£ cLCLCbc=FCb
This serves as a consistency check across the two datasets for
the asset side of the balance sheet. There is no correspond­
ing check on the liability side since banks do not report foreign
liabilities (FL) in the CBS.

In practice, some statistical discrepancies arise because the two

Consistency Check and Data Limitations
In principle, for each banking system, total INTCb (summed
across reporting countries in the LBSN) plus LCLC (summed
sets of statistics are collected in fundamentally different ways.
For many banking systems (Belgian, Canadian, Dutch, French,
German, Italian, Spanish and UK banks) the match is fairly close.
The match is not as satisfactory for Swiss and US banks. Discrep­
ancies arise for three main reasons. First, the set of reporting

Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 329
banks in the CBS differs from that reporting LBSN in various
reporting countries. 3 8 Second, some banking systems have
offices in countries that do not report in the LBSN, yet those
offices are included in the worldwide consolidated positions
reported in the CBS. In addition, some countries report incom­
plete positions in the LBSN; the United States, for example,
does not report foreign currency positions vis-a-vis US residents.
A third problem that affects the calculations is that the resi­
dency, counterparty sector and currency of a portion of banks'
liabilities are unknown. These "unknown" liabilities are typi­
cally debt securities issued by banks. Once these securities
are traded on secondary markets, reporting banks no longer
know the residency or the counterparty sector of the entity
that holds these securities. Unfortunately, when the data are
reported to the BIS, the currency of these "unallocated" posi­
tions is not reported, even though, in principle, this is known by
the reporting banks. While these positions are small on a gross
basis (Figure 16.2), they are large on a net basis (Figures 16.3
and 16.4), and thus should not be excluded from the analysis.
Across all reporting countries, the United Kingdom reports by far
the largest "unallocated" liability positions (roughly $800 billion
in mid-2007 for the major European banks' offices located there).
The currency denomination of these liabilities can be estimated
by using the BIS international debt securities database, which
provides information on issuance of debt securities by banks
located in various countries around the world. In Figure 16.2,
the unknown positions are plotted in their raw form, whereas in
Figures 16.3, 16.4 and 16.5 the positions are allocated by currency
by applying the currency split from the debt securities database.
Because the counterparty sector of these positions, needed for
Figures 16.4 and 16.5, remains unknown, we make the conserva­
tive assumption that all unallocated US dollar liabilities are held by
non-banks. This assumption biases downwards the net positions
vis-a-vis non-banks (our lower-bound estimate of the US dollar
funding gap) in Figure 16.4 and Figure 16.5 (bottom panels).
Finally, the breakdowns by sector and currency in the LBSN are
in some cases incomplete. For each banking system b, total
interbank claims (IBC) in a particular currency are the sum of
claims on other (unaffiliated) banks (OTHBC) and inter-office
claims (IOC). That is,
IBC„ = Y ,IB C „ = ^r
38 This is problematic in the case of US banks, since the major US invest­
ment banks are generally included in the LBSN (reported by all coun­
tries), but were not included in the CBS reported by the United States
until Q1 2009, the last quarter of our sample.
330 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
with a corresponding equation for interbank liabilities.
The inter-office asset and liability positions must be stripped
out of total foreign claims in order to make the LBSN and
CBS data comparable on a gross basis, as in Figures 16.2 and
16.5. Some LBSN-reporting countries/regions, however, do
not provide a complete currency breakdown (eg Singapore,
Hong Kong SAR and the Channel Islands), while others provide
only limited currency information for inter-office positions (eg
France, Germany, Italy and Japan split inter-office activity into
domestic and foreign currencies). To the extent possible, we
estimate the missing inter-office components, although some
uncertainty still remains in the overall interbank positions for
some banking systems. This makes it difficult to pin down the
extent of reliance on interbank financing, as shown by the two
alternative estimates presented in Figures 16.4 and 16.5. On a
net basis (claims minus liabilities), inter-office positions should,
in principle, sum to zero across all reporting office locations.
This implies that net "interbank" claims (IBC - IBL) should
equal net claims on "other banks", both of which are observ­
able in the data:
£ r (/OCri - /O L J = 0 =>
L (IBC„ - IBL „) = £ (OTHBCrb - OTHBL,b).
The solid blue lines in Figures 16.4 and 16.5 track
^ r(/BCrb - IBLrb), or net interbank positions calculated without
stripping out inter-office positions, while the dashed blue line
tracks ^ r(OTHBCrb - OTHBLrb), or the reported positions vis-
a-vis unaffiliated banks only. The dashed black lines in Figures
16.4 and 16.5 track the implied reliance on FX swaps which
corresponds to this alternative estimate of interbank positions.
Which set of estimates is more accurate depends on the rela­
tive sizes of observed versus missing inter-office positions, and
whether banks have offices with (unobserved) offsetting posi­
tions in non-reporting countries.
References
Allen, F and D Gale (1998): "Optimal financial crises", Journal of
Finance, 53(4), pp 1245-84.
Baba, N and F Packer (2009a): "Interpreting deviations from
covered interest parity during the financial market turmoil of
2007-08", Journal of Banking and Finance, forthcoming.
— (2009a): "From turmoil to crisis: dislocation in the FX swap
market before and after the failure of Lehman Brothers", Journal
of International Money and Finance, forthcoming.
Baba, N, R McCauley and S Ramaswamy (2009): "Dollar money
market funds and non-US banks", BIS Quarterly Review, March.
Bagehot, W (1873): Lombard Street: a description of the money
market, New York: Scribner, Armstrong & Co.
Bank for International Settlements (2009a): "Highlights of inter­
national banking and financial market activity", BIS Quarterly
Review, June.
— (2009b): "An assessment of financial sector rescue pro­
grammes", BIS Papers, no 48, July.
Bernanke, B (2008): "Policy coordination among central banks",
speech at the Fifth European Central Bank central banking con­
ference, Frankfurt, 14 November.
Capie, F (1998): "Can there be an international lender of last
resort?", International Finance, 1(2), pp 311-25.
Cetorelli, N and L Goldberg (2008): "Banking globalization,
monetary transmission, and the bank lending channel", NBER
Working Papers, no 14101.
Chang R and A Velasco (2000): "Financial fragility and the
exchange rate regime", Journal o f Economic Theory, 92,
pp 1-34.
— (2001): "A model of financial crises in emerging markets",
Quarterly Journal of Economics, 116, pp 489-517.
Devereux, M and A Sutherland (2009): "Valuation effects and
the dynamics of net external assets", Journal of International
Economics, forthcoming.
Diamond, D and R Rajan (2001): "Liquidity risk, liquidity cre­
ation, and financial fragility: a theory of banking", Journal of
Political Economy, 109(2), pp 287-327.
— (2006): "Money in a theory of banking", American Economic
Review, 96(1), pp 30-53.
European Central Bank (2009): EU banks' funding structures and
policies, May.
Faria, A and P Mauro (2009): "Institutions and the external capi­
tal structure of countries", Journal of International Money and
Finance, 28, pp 367-91.
Fischer, S (1999): "On the need for an international lender of
last resort", Journal o f Economic Perspectives, 13(4),
pp 85-104.
Flannery, M and C. James (1984): "Market evidence on the
effective maturity of bank assets and liabilities", Journal of
Money, Credit and Banking, 16(4,1), pp 435-45.
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response
Forbes, K (2008): "Why do foreigners invest in the United
States?", NBER Working Papers, no 13908.
Fukao, M (1991): "Exchange rate movements and capital-asset
ratio of banks: on the concept of structural positions", BOJ
Monetary and Economic Studies, 9(2), September.
Goodhart, C (1995): The central bank and the financial system,
MIT Press.
Jeanne, O and C Wyplosz (2003): "The international lender
of last resort: how large is large enough?", in M Dooley and
J Frankel (eds), Managing currency crises in emerging markets,
University of Chicago Press, pp 89-118.
Kindleberger, C (1950): The dollar shortage, MIT Press and
John Wiley & Sons, Inc.
— (1996): Manias, panics, and crashes—a history of financial
crises, John Wiley & Sons, Inc.
Lane, P and G M Milesi-Ferretti (2001): "The external wealth of
nations: measures of foreign assets and liabilities for industrial
and developing countries", Journal of International Economics,
55(2), pp 263-294.
Lane, P and J Shambaugh (2009a): "Financial exchange rates
and international currency exposures", American Economic
Review, forthcoming.
— (2009b): "The long of short of it: determinants of foreign
currency exposure in external balance sheets", NBER Working
Papers, no 14909.
Lerrick, A and A Meltzer (2003): "Blueprint for an international
lender of last resort", Journal of Monetary Economics, 50,
pp 289-303.
McCauley, R (1984): "Maturity matching in the euromarkets",
New York Federal Reserve Quarterly Review, 9(1), pp 33-5.
Mishkin, F (1999): "Global financial instability: framework,
events, issues", Journal of Economic Perspectives, 13(4),
pp 3-20.
Morgan, G and S Smith (1987): "Maturity intermediation and
intertemporal lending policies of financial intermediaries",
Journal of Finance, 42(4), pp 1023-34.
Obstfeld, M, J Shambaugh, and A Taylor (2009): "Financial
instability, reserves, and central bank swap lines in the panic of
2008", American Economic Review, 99(2), pp 480-86.
Peek, J and E Rosengren (2001): "Determinants of the Japan
premium: actions speak louder than words", Journal of Interna­
tional Economics, 53, pp 283-305.
■ 331
Rajan, R and I Tokatlidis (2005): "Dollar shortages and crises", Taylor, J and J Williams (2009): "A black swan in the money market",
International Journal of Central Banking, 1(2), pp 177-220. American Economic Journal: Macroeconomics, 1(1), pp 58-83.

Schwartz, A (1999): "Is there a need for an international lender Tille, C and E van Wincoop (2007): "International capital flows",
of last resort?", Cato Journal, 19(1), pp 1-6. NBER Working Papers, no 12856.
Stigum, M and A Crescenzi (2007): Stigum's Money Market, Triffin, R (1957): Europe and the money muddle—from bilater­
fourth edition, McGraw Hill. alism to near-convertibility 1947-1956, Yale University Press.

Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Covered Interest
Parity Lost:
Understanding
the Cross-Currency
Basis
Learning Objectives
After completing this reading you should be able to:

Differentiate between the mechanics of FX swaps and Assess the causes of covered interest rate parity violations
cross-currency swaps. after the financial crisis of 2008.

Identify key factors that affect the cross-currency swap

basis.

Excerpt is by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko, from BIS Quarterly Review.

Covered interest parity verges on a physical law in inter­
national finance. And yet it has been systematically vio­
lated since the Great Financial Crisis. Especially puzzling
have been the violations since 2014, even once banks
had strengthened their balance sheets and regained easy
access to funding. We offer a framework to think about
these violations, stressing the combination of hedging
demand and tighter limits to arbitrage, which in turn
reflect a tighter management of risks and bank balance
sheet constraints. We find empirical support for this frame­
work both across currencies and over time.
JE L classification: F31, G15, G2.
Covered interest parity (CIP) is the closest thing to a physical
law in international finance. It holds that the interest rate dif­
ferential between two currencies in the cash money markets
should equal the differential between the forward and spot
exchange rates. Otherwise, arbitrageurs could make a seem­
ingly riskless profit. For example, if the dollar is cheaper in
terms of yen in the forward market than stipulated by CIP, then
anyone able to borrow dollars at prevailing cash market rates
could profit by entering an FX swap—selling dollars for yen at
the spot rate today and repurchasing them cheaply at the for­
ward rate at a future date.
Yet since the onset of the Global Financial Crisis (GFC), CIP
has failed to hold. This is visible in the persistence of a cross­
currency basis since 2007. The cross-currency basis indicates
the amount by which the interest paid to borrow one currency
by swapping it against another differs from the cost of directly
borrowing this currency in the cash market. Thus, a non-zero
cross-currency basis indicates a violation of CIP. Since 2007,
the basis for lending US dollars against most currencies, nota­
bly the euro and yen, has been negative: borrowing dollars
through the FX swap market became more expensive than
direct funding in the dollar cash market. For some currencies,
such as the Australian dollar, it has been positive (Graph 1, left-
hand and centre panels).
Initially, the violations of CIP were seen as a reflection of
strains in global interbank markets. Specifically, heightened
concerns about counterparty risk and constrained bank access
to wholesale dollar funding inhibited arbitrage during the
GFC, and again during the subsequent euro area sovereign
debt crisis. But, puzzlingly, the violations have persisted even
after these strains dissipated. The basis has widened since
2014, for both short- and long-term borrowing, despite fading
concerns about bank credit quality and recovery in wholesale
334 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
dollar funding markets. 1 Why has arbitrage not reduced the
basis to zero?
In this special feature, we argue that the answer to this puzzle
lies in the combination of the evolving demand for FX hedges
and new constraints on arbitrage activity. The former explains
why the basis opens up, and the latter why it does not close. A
growing demand for dollar hedges on the part of banks, institu­
tional investors and issuers of non-US dollar bonds has put pres­
sure on the basis. At the same time, limits to arbitrage (in the
sense discussed by Shleifer and Vishny (1997), among others)
have become more binding. These reflect lower balance sheet
capacity because of tighter management of the risks involved
and the associated balance sheet constraints. Empirically, we
find that proxies for the volume of hedging demand, together
with proxies for balance sheet costs, help explain CIP violations,
both across currencies and over time. If the factors we identify
are the right ones, CIP deviations look to be here to stay even in
non-crisis times, as long as the demand for currency hedges is
sufficiently high and imbalanced across currencies. 21
The rest of this feature is organised as follows. The first section
lays out the framework for our analysis. The second and third
sections examine, respectively, the variation of the basis across
currencies and over time in the yen/dollar basis. The conclusion
highlights some implications and outstanding questions.
17.1 A FRA M EW O RK
The basic mechanics behind CIP are fairly simple. Interest rates
in the cash market and the spot exchange rate can be taken as
given—these markets are much larger than those for FX deriva­
tives. Hence, it is primarily shifts in the demand for FX swaps or
currency swaps that drive forward exchange rates away from CIP
and result in a non-zero basis (Box 17.1). Any such deviations
should, in principle, immediately trigger arbitrage transactions,
bringing the basis back to zero. The reason is that, in an ideal
world, CIP arbitrage is treated as riskless. By construction, FX
swaps do not entail an open currency position. In addition, it is
assumed that the credit, counterparty, market and liquidity risks
involved are negligible. Unimpaired access to cash and deriva­
tives markets then allows arbitrageurs to close the basis.
1 Also, unlike in earlier US dollar funding stress episodes (Cetorelli
and Goldberg (2011, 2012)), banks have drawn very little on central
bank swap lines: https://apps.newyorkfed.org/markets/autorates/
fxswaps-search-result-page.
2 Sushko et al (2016) treat these issues from a more technical perspec­
tive and provide broader econometric results.
 Cross-currency basis against the US dollar, interbank credit risk and market risk1 Graph 1

Three-month basis Three-year basis Libor-OIS spreads and the VIX

Basis points Basis points Percentage points Percentage points

70 40
1 IB
r
l f * r W^PVa
0

-70 fr V yu -40

-140 If V -80

I I I I I I I -210 I I 1 1 1 I I I I I I " 12° " 1 I I I I I I

06 08 10 12 14 16 06 08 10 12 14 16 06 08 10 12
USD/AUD USD/EUR USD/JPY Libor-OIS spread (Ihs):
US ----EA - - VIX

1 The vertical lines indicate 15 September 2008 (Lehman Brothers file for Chapter 11 bankruptcy protection) and 26 October 2011 (euro area
authorities agree on debt relief for Greece, leveraging of the European Financial Stability Facility and the recapitalisation of banks). 2 Chicago
Board Options Exchange S&P 500 implied volatility index; standard deviation, in percentage points per annum.
Sources: Bloomberg; authors' calculations.

BOX 17.1 CIP, FX SWAPS, CROSS-CURRENCY SWAPS AND THE FACTORS THAT
MOVE THE BASIS
CIP is a textbook no-arbitrage condition according to which
interest rates on two otherwise identical assets in two differ­
ent currencies should be equal once the foreign currency risk
is hedged:
F 1+r
S ~ 1 + r*
where S is the spot exchange rate in units of US dollar per
foreign currency, F is the corresponding forward exchange
rate, r is the US dollar interest rate, and r* is the foreign cur­
rency interest rate. In practice, the relationship between F
and S is read off market transactions in FX instruments, nota­
bly FX swaps and cross-currency swaps.
In an FX swap, one party borrows one currency from, and
simultaneously lends another currency to, a second party
(see also Baba et al (2008)). The borrowed amounts are
exchanged at the spot rate, S, and then repaid at the
pre-agreed forward rate, F, at maturity. The implicit rate
of return in an FX swap is determined by the difference
between Fand S, and the contract is typically quoted in
forward points (F — S). If the party lending a currency via FX
swaps makes a higher or lower return than implied by the
interest rate differential in the two currencies, then CIP fails
to hold. Typically, the US dollar has tended to command
a premium in FX swaps. In this case, rearranging the CIP
equation yields the following relationship between (F - S),
r and r*:
1 +r
1 + r*
A positive ("wide") value of (F — S), above, indicates that a
party lending US dollars sells the foreign currency forward
at a higher dollar price than warranted by the interest dif­
ferential. Equivalently, a party borrowing US dollars via an FX
swap—say, to hedge its US dollar asset—is effectively paying
a higher interest rate on the swapped dollars than is paid in
the cash market.
A cross-currency swap is a longer-term instrument, typically
above one year, in which the two parties also simultaneously
borrow and lend an equivalent amount of funds in two dif­
ferent currencies. At maturity, the borrowed amounts are
exchanged back at the initial spot rate, S, but during the life
of the swap the counterparties also periodically exchange
interest payments. In a cross-currency basis swap, the refer­
ence rates are the respective Libor rates plus the basis, b.
Again, if the forward points (F — S) are greater than war­
ranted by CIP, then, assuming a oneperiod maturity, the
basis, b, will effectively be the amount by which the interest

C hap ter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 335
(Continued)
rate on one of the legs has to be adjusted so that the parity
with the pricing of FX swaps holds:
(1 + r + b\
F - S = S \ ----------- ) - S
V 1 + r* /
In the above example, the FX swap implied US dollar rate,
F/s (1 + r*), exceeds actual US dollar Libor, 1 + r, if the party
borrowing US dollars in a cross-currency swap pays the basis,
b, on top of US dollar Libor. Thus, failure of CIP has implica­
tions for the relative cost of funding in the cash and swap
markets. Whenever CIP fails, one party ends up paying the
currency basis on top of the cash market rates to borrow
the corresponding currency, while the other counterparty in
effect receives an equivalent discount when borrowing the
other currency.
A number of factors can cause CIP to fail. For example,
market liquidity in the underlying instruments may evapo­
rate, so that the difference between bid and ask prices for
forward and spot transactions is non-trivial. For simplicity,
let us assume that r* is sufficiently small, so that 1 + r* ~ 1 .
Denoting by Sa the spot ask rate and by F 5 the forward bid
rate, CIP deviations due to a drop in market liquidity will be
given by:
F or other participants assign to deploying their balance sheet
(r - r*) = -
CIP can also fail because of credit risks in the underlying
investments. If CIP arbitrage is conducted by global banks
borrowing and lending in the respective Libor markets, then
a rise in counterparty credit risks in the interbank markets,
typically captured using Libor-OIS spreads, could result in
CIP deviations. Similarly, if banks or asset managers engage
in CIP arbitrage using government bonds in the two cur­
rencies, then deviations might result from differences in
sovereign credit risks, typically measured using sovereign
CDS spreads.
More generally, suppose rand r* are the respective risk-free
rates and rp is the risk premium for the underlying investment
over the duration of the swap. Then CIP deviations measured
using risk-free rates will be given by:
F -S
b = --------- (r —r*) = rp
In recent years, the textbook CIP arbitrage framework has been
challenged in two ways. Initially, the focus was on the con­
straints on arbitrage arising from the banks' counterparty credit
risk concerns and the wholesale US dollar funding strains that
surfaced during crisis episodes. These episodes included the
Japanese banking crisis (the "Japan premium", Hanajiri (1999));
the onset of the GFC in 2007-08 (eg Baba et al (2008), Baba and
336 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Even if risk premia in the underlying transaction are low, CIP
deviations can arise if the demand to hedge one of the cur­
rencies is large. Then, even small risk premia can have big
effects when scaled by the large size of the balance sheet
exposures needed to meet the hedgers' demand. For exam­
ple, Sushko et al (2016) show that CIP deviation can be pro­
portional to the hedging demand multiplied by the per-dollar
balance sheet costs of FX derivatives exposures:
F-S
b = —------(r - r*) oc rp x F X Fledging Demand
In each of the above examples, the price that is actually set
in FX derivatives is that of the forward leg of the swap, F.
As shown, CIP arbitrageurs will pass on their balance sheet
costs of taking the other side of FX hedging demand via FX
swaps as wider forward points, (F - S), than warranted by
CIP. The per-dollar balance sheet costs themselves are repre­
sented by rp in this example. Since markets have to clear, the
aggregate position of CIP arbitrageurs when the US dollar is
at a premium in FX swaps will be equal to the aggregate net
position of currency hedgers. The latter will be paying the
forward points, (F - S), to hedge their US dollar assets.
What are some of the real-world counterparts to rp in non­
crisis times? In aggregate, rp will reflect any costs that banks
in CIP arbitrage, which in turn will reflect their risk manage­
ment practices. For individual players, these practices may
even include absolute credit limits that would set a maximum
for the underlying exposures to the underlying instruments
and counterparties. Even without strict limits, the funding
cost of the capital allocated to the arbitrage activity, notably
to the (current and potential future) derivatives exposures
involved, will prevent the basis from closing when it opens up
owing to changes in hedging demand.
The specific constraints, and hence the instruments involved,
will also depend on the players acting as arbitrageurs. For
instance, for highly rated supranational and quasi-govern­
ment agencies, which can arbitrage the long-term basis
thanks to their top credit rating by issuing bonds in US dol­
lars at attractive rates and then swapping them out, rp is
more closely related to the costs of placing bonds in different
currencies. For hedge funds, which rely on collateralised mar­
kets to fund CIP arbitrage, the price and availability of repo
market funding will play a significant role.
Packer (2009), Coffey et al (2009), Mancini-Griffoli and Ranaldo
(2012), Levich (2012)); and the euro area sovereign debt crisis in
2011-12 (McCauley and McGuire (2014), Ivashina et al (2015)).
Since 2014, attention has shifted to other factors and con­
straints. Most studies have invoked some notion of capital
constraints of CIP arbitrageurs in the face of FX swap funding
demand from banks (lida et al (2016)), from foreign currency
bond issuers (Liao (2016)) or from broader saving and invest­
ment imbalances (Du et al (2016)).3 Similarly, Shin (2016)
attributes the persistent deviations from the CIP to a sys­
temic risk factor linked to the US dollar's role as the global
funding currency . 4
Drawing on our more technical work (Sushko et al (2016)), the
framework we propose in this study has two features. First, it
focuses on one key source of pressure on the basis, namely
net foreign currency hedging demand that is largely insensi­
tive to the size of the basis. Second, similarly to other studies,
it also assumes the presence of limits to arbitrage linked to
the costs involved in deploying balance sheets, in turn reflect­
ing tighter management of capital and funding risks. This
can create a balance sheet constraint on CIP arbitrage that
becomes more binding as the size of the aggregate FX hedg­
ing positions grows.
Our framework gives rise to two hypotheses. First, in the cross
section, the size and sign of the basis across currencies should
be related to the net hedging position vis-a-vis the US dollar.
Second, overtime, the evolution of the basis should depend on
that of net dollar hedging needs. Let us first consider each of
the two components of the framework— FX hedging demand
and constraints on arbitrage—in more detail.
Demand for Currency Hedges: Why
the Basis Opens Up
Hedging of open FX positions is the main proximate driver of
the demand for FX swaps. We focus on three sources of hedg­
ing demand that are rather insensitive to the size of the basis,
and, hence, exert sustained pressure on it even when it is
non-zero: demand from banks, institutional investors and
non-financial firms.
A first, structural source of demand for foreign currency hedges
arises from banks' business models. For a long time, banks have
been the main players running currency mismatches on their bal­
ance sheets (managed mainly via swaps). Banking systems may
be structurally short or long in specific currencies, given their
core deposit base. A shortfall in foreign currency funding can
then be managed by cash borrowing in money and bond
3 He et al (2015) take the currency basis as given, to study the effects of
FX swap market dislocations on the ability of non-US banks to supply US
dollar loans when US monetary conditions tighten.
4 Transaction costs also appeared to play a temporary role for some cur­
rencies in the aftermath of the Swiss National Bank's abandonment of
the currency peg (Pinnington and Shamloo (2016)).
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis
markets. The remaining gaps between banks' assets and liabili­
ties in a given currency would be closed using currency deriva­
tives such as FX swaps. 5
The second source of demand arises from the strategic hedging
decisions of institutional investors, such as insurance companies
and pension funds. Institutional investors use swaps to strategi­
cally hedge foreign currency investments. In recent years, the
term and credit spread compression on the back of unconven­
tional monetary policies in major jurisdictions has boosted these
cross-currency investment and funding flows. 6 These investors'
hedge ratios tend to be quite insensitive to hedging costs and
to move slowly over time. 7 Thus, anything that induces these
investors to increase or reduce their foreign currency invest­
ments tends to put pressure on the basis.
The third source of demand arises from non-financial firms'
debt issuance across currencies as they seek to borrow oppor­
tunistically in markets where credit spreads are narrower. Under
normal market conditions and for most currencies, this may
not be an important factor. But it can become quite relevant
when credit spreads differ systematically, for example when
they are compressed by central bank large-scale asset pur­
chases. Recently, for instance, many US firms needing dollars
have been issuing in euros to take advantage of very attractive
spreads in that currency and have then swapped the proceeds
into dollars (Box 17.2). This allows them to use the dollars for
their business purposes while avoiding a currency mismatch in
euros. Essentially, through the swap market, they borrow dol­
lars and lend euros.
Other factors could also put pressure on the basis, but we
exclude them from our analysis because of data limitations.
Firms' hedging of trade receivables or subsidiary cash flows are
one case in point. Another could be speculative FX positions,
which can rely on forwards and swaps (eg yen carry trades). We
posit, therefore, that the sources of pressure we identify are
5 For example, in the second half of 2015, temporary pressure on non-
US banks' dollar funding emerged as US money market funds (MMFs)
divested from their unsecured obligations. This reflected adjustment to
US MMF regulatory reform set to take effect in October 2016. Still, at
least in aggregate, non-US banks retained $5.5 trillion in deposits off­
shore and at their US branches in the last three quarters of 2015, which
rose to $5.7 trillion in Q1 2016, according to BIS and Federal Reserve
flow of funds data.
6 Domanski et al (2015) document increasing investment in long-term
foreign currency bonds by the German insurance sector seeking to
extend asset duration so as to match the rising duration of its liabilities
as yields in the euro area fell to very low levels.
7 The FX-hedged investment has a payoff that resembles the return of
leveraged investors in the target bond market: in the case of bonds, this
is equal to the excess of the bond yield over the short-term financing
cost ("the carry"), plus or minus a price gain or loss on the bond.
■ 337
 BOX 17.2 REVERSE YANKEE ISSUANCE IN THE EURO AND THE EUR/USD BASIS
Corporate credit spreads in the euro bond market have
fallen relative to those in the US dollar bond market, largely
driven by ECB bond purchase programmes (Graph B, left-
hand and centre panels). In response, US firms have found
it more cost-effective to issue in euros, through so-called
reverse yankee bonds, and then swap the proceeds into US
dollars (right-hand panel). The hedging of currency risk by US
firms issuing in the euro increases demand for cross-currency
swaps. Hence, the widening of corporate asset swap spread
differentials and the surge in euro issuance since 2014 have
coincided with a marked widening of the currency basis (cen­
tre panel).
For example, consider a BBB-rated US telecoms firm whose
bonds yield 1 0 0 basis points over the interest rate swap rate
in dollars, but only 50 basis points in euros. If CIP held, the
firm would save 50 basis points by issuing in euros and swap­
ping back to dollars. In fact, the firm would have an incentive
to do that for all its new debt. One can then see the widen­
ing of the basis as tending to reconcile the different spreads
in the two markets.
According to data from Thompson Reuters, the majority of
reverse yankee issuance has been long-term, with an aver­
age maturity of about 1 0 years and with 15- and 2 0 -year
tenors also commonplace. Issuance at shorter maturities is
rare, because, from the perspective of the US non-financial
issuer, the all-in issuance costs (ie taking the currency swap
into account) of short-term euro-denominated debt are still
greater than issuing short-term US dollar debt, owing to the
wider currency basis relative to the corporate asset swap
spread differential at the short end.

Corporate credit spreads, reverse yankee issuance and the EUR/USD basis Graph B

Corporate asset swap spread Spread differential and the basis US non-financial firms' EUR debt
issuance
Basis points Basis points

375

06 08 10 12 14 16 06 08 10 12 14 16
United States (US) --- Euro area (EA) Corp spread gap: 5-year currency basis:
• - - US minus EA ---- EUR/USD

Sources: Bank of America Merrill Lynch; Bloomberg; BIS debt securities statistics; authors' calculations.

sufficient to capture the key relationships. 8 At the more funda­
mental level, monetary (Box 17.3) and financial conditions, as
well as institutional differences across the respective jurisdic­
tions, largely determine the extent of foreign currency funding
and investment flows in the first place.
8 This would be so if the other sources of FX hedging demand co-move
positively with those we identify. The exclusion of speculative demand may
actually make it harder for us to find a relationship with hedging demand,
as speculation may lead to offsetting pressure on the basis. For instance,
easy monetary policy could boost FX-hedged investments in search of
higher returns, but it could also encourage carry trades. Those carry trades
could push down the forward rate even as hedging demand pushed it up.
Limits to Arbitrage: Why the Basis Does
Not Close
Structural changes in how market participants have been pricing
market, credit, counterparty and liquidity risks post-crisis have
tightened limits to arbitrage. Balance sheet space is rented, not
free . 9 Specifically, as a result of tighter management of risks
and related balance sheet constraints, arbitrage now incurs a
cost per unit of balance sheet. This cost is passed on to the
9 For a conceptual discussion, see Duffie (2016).

338 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
pricing of FX swaps, introducing a premium (or discount,
depending on the currency) in response to imbalances in the
swap market. One result is that the currency spot-forward rela­
tionship goes out of line with CIP (Box 17.1).
Arbitrage can be both costly and risky. Typically, it requires the
arbitrageur to enlarge its balance sheet, incur credit risk in both
borrowing and investing, and possibly face mark-to-market and
liquidity risk (given the need to transfer collateral or take paper
gains or losses) in the valuation of the positions.
While these risks and costs exist all the time, participants have
been managing them more actively post-crisis. Before the GFC,
these risks were not fully priced in the relevant markets and,
partly as a result, dealer banks had raised their leverage to
dangerous levels (Shin (2010)). The crisis brought them to light.
Since then, pressure from shareholders, creditors and prudential
authorities has reinforced and hard-wired participants' aware­
ness. As a result, leverage has declined and there has been less
willingness to deploy the balance sheet for activities that make
heavy demands on it, such as arbitraging the basis.
Changes in regulation have reinforced market pressures for a
tighter management of balance sheet risks. For example,
changes related to credit value adjustments have sought to
incentivise dealers to price the counterparty risk in their deriva­
tives portfolios more accurately. Similarly, potential future expo­
sure adjustment charges in both Basel III and US leverage ratios
require market participants to hold capital in proportion to their
derivatives and other exposures. 1 0
The bottom line is clear. These tighter limits on arbitrage make
it harder to narrow the basis whenever it opens up as a result of
pressures that reflect underlying order imbalances. In particular,
even in the absence of bank funding strains like those seen dur­
ing the GFC, a sufficiently high net demand for currency hedges
could result in persistent deviations from CIP.
17.2 THE CU R R EN CY BASIS
IN THE CRO SS SECTIO N
Can our framework help explain how the sign and, possibly, the
size of the basis vary across currencies? We test this by juxtaposing
quantitative indicators for the various players' hedging demands
and the basis. 11 In evaluating the results, it should be borne in
10 This need not result from individual pricing decisions. For instance,
internal credit limits may constrain individual balance sheets and, in
aggregate, be reflected in a larger basis.
11 Our findings also hold if price indicators are used; see Sushko et al
( 2016 ) .
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis
mind that the sample is necessarily limited, as we have to restrict it
to freely tradable currencies in jurisdictions with no capital controls,
with a highly rated sovereign and for which data are available.
Quantitative Indicators of Hedging
Demand
Assembling estimates of hedging demand runs into two types
of limitation.
The first is conceptual. Some financial institutions play the dual
role of putting pressure on the basis and arbitraging it. For
instance, banks' business models may lead them to fund them­
selves through swaps in order to hedge their balance sheet
mismatches, even as they act as arbitrageurs. This means that
proxies for their swap positions conflate their two roles. How­
ever, and despite such ambiguity, our results suggest that the
balance sheet hedging motive dominates.
The second relates to data availability. No statistics fully cover the
hedging demand for a given currency; tough choices and approx­
imations are needed. Hence, we focus on the three main sets of
players—banks, institutional investors and nonfinancial firms—and
even there we have to make a number of assumptions.
For banks, our benchmark measure is their "funding qap" in the
US dollar. 1 2 The funding gap, derived from the BIS international
banking statistics, is an estimate of banks' demand for hedging
through the FX swap market (McGuire and von Peter (2009,
2012), Fender and McGuire (2010)). Specifically, for banks head­
quartered in a particular country (eg Japan or Australia), we mea­
sure the difference between their consolidated global on-balance
sheet assets and liabilities in a particular foreign currency. Assum­
ing that banks hedge their currency risk, the resulting gap indi­
cates the size of their off-balance sheet position in a given
currency, which will largely be managed by FX swaps. 1 3
For institutional investors, we rely on central banks for esti­
mates of Australian, euro area and Swedish institutions' hedged
foreign assets; and on industry sources for Japanese life insur­
ers' holdings and hedge ratios. 1 4 We neglect US investors'
12 Except in the case of Sweden, where we also look at the euro (see
below).
13 Partly owing to data limitations, we do not include US banks' cor­
responding positions. US-headquartered banks' estimated net long
positons in the key currencies we are considering are relatively small
compared with non-US banks' net long dollar positions. As a result, the
bulk of our analysis can safely focus on the latter.
14 This means that, except for the euro area, we cannot single out US
dollar holdings, so that our estimate is an upper bound for the institu­
tions covered.
■ 339
 BOX 17.3 CIP DEVIATIONS AND MONETARY POLICY ANNOUNCEMENTS
M onetary policy can boost hedging dem and through both
price and quantity effects. By lowering the yield curve and,
in particular, by compressing the term prem ium and credit
spreads, easing encourages investors to seek return and
duration in foreign currency bonds and foreign issuers to
sell bonds in the corresponding currency to obtain cheaper
funding. Large-scale asset purchases strengthen these effects
by w ithdraw ing securities from the market. And so does the
adoption o f negative interest rates, which can result in nega-
tive yields stretching o u t to long m aturities.©
Much o f the w idening o f the USD basis since 2014 has
coincided w ith m onetary policy easing announcements by
the Bank o f Japan (BoJ) and the ECB. Indeed, the w iden-
ing began in earnest w ith the ECB's ram ping-up o f easing
measures, including the 5 June 2014 announcem ent o f nega-
tive rates (Graph C, left-hand panel). The announcem ent o f
ECB governm ent bond buying (quantitative easing, QE) on
22 January 2015 also had a significant im pact on the USD/
JPY basis, owing perhaps to expected policy contagion or
more technical factors (eg French banks' role as JPY/USD
arbitrageurs). Similarly, the BoJ's Q uantitative and Q ualitative
M onetary Easing (QQE) announcem ents as well as its move
to negative policy rates saw the USD/JPY basis widen. In fact,
the short-term announcem ent effects were even starker fo r
the BoJ (Graph C, right-hand panel).
O ne possible explanation fo r th e responsiveness o f the
basis to m onetary policy announcem ents is th a t th e swap
dealers th a t provide currency hedges e xpect the outflow s
from th e euro or the yen to increase when the ECB or the
BoJ eases policy. This includes the flow s hedged fo r cur-
rency risk, which push up the dem and fo r FX swaps or
cross-currency swaps. Hence, the swap dealers set higher
prices fo r currency hedges, which results in w id e r CIP devia-
tions. Conversely, when the ECB or the BoJ surprises w ith
less easing than a n ticip a te d , dealers revise dow nw ards the
expected hedging dem and com ing th e ir way, low er th e ir
prices and, hence, help narrow the basis. This happened
on 3 D ecem ber 2015 (green vertical line, left-hand panel):
the announced ECB stim ulus was low er than w hat m arket
participants had expected in the run-up to the Federal
Reserve's firs t rate hike. Such expectations had been firm -
ing during the previous m onth fo llo w in g the u p b e a t US
jobs data release in N ovem ber (orange vertical line). A fte r
the ECB announcem ent, m arket participants revised dow n
th e ir expected volum es o f cross-currency flow s o u t o f the
euro area.

Monetary policy announcements and one-year currency basis

In basis points Graph C

One-year currency basis O ne-year basis around selected announcements

USD/EUR basis ---- USD/JPY basis days

---- Average USD/EUR basis (Ihs)
---- Average USD/JPY basis (rhs)

The solid vertical lines in the left-hand panel correspond to the following ECB monetary policy announcements: 8 May 2014, 5 June 2014,
22 August 2014 (Jackson Hole), 22 January 2015 and 21 January 2016. The green vertical line corresponds to the ("disappointing") 3 December
2015 ECB announcement. The orange vertical line indicates the 6 November 2015 US job report. The dashed vertical lines in the left-hand
panel correspond to the following Bank of Japan monetary policy announcements: 4 April 2013, 31 October 2014, 29 January 2016 plus the
16 September 2015 (S&P) Japan downgrade. The same dates are used to calculate the basis reaction around the announcement dates.
Sources: Bloomberg; BIS calculations.
©See Borio and Zabai (2016) for a survey of unconventional monetary policy measures that documents and discusses these effects. On the
relationship of central bank deposit rate changes and the currency basis, see Brauning and Ivashina (2016, Table IX).

340 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Currency hedging by banks, institutional investors and non-financial corporates
As a percentage o f 2015 GDP Graph 2

Australia Japan Sweden Euro are#

20 20 5.0

10 10 2.5

0 0 OO

-10 -10 -2.5

-20 -20 -5.0

Institutional investors1 Banks, in US dollars2 Banks, in euros3 Non-financial corporates5

1 Foreign currency securities holdings of institutional investors (eg pension funds and insurance companies) multiplied by the respective
currency hedge ratios; for the euro area, US dollar debt securities holding only, assuming 100% currency hedge ratios. 2 Each jurisdiction's
BIS reporting banks' consolidated net US dollar assets. 3 Each jurisdiction's BIS reporting banks' consolidated net euro assets. 4 2015
quarterly average. 5 Local currency debt outstanding issued by US non-financial corporations.

Sources: Hilander (2014); Rush et al (2013); ECB; Eurosystem Working Group on Securities Statistics; The Life Insurance Association of Japan;
Barclays; BIS international banking statistics and debt securities statistics; authors' calculations.

positions. This is not likely to be a problem , however, since US
investors have more o p p o rtu n ity to diversify w ith o u t buying
foreign currency assets, given the size o f the global dollar
financial markets.
For non-financial firms, we consider bonds o u tsta n d in g issued
by co rp o ra tio n s h e a d q u a rte re d o u tsid e th e country, draw ing
on BIS in te rn a tio n a l d e b t securities statistics. For instance, we
take euro issues by US firm s to fund th e ir d o lla r op e ra tio n s,
1A
and exclude issues by banks to avoid d o u b le -c o u n tin g . We
do n o t include d o lla r issuance by non-US firm s because,
given th e predom inance o f th e US d o lla r as an invoicing
15 Three quarters of US investors' holdings of foreign bonds were dollar-
denominated at the end of 2014 (US Treasury et al (2016)). In general,
hedge ratios for foreign equity holdings are low and well below those
for bonds, so that they are less of an issue (although those of Japanese
shares are often hedged). Hilander (2014, p 13) reports a 20% hedge
ratio on foreign shares in Sweden.
16 We could also include domestic currency issuance by foreign firms
from outside the United States, which may hedge into the US dollar
(given its extensive international use), or hedge back into eg the
Australian dollar or Canadian dollar through the US dollar. So, our
figure should best be regarded as a lower bound. At the same time,
not all issuance need be hedged: some firms may prefer to incur
currency risk in an attempt to lower their funding costs further.
currency, many such firm s do n o t hedge d o lla r d e b t (eg
Borio (2016)).1
17
6
1
5
Graph 2 shows indicators o f hedging dem and from the various
sectors fo r fo u r jurisdictions fo r which we were able to obtain
b e tte r data: Australia, the euro area, Japan and Sweden. A posi-
tive value fo r a bar indicates net borrow ing o f US dollars against
local currency via swaps (positive net FX hedging dem and vis-a-
vis the US dollar) fo r the corresponding sector, while a negative
value shows net dollar lending. The figures are scaled by GDP.
The graph reveals clear differences across countries and sectors.
Especially noteworthy is the position o f the banking sector rela-
tive to that o f institutional investors. Where banks have a surplus
o f domestic currency deposits relative to domestic currency loans,
they use the FX swap market to borrow dollars to hedge their dol-
lar lending. In doing so, they com pete with domestic institutional
investors that use swaps to hedge their dollar investments. As a
17 Moreover, given that credit spreads favour one currency over another,
incentives to issue and put pressure on the basis are bound to be one­
sided. In the case of the dollar/euro pair, for instance, where spreads
have favoured issuance in euros, euro area issuers in dollars have typi­
cally been toprated European supranationals and agencies, which can
afford to issue in USD thanks to their topnotch creditworthiness. These
institutions in effect operate as arbitrageurs, actively harvesting the basis
(see also below). They do the same in the Australian dollar market.

Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 341
 Currency hedging demand and three-year basis

-0.75 -0.50 -0.25 0.00 0.25

Banks' net USD liabilities (2015 average, USD trn)
AU = Australia; CA = Canada; CH = Switzerland; EA = euro area; GB = United Kingdom; JP = Japan; NO = Norway;
SE = Sweden.

For Sweden, net euro liabilities (horizontal axis) and the SEK/EUR basis (vertical axis).

Sources: Bloomberg; BIS international banking statistics and debt securities statistics; authors' calculations.

result, banks add to the aggregate hedging demand and hence
to the size o f the potential imbalance. This is the case in Japan,
where they have used domestic yen deposits to fund their expan-
sion abroad, mainly in dollars, by making heavy use o f swaps. By
contrast, in Australia and Sweden the banking sector provides a
natural counterpart to institutional investors' hedging needs. That
is, given the large domestic currency m ortgage book relative to
the domestic deposit base, banks rely on the FX swap market for
funding. This offsets institutional investors' hedging demand.
The hedging needs o f US corporate bond issuers, which add
to those o f dom estic institutional investors, are in general quite
small com pared w ith those o f other sectors. The main exception
is the recent experience in the euro area, where US nonfinan-
cial firm s' issuance in euros has surged since 2014. This reverse
yankee issuance reflects the fact th a t euro-denom inated cor-
porate credit spreads have fallen significantly relative to those
in dollars, largely because o f ECB bond purchase program m es
(Boxes 17.2 and 17.3).
The sign o f the basis aligns quite well w ith these indicators.
W here banks com pete w ith institutional investors to borrow d o l-
lars through the swap market, as in Japan, the currency basis is
negative, ie dollar borrow ing via the FX swap m arket is in higher
dem and and hence more costly than in the cash market. The
same is true in the euro area, where non-financial firm s' dem and
fo r dollar borrow ing via FX swaps looms large. By contrast, in
Australia, where banks offset institutional dem and fo r hedges by
lending dollars in the swap market, the currency basis is positive.
In the case o f Sweden, the dollar basis is negative, even though
banks are in the same position as those in Australia in that cur-
rency. However, the euro/krona basis is positive. This reflects the
fact that the FX swap euro market, rather than the dollar market,
is the marginal funding source for excess krona lending (darker
colour bars), since swapping out o f euros is more expensive than
out o f dollars. Accordingly, the picture in Sweden resembles that
in Australia once the right currency pair is chosen . 18
Focusing exclusively on the position o f the banking sector in US
dollars (or euros fo r Sweden) confirms the previous finding. In
a sample o f eight econom ies (now including also Canada, N or-
way, Switzerland and the United Kingdom), the banks' position
is consistent w ith the sign o f the basis (Graph 3). This also sug-
gests that, in our sample, when banks are in the opposite posi-
tion to institutional investors, their hedging needs are typically
larger, so th a t they end up being the swing factor. N ote also th a t
Australian and Swedish banks' position is indeed exceptional:
banks typically add to resident institutional investors' hedging
needs, rather than offsetting them . In the case o f the euro area,
the fit improves significantly when we add eurodenom inated
bonds issued by US non-financial firm s (reverse yankees). This
addition raises our measure o f currency hedging dem and in the
EUR/USD pair from less than $28 billion to as much as $250 b il-
lion (the EA d o t moves to the left in Graph 3).
18 Hilander (2014, Table 5) shows that, in addition to Swedish banks, foreign
banks too provide currency hedges to Swedish investors, balancing them
against the hedges provided to non-Swedish holders of Swedish bonds.

342 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Sources of currency hedging demand and the JPY/USD basis Graph 4

FX hedging dem and by sector FX hedging dem and and the basis FX hedging dem and and the basis
(Jan 2008-D ec 2015)
USD trn USD trn Basis points

Q.
-Q
c/T
"</>
ru
_Q
03
>i%
CD

CD
CD

05 07 09 11 13 15 06 08 10 12 14 16 1.0 1.1 1.2 1.3

USD cross-currency funding: Total net USD positioning (Ihs) Total net USD positioning, USD trn
JP banks' net USD claims 1 Three-year basis (rhs)
JP life ins cos' FX hedged bonds2
US corporates' JPY bonds
---- Total net USD positioning

1 Difference between gross US dollar assets and liabilities of Japanese banks; quarterly data linear-interpolated to monthly
frequency. 2 Japan life insurance companies' currency-hedged US dollar bond holdings estimated by multiplying the stock of the insurance
companies' FX bond holdings by their time-varying currency hedge ratios; monthly frequency.

Sources: Bank of Japan; Japanese Ministry of Finance; The Life Insurance Association of Japan; Barclays FICC Research; Bloomberg; BIS
international banking statistics and debt securities statistics; authors' calculations.

17.3 THE CURRENCY BASIS IN THE $0.9 trillio n . D uring this p e riod, banks needed dollars to

TIME SERIES: THE YEN/DOLLAR CASE finance th e ir overseas loan expansion and to hedge th e ir own
fore ign bond h o ld in g s . 1 9 Since 2015, Japanese banks have
also relied m ore on FX swaps fo r USD fu n d in g due to the
We next test our hypothesis by exam ining the tim e series o f the
low er availability o f wholesale USD fu n d in g , because o f US
yen/dollar basis. This has been the m ost extrem e and persistent
M M Fs' disinvestm ent from fo re ig n banks' certificates o f
non-zero basis among the m ajor currencies, w ith banks and insti-
d e p o sit and tim e deposits in anticip a tio n o f upcom ing US
tutional investors both bidding fo r hedges. Moreover, it is the
M M F reform . Japanese banks have been especially affected,
currency pair fo r which b e tte r data on the evolution o f institu-
as th e y have been the largest fo re ig n bank issuers o f unse-
tional investors' hedging needs are available. Before turning to
cured paper in US m oney m arkets; approxim ately tw o thirds o f
the evidence, a few facts can help set the context.

Demand for Currency Hedges

and the Basis
O ur measure o f the aggregate US dollar hedging needs o f
Japanese banks, institutional investors and US non-financial
firm s (samurai bond issuers) has increased considerably since
the crisis: from $0.9 trillio n in 2009 to over $1.2 trillion in 2015
(Graph 4, left-hand panel).
The banking sector has been the main driver, w ith its esti-
m ated d o llar fu n d in g gap g ro w in g from around $ 0 . 6 trillio n to
19 The figures for Japanese banks' net US dollar positions, which are
derived from the BIS international banking statistics, include both these
banks' own dollar positions and those managed on behalf of their cli­
ents (in trust accounts). As a result, the figures overstate the former. It
is not known how much of trust account positions is hedged. However,
for the analysis that follows, it is the dynamics of the series rather than
the absolute amount that is important. As long as the share of the dol­
lars held on behalf of clients in the total net dollar position of Japanese
banks and their hedge ratios are relatively stable, then the inclusion of
these positions should not bias our results.

C hap ter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 343
 JPY/USD basis and US-Japan repo spreads
The basis and the US-JP repo spread differential
Basis points
Lhs: Rhs:
--- 1-month basis ---- 1-month repo spread differential,
US minus JP (basis points)1
2
VIX (percentage points)
1 For the United States, repo rate minus federal funds rate; for Japan, repo rate minus call rate. 2 Chicago Board Options Exchange S&P 50C
implied volatility index; standard deviation, in percentage points per annum. 3 Repo spreads and currency basis calculated using the
respective OIS rates.
Sources: Bloomberg; authors' calculations.
th e ir $600 billion o f liabilities in New York is unsecured funding
(Pozsar and Smith (2016)).20
Thus, Japanese banks' reliance on swaps to fund their foreign
assets has reduced their capacity to serve as counterparties to
non-bank hedgers in cross-currency markets and to arbitrage
the basis. In particular, Japanese life insurers' search fo r yield
overseas has led them to increase FX-hedged investments in US
dollar-denom inated bonds (with average hedge ratios of
60-70% ).21 Issuance o f samurai bonds has not played a signifi-
cant role, owing to the thin corporate bond m arket in Japan.
C onfirm ing our hypothesis, after a clear break during the GFC, a
remarkably close relationship em erged between variations in our
measure o f hedging dem and and the basis (Graph 4, centre and
right-hand panels). This is shown using the three-year basis, but
20 Assets under management have been migrating from prime US insti­
tutional MMFs to government MMFs due to the reform to be phased in
in October 2016. By August 2016, prime MMFs had lost more than $360
billion in assets, according to Fitch. Non-US banks, in particular, had
lost substantial amounts of MMF funding, inducing them to seek other
sources of US dollars, including through FX swaps.
21 We obtained the time-varying hedge ratios of Japan's life insurance
companies by courtesy of Barclays FICC Research team; see Barclays
(2015). In contrast to those of life insurance companies, the hedge ratios
for Japan's pension funds (dominated by the unhedged Government Pen­
sion Investment Fund) are low, and therefore ought not to affect the basis.
344 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Graph 5
The basis and quarter-end jum ps in the repo spreads 3
Basis points Basis points
2014 2015 2016
1-week repo spread differential, US minus JP (Ihs)
1-week basis (rhs)
the picture w ould be similar fo r other m aturities. Pre-crisis, the
basis was very small and stable, regardless o f hedging volumes;
post-crisis, it has tracked them remarkably closely. In particular,
an increase in hedging dem and has coincided w ith a w idening
o f the basis fu rth e r into negative territory.
Tighter Limits to Arbitrage and the Basis
The sudden break in the basis during the GFC points to the
em ergence o f the limits to arbitrage discussed above. But is
it possible to find more direct evidence o f these new balance
sheet constraints? Some developm ents are consistent w ith them .
First, as the GFC raised awareness o f counterparty risk, many
m arket participants switched from unsecured to secured fu n d -
ing sources, notably repo markets. Reliance on the repo m arket
constrains the arbitrageurs' flexibility, since the borrow er cannot
obtain funds w ith o u t having the underlying security to pledge as
collateral. Since mid-2014, the Bank o f Japan's move to increase
governm ent bond purchases (making them more scarce as col-
lateral), even as the Federal Reserve stopped its net purchases,
has made dollar repo funding more expensive relative to yen
repo funding. As a result, arbitraging the yen/dollar basis has
becom e more expensive, and the basis has w idened even when
financial m arket volatility (the VIX) has remained w ithin normal
ranges (Graph 5, left-hand panel).
 CIP arbitrage by banks in USD/JPY and by supranational bond issuers in USD/EUR Graph 6

Foreign bank claims on theJapanese official sector 1 and European supranationals ' 2 cum ulative issuance in euros
JPY/USD basis and US dollars and EUR/USD basis
Basis points USD bn Basis points USD bn

2014 1 2015 1 2016

Lhs: Bond issuance denominated in (rhs):
Foreign bank claims on Japanese official sector (rhs) — 3-year USD/EUR basis Euros US dollars

1 Non-Japanese banks' consolidated claims on an ultimate risk basis, including yen claims booked in Japan, on the official sector, which
includes the Ministry of Finance and the Bank of Japan. There was a series break in Q1 2009, when two US securities firms started to report
as bank holding companies. 2 European supranational and agency issuers include CADES, the EIB, Eurofima, the KfW and OKB.

Sources: Bloomberg; European Investment Bank (EIB); BIS international banking statistics and debt securities statistics; BIS calculations.

Second, since 2014 the basis has started to exhibit quarter-
end spikes, along w ith repo rates, indicating th a t arbitrage has
becom e harder (Graph 5, right-hand panel). This has coincided
w ith the greater im portance attached to quarter-end reporting
and regulatory ratios follow ing regulatory reforms.
Third, the riskiness o f claims on the Japanese official sector
may also have played a significant role. Banks' exposures to
the Japanese official sector are already sizeable relative to their
equity. As the basis w idened, BIS reporting banks, especially
big US, French and UK banks, increased th e ir claims on the
Japanese official sector from about $200 billion in Q4 2014 to
$323 billion at the end o f 2015, no d o u b t in part reflecting their
arbitrage activities (Graph 6 , left-hand panel). A t the end o f the
period, th e ir exposure to the Japanese official sector, including
(Box 17.1 and Du e t al (2016)). This activity is reflected in the ris-
ing share o f US dollar bond liabilities o f m ajor euro area supra-
national agencies com pared w ith their home currency (ie euro)
bond liabilities (Graph 6 , righthand panel). However, such "issu-
ance a rb itra g e " slowed when the interest rate swap rate fell
below the US Treasury yield in Q3 2015. Since such supranation-
als have to issue at rates above US Treasury yields, this inversion
o f US dollar interest rate swap spreads sharply increased their
costs o f placing a 7- to 10-year bond in US dollars and swapping
it into euros . 2 2
Regression Results
We next test fo r the presence o f a link betw een hedging

both the central bank and the governm ent, represented 10-19% dem and and the basis as well as the role o f arbitrage constraints

o f th e ir equity. The w idening o f the yen/dollar basis follow ing econom etrically. Specifically, we add our quantitative indicator

Standard & Poor's dow ngrade o f Japan in 2015 highlights the o f aggregate hedging dem and to standard specifications o f the

role o f internal limits on these exposures as a factor constraining basis . 2 3 O ur results provide evidence fo r such a link.
arbitrage (see also Box 17.3).

Finally, in less direct ways, developm ents in related markets can

im pede arbitrage activities. Markets fo r interest rate swaps are
one such example. Top-rated European supranationals and
agencies have relied on th e ir funding cost advantage to arbi-
trage the basis by issuing bonds in US dollars and swapping the
proceeds back into euros, thus collecting the currency basis
22 At the end of 2013, major euro area supranationals had $660 billion
equivalent in euro bonds outstanding, but only $355 billion in dollar
bonds. In the following six quarters, they issued $192 billion in dollar
bonds and only $178 billion in euro bonds, pointing to a shift of over
$10 billion per quarter from euro to dollar.
oo
For a much more extensive analysis, see Sushko et al (2016).

C hap ter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 345
Table 17.1 Regression Analysis of the JP Y /U S D Basis, D ecem ber 2007-D ecem b er 2015

Dependent Interaction Repo Spread

Variable Libor-OIS (a) Demand (b) (c) = (a) x (b) Difference (d) FX bid-ask (e) Constant Observations R2

Three- -1 1 3 .6 2 *** -2 9 .3 0 * 2.16*** _ 19 4 2 *** 72 0.679

m onth (27.00) (17.10) (0.74) (2.54)

Three- 0.06 -1 .5 3 -44.48*** -4 4 .7 0 * * * 2.07*** -1 5 .4 9 * * * 67 0.794

m onth (33.90) (1-16) (13.3) (13.60) (0.52) (2.3)

Two-year -1 6 .2 3 * * * -0.91** -2 6 .1 1 * * * -0 .1 7 -0 .2 5 67 0.506

(4.30) (0.39) (6 .0 0 ) (0.23) (0.76)

Two-year - 1 0 .0 2 -0.88** -2 .4 2 -2 6 .6 7 * * * -0 .1 4 -0 .1 4 67 0.509

(13.10) (0.38) (4.80) (5.98) (0.23) (0.81)

Robust standard errors in parentheses; ***/**/* denotes significance at the 1/5/10% level. Unit root test (ADF) rejects the null in levels for three-month,
which is regressed in levels; unit root test fails to reject null in levels for two-year, which is regressed in first differences. AR(1) not significant.
Source: Sushko et al (2016).

The standard specification fo r the three-m onth basis— the te n o r
on which m ost o f the em pirical w ork has focused— is shown in
the first row o f Table 17.1. The size o f the basis is considered to
be a function o f counterparty risk (Libor-OIS spread), funding
liquidity (repo spreads) and m arket liquidity (currency m arket
bid-ask spreads). This is in the spirit of, fo r instance, Mancini-
G riffoli and Ranaldo (2012) and Pinnington and Shamloo
(2016). The specification perform s reasonably well: the coef-
ficients o f the explanatory variables are all econom ically and
statistically significant.
Once we add the quantitative indicator o f hedging demand,
the perform ance clearly im proves (Table 17.1, second row). The
indicator is added on its own and interacted w ith the Libor-OIS
spread, as derived form ally in Sushko et al (2016). In particular,
the interaction o f m oney m arket strains and hedging dem and
pressures (column (c), in bold) m atters and m oney m arket strains
alone (column (a)) now no longer exert a significant im pact. The
coefficient on the interaction term suggests th a t a 1 % rise in the
Libor-OIS spread com bined w ith 1% higher dem and fo r forw ard
hedges is associated w ith a 45 basis p o in t w ider basis. This
result indicates th a t higher dem and fo r hedges works to g e th e r
w ith the m arket dislocations identified in previous research to
drive the basis.
Furtherm ore, fo r the tw o-year basis swap, the pressure o f hedg-
ing dem and has a direct (linear) effect on the basis (Table 17.1,
third row, in bold), while the interaction term is no longer sig-
nificant (fourth row). In particular, the estim ated coefficient o f
— 0.913 indicates th a t 1% higher dem and fo r currency hedges
translates into roughly a 1 basis p o in t w ider basis. This points to
the cost o f long-term cross-currency swaps being a more direct
barom eter o f the imbalances in cross-currency flows hedged fo r
currency risk, whereas the cost o f short-term FX swaps is much
more sensitive to risk premia and bank funding strains, particu-
larly during crisis episodes (Graph 1).
Overall, the econom etric evidence indicates that, while gener-
ally ignored, hedging dem and played a role even before the
w idening o f the basis from 2014, when m arket tensions were
subdued. No doubt, heightened counterparty risks did influence
the basis in 2008-09 and again in 2011-12. But the dem and fo r
dollar hedging has been at w ork th ro u g h o u t . 2 4 And it has con-
tinued to play a significant role since.
CONCLUSIONS
We have argued th a t the puzzling systematic and persistent
violation o f CIP since the GFC reflects the com bination o f FX
hedging dem and and limits to arbitrage arising from lower
balance sheet capacity, in turn due to tig h te r m anagem ent o f
risks and associated balance sheet constraints. This explanation
suggests that, even at the height o f m arket tensions, hedging
dem and played an im portant, but underappreciated, role. We
use BIS banking and d e b t securities statistics in com bination
w ith national data to construct estimates o f currency hedging
dem and fo r select m ajor currencies against the US dollar. We
find th a t quantity-based indicators o f hedging dem and track the
24 See Sushko et al (2016) for broader results, including panel evidence
that extends the key results beyond the yen/dollar basis using exclu­
sively the banks' position, for which consistent data are available.

346 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
variation in the basis both across currencies at a given p o in t in
tim e and, in the case o f the dollar/yen basis, o v e rtim e .
Im portantly, our analysis has been largely confined to the proxi­
mate determ inants o f the basis, as we have not looked much
into the factors driving currency hedging dem and in the first
place. We have mainly lim ited ourselves to docum enting the
possible im portance o f extraordinary m onetary accom m odation
by the Bank o f Japan and the ECB in w idening the basis around
policy announcements.
References
Baba, N and F Packer (2009): "From turm oil to crisis: disloca-
tions in the FX swap m arket before and after the failure o f
Lehman Brothers", Journal of International M oney and Finance,
vol 28, no 8 , pp 1350-74.
Baba, N, F Packer and T Nagano (2008): "The spillover o f money
m arket turbulence to FX swap and cross-currency swap mar-
kets", BIS Quarterly Review, March, pp 73-86.
Barclays (2015): "Asia-Pacific cross-currency basis: w idening
pressure, from Japan to Asia", 1 December.
Borio, C (2016): "M o re pluralism, more stability?", speech at the
Seventh High-level SNB-IMF Conference on the International
M onetary System, Zurich, 10 May.
Borio, C and A Z a b a i (2016): "U nconventional m onetary policies:
a re-appraisal", BIS Working Papers, no 570, July.
Brauning, F and V Ivashina (2016): "M o n e ta ry policy and global
banking", June, mimeo.
Cetorelli, N and L G oldberg (2011): "G lobal banks and interna-
tional shock transmission: evidence from the crisis", IM F Eco­
nomic Review, vol 59, no 1, pp 41-76.
___ (2012): "F ollow the money: quantifying dom estic effects
o f foreign bank shocks in the Great Recession", American Eco­
nomic Review, vol 102, no 3, pp 213-18.
Coffey, N, W Hrung and A Sarkar (2009): "C apital constraints,
counterparty risk, and deviations from covered interest parity",
Federal Reserve Bank o f New York, Staff Reports, no 393.
Domanski, D, H S Shin and V Sushko (2015): "The hunt fo r dura-
tion: not waving but drow ning?", BIS Working Papers, no 519,
O ctober.
Du, W, A Tepper and A Verdelhan (2016): "C overed interest
rate parity deviations in the post-crisis w o rld ", May, available at
SSRN 2768207 2768207, SSRN.
Duffie, D (2016): "W hy are big banks offering less liquidity to
bond markets?", Forbes, 11 March.
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis
Fender, I and P McGuire (2010): "Bank structure, funding risk
and the transmission o f shocks across countries: concepts and
m easurem ent", BIS Quarterly Review, September, pp 63-79.
Hanajiri, T (1999): "Three Japan premiums in autumn 1997 and
autumn 1998— why did premiums diffe r betw een m arkets?",
Bank of Japan Financial Markets Department Working Paper
Series, no 99-E-1.
He, D, E W ong, ATsang and K Ho (2015): "Asynchronous
m onetary policies and international dollar cre d it", Hong Kong
Institute fo r M onetary Research, Working Papers, no 19-2015,
September.
Hilander, E (2014): "Short-term funding in foreign currency by
major Swedish banks and their use o f the short-term currency
swap m arket", Sveriges Riksbank Economic Review, no 1, pp 1-23.
lida, T, T Kimura and N Sudo (2016): "A n upsurge in a CIP devia-
tion during the noncrisis period and the role o f divergence in
m onetary policy", Bank of Japan Working Paper Series, no
16-E-14, August.
Ivashina, V, D Scharfstein and J Stein (2015): "D ollar funding and
the lending behavior o f global banks", Quarterly Journal of Eco­
nomics, vol 130, no 3, pp 1241-81.
Levich, R (2012): "FX counterparty risk and trading activity in
currency forw ard and future m arkets", Review of Financial Eco­
nomics, 2 1 , pp 102 - 1 0 .
Liao, G (2016): "C re d it m igration and covered interest parity",
Harvard University, mimeo.
Mancini G riffoli, T and A Ranaldo (2012): "Lim its to arbitrage
during the crisis: finding liquidity constraints and covered inter-
est p a rity", Working Papers on Finance, no 1212, University of
St Gallen School o f Finance.
McCauley, R and P McGuire (2014): "Non-US banks' claims on
the Federal Reserve", BIS Quarterly Review, March, pp 89-97.
McGuire, P and G von Peter (2009): "The US dollar shortage in
global banking", BIS Quarterly Review, March, pp 47-63.
___ (2012): "The US dollar shortage in global banking and the
international policy response", International Finance, June.
Pinnington, J and M Shamloo (2016): "Lim its to arbitrage and
deviations from covered interest rate p a rity", Bank o f Canada,
Staff Discussion Papers, 16-4.
Pozsar, Z and S Smith (2016): "Japanese banks, LIBOR and the
FX swap lines", C redit Suisse Fixed Income Research, Global
M oney Notes #7, August.
Rush, A, D Sadeghian and M W rig h t (2013): "Foreign currency
exposure and hedging in A ustralia", Reserve Bank o f Australia,
Bulletin, December, pp 49-57.
■ 347
Shin, H S (2010): Risk and liquidity, O xford University Press.
___ (2016): "G lobal liquidity and procyclicality", speech at the
W orld Bank conference on The state of economics, the state of
the world, W ashington DC, 8 June.
Shleifer, A and R Vishny (1997): "The limits o f a rb itra g e ", Journal
of Finance, vol 52, no 1, pp 35-55.
Sushko, V, C Borio, R McCauley and P McGuire (2016): "Failure
o f covered interest parity: FX hedging dem and and costly bal-
ance sheets", BIS Working Papers, forthcom ing.
US Treasury, Federal Reserve Bank o f New York and Board o f
Governors o f the Federal Reserve System (2016): US portfolio
holdings of foreign securities as of December 31, 2014, January.

348 Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Risk Management
for Changing Interest
Rates: Asset-Liability
Management
and Duration
Techniques
Learning Objectives
A fte r com pleting this reading you should be able to:

Discuss how asset-liability m anagem ent strategies can Describe duration gap m anagem ent and apply this
help a bank hedge against interest rate risk. strategy to p ro te ct a bank's net w orth.

Describe interest-sensitive gap m anagem ent and apply Discuss the lim itations o f interest-sensitive gap
this strategy to maximize a bank's net interest margin. m anagem ent and duration gap m anagement.

Excerpt is Chapter 7 o f Bank M anagem ent & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia C. Hudgins.

349
KEY TOPICS IN THIS CHAPTER
• Asset, Liability, and Funds M anagem ent
• M arket Rates and Interest Rate Risk
• The Goals o f Interest Rate Hedging
• Interest-Sensitive Gap M anagem ent
• Duration Gap M anagem ent
• Lim itations o f Interest Rate Risk M anagem ent Techniques
18.1 INTRODUCTION
Financial institutions today are often highly com plex organiza-
tions, offering m ultiple financial services through m ultiple
departm ents, each staffed by specialists in making different
kinds o f decisions . 1 Thus, different groups o f individuals inside
each m odern financial firm usually make the decisions about
which customers are to receive credit, which securities should be
added to or subtracted from the institution's p o rtfo lio , which
term s should be offered to the public fo r loans, investm ent
advice, and other services, and which sources o f funding the
institution should draw upon.
Yet, all o f the fore going m anagem ent decisions are intim ately
linked to each other. For example, decisions on which custom er
credit requests should be fulfilled are closely related to the
ability o f the financial firm to raise funds in order to support
the requested new loans. Similarly, the am ount o f risk th a t a
financial firm accepts in its p o rtfo lio is closely related to the ade-
quacy and com position o f its capital (net worth), which protects
its stockholders and creditors against loss. Even as a financial
institution takes on more risk it must p ro te ct the value o f its net
w orth from erosion, which could result in ultim ate failure.
In a well-m anaged financial institution all o f these diverse
m anagem ent decisions must be coordinated across the whole
institution in order to ensure they do not clash w ith each other,
leading to inconsistent actions th a t dam age earnings and net
w orth. Today financial-service managers have learned to look at
th e ir asset and liability portfolios as an integrated whole, con-
sidering how their institution's w hole p o rtfo lio contributes to
the firm 's broad goals o f adequate p ro fita b ility and acceptable
risk. This type o f coordinated and integrated decision making
is known as asset-liability management (ALM). The collection
o f managerial techniques known as asset-liability m anage-
m ent provides financial institutions w ith defensive weapons to
handle such challenging events as business cycles and seasonal
1 Portions of this chapter are based upon Peter S. Rose's article in The
Canadian Banker [6] and are used with the permission of the publisher.
350 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
pressures and w ith offensive weapons to shape portfolios o f
assets and liabilities in ways th a t prom ote each institution's
goals. The key purpose o f this chapter is to give the reader a
picture o f how this integrated approach to managing assets,
liabilities, and equity really works.
18.2 ASSET-LIABILITY MANAGEMENT
STRATEGIES
Asset Management Strategy
Financial institutions have not always possessed a com pletely
integrated view o f th e ir assets and liabilities. For example,
through m ost o f the history o f banking, bankers tended to
take their sources o f funds— liabilities and equity— largely fo r
granted. This asset management view held th a t the am ount
and kinds o f deposits a depository institution held and the vo l-
ume o f other borrow ed funds it was able to a ttract were largely
determ ined by its customers. Under this view, the public deter-
mined the relative amounts o f deposits and other sources of
funds available to depository institutions. The key decision area
fo r m anagem ent was not deposits and other borrow ings but
assets. The financial manager could exercise control only over
the allocation o f incom ing funds by deciding who was to receive
the scarce quantity o f loans available and w hat the term s on
those loans w ould be. Indeed, there was some logic behind this
asset m anagem ent approach because, prior to recent deregula-
tion o f the industry, the types o f deposits, the rates offered, and
the nondeposit sources o f funds depository institutions could
draw upon were closely regulated. Managers had only lim ited
discretion in shaping th e ir sources o f funds.
Liability Management Strategy
Recent decades have ushered in dram atic changes in asset-
liability m anagem ent strategies. C onfronted w ith fluctuating
interest rates and intense com petition fo r funds, financial firms
began to devote greater attention to opening up new sources
o f funding and m onitoring the mix and cost o f th e ir deposit
and nondeposit liabilities. The new strategy was called liability
management. Its goal was simply to gain control over funds
sources com parable to the control financial managers had long
exercised over their assets. The key control lever was price— the
interest rate and other term s offered on deposits and other
borrow ings to achieve the volum e, mix, and cost desired. For
example, a lender faced w ith heavy loan dem and th a t exceeded
its available funds could simply raise the offer rate on its b o rro w -
ings relative to its com petitors, and funds w ould flo w in. On the
other hand, a financial institution flush w ith funds but w ith few
profitable outlets fo r those funds could
leave its offer rate unchanged or even
lower th a t price, letting com petitors o u t- Managing
bid it fo r w hatever funds were available in a financial
institution’s
the m arketplace. Exhibit 18.1 charts the
response to
goals o f asset-liability m anagement. changing
market
interest
Funds Management
rates

Strategy
The m aturing o f liability m anagem ent Exhibit 18.1
techniques, coupled w ith more volatile
interest rates and greater risk, eventu-
ally gave birth to the funds management approach, which
dom inates today. This view is a more balanced approach to
asset-liability m anagem ent th a t stresses several key objectives:
1. M anagem ent should exercise as much control as possible
over the volum e, mix, and return or cost o f both assets and
liabilities in order to achieve the financial institution's goals.
2. M anagem ent's control over assets must be coordinated
w ith its control over liabilities so th a t asset m anagem ent
and liability m anagem ent are internally consistent and do
not pull against each other, Effective coordination in man-
aging assets and liabilities will help to maximize the spread
between revenues and costs and control risk exposure.
3. Revenues and costs arise from both sides o f the balance
sheet (i.e., from both asset and liability accounts). M anage-
m ent policies need to be developed th a t maximize returns
and effectively control costs from supplying services.
The traditional view th a t all income received by financial firms
must come from loans and investments has given way to the
notion th a t financial institutions today sell a bundle of financial
services— credit, payments, savings, financial advice, and the
like— th a t should each be priced to cover their cost o f produc-
tion. Income from managing the liability side o f the balance
sheet can help achieve p ro fita b ility goals as much as revenues
generated from managing loans and other assets. Many financial
firm s carry out daily asset-liability m anagem ent (ALM) activities
through asset-liability com m ittees (ALCO), usually com posed o f
key officers representing d iffe re n t departm ents o f the firm .
CONCEPT CHECK
18.1. W hat do the follow ing term s mean: asset manage­
ment? liability management? funds management?
18.2. W hat factors have motivated financial institutions to
develop funds management techniques in recent years?
Asset-liability management in banking and financial services.
18.3 INTEREST RATE RISK: ONE
OF THE GREATEST MANAGEMENT
CHALLENGES
No financial manager can com pletely avoid one o f the toughest
and potentially m ost dam aging form s o f risk th a t all financial
institutions must face— interest rate risk. When interest rates
change in the financial m arketplace, the sources o f revenue
th a t financial institutions receive— especially interest income
on loans and investm ent securities— and their m ost im portant
source o f expenses— interest cost on borrow ings— must also
change. Moreover, changing interest rates also change the
m arket value o f assets and liabilities, thereby changing each
financial institution's net w o rth — the value o f the owner's invest-
m ent in the firm . Thus, changing interest rates im pact both the
balance sheet and the statem ent o f income and expenses of
financial firms.
Forces Determining Interest Rates
The problem w ith interest rates is th a t although they are criti-
cal to m ost financial institutions, the managers o f these firms
simply cannot control either the level o f or the trend in m arket
rates o f interest. The rate o f interest on any particular loan
or security is ultim ately determ ined by the financial m arket-
place where suppliers o f loanable funds (credit) interact w ith
dem anders o f loanable funds (credit) and the interest rate (price
o f credit) tends to settle at the p o in t where the quantities o f
loanable funds dem anded and supplied are equal, as shown in
Exhibit 18.2.
In granting loans, financial institutions are on the supply side
o f the loanable funds (credit) m arket, b u t each lending in stitu -
tio n is only one supplier o f cre d it in an international m arket
fo r loanable funds th a t includes many thousands o f lenders.
Similarly, financial institutions also com e into the financial

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 351
 Quantity of loanable funds
Exhibit 18.2 Determination of the rate of interest in the financial
marketplace where the demand and supply of loanable funds (credit)
interact to set the price of credit.

m arketplace as dem anders o f loanable funds (credit) when
they o ffe r d e p o sit services to the public or issue nondeposit
lOUs to raise funds fo r lending and investing. But, again,
each financial in stitu tio n , no m a tte r how large it is, is only one
dem ander o f loanable funds in a m arket containing many th o u -
sands o f borrow ers.
The Measurement of Interest Rates
W hen we use the term interest rates exactly w hat do we mean?
How are interest rates measured?
M ost o f us understand what interest rates are because we have
borrow ed money at one tim e or another and know th a t interest

Thus, w hether financial firm s are on the supply side or the
dem and side o f the loanable funds (credit) m arket at any given
m om ent (and financial interm ediaries are usually on both sides
o f the credit m arket simultaneously), they cannot determ ine
the level, or be sure about the trend, o f m arket interest rates.
Rather, the individual institution can only react to the level o f
rates are the price of credit, dem anded by lenders as compensa-
tion for the use o f borrow ed funds. In simplest terms the interest
rate is a ratio o f the fees we must pay to obtain credit divided by
the am ount o f credit obtained (expressed in percentage points
and basis points [i.e., 1/100 o f a percentage point]). However,
over the years a bewildering array o f interest rate measures have

and trend in interest rates in a way th a t best allows it to achieve
its goals. In other words, m ost financial managers must be price
takers, not price makers, and must accept interest rate levels as
a given and plan accordingly.
As m arket interest rates move, financial firm s typically face
been developed.
For example, one o f the m ost popular rate measures is the yield
to maturity (YTM)— the discount rate th a t equalizes the current
m arket value o f a loan or security w ith the expected stream of
future income payments th a t the loan or security will generate.

at least tw o m ajor kinds o f interest rate risk— price risk and In term s o f a form ula, the yield to m aturity may be found from
reinvestm ent risk. Price risk arises when m arket interest rates Expected cash flow Expected cash flow
rise, causing the m arket values o f m ost bonds and fixed-rate Current market price _ in Period 1 + in Period 2
loans to fall. If a financial in stitu tio n wishes to sell these fin a n - o f a loan or security (1 + YTM ) 1 (1 + YTM ) 2
cial instrum ents in a rising rate period, it must be prepared to
Sale or redem ption
accept capital losses. Reinvestment risk rears its head when
Expected cash flo w price o f security
m arket interest rates fall, forcing a financial firm to invest
in Period n or loan in Period n
incom ing funds in low er-yielding earning assets, low ering its + ••• + ------------------------------+ ------------------------------- 18.1
(1 + YTM)n (1 + YTM)n
expected fu ture incom e. A big part o f m anaging assets and
liabilities consists o f fin d in g ways to deal effectively w ith these where n is the num ber o f years th a t payments occur. For exam -
tw o form s o f risk. ple, a bond purchased today at a price o f $950 and prom ising

352 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
an interest paym ent o f $ 1 0 0 each year over the next three years, makes calculations easier b u t is theoretically incorrect. The pur-
when it will be redeem ed by the bond's issuer fo r $ 1 , 0 0 0 , will chase price o f a financial instrum ent, rather than its face am ount,
have a prom ised interest rate, measured by the yield to m atu- is a much b e tte r base to use in calculating the instrum ent's true
rity, determ ined by: rate o f return.

$100 $100 $100 $1000 To convert a DR to the equivalent yield to m aturity we can use
$950 = + + +
(1 + YTM ) 1 (1 + YTM ) 2 (1 + YTM ) 3 (1 + YTM) the form ula

This bond's YTM is determ ined to be 12.10 percent . 2 YTM

(100 — Purchase price) 365
equivalent = (18.3)
A n other popular interest rate measure is the bank discount Purchase price Days to m aturity
yield
rate, which is often quoted on short-term loans and money
m arket securities (such as Treasury bills). The form ula fo r
For the m oney m arket security discussed previously, its
calculating the discount rate (DR) is as follows:
equivalent yield to m aturity w ould be
100 — Purchase price on loan or security
(100 - 96) 365
100 YTM equivalent = ------ — ------ X = 0.1690, or 16.90 percent
360
(18.2) or 16 percent + 90 basis points
N um ber o f days
to m aturity W hile the tw o interest rate measures listed above are popular,

For exam ple, suppose a m oney m arket security can be pur- we should keep in mind th a t there are literally dozens o f other
chased fo r a price o f $96 and has a face value o f $100 to be measures o f "th e interest rate," many o f which we will encoun-
paid at m aturity. If the security matures in 90 days, its interest te r in later chapters o f this book.
rate measured by the DR must be

_ (100 - 96)
DR = ----- — — ------ X
360
— — = 0.16, or 16 percent The Components of Interest Rates
100 90 K
O ver the years many financial managers have trie d to forecast
We note th a t this interest rate measure ignores the effect o f
future m ovem ents in m arket interest rates as an aid to com bat-
com pounding o f interest and is based on a 360-day year, unlike
ing interest rate risk. However, the fact th a t interest rates are
the yield to m aturity measure, which assumes a 365-day year
determ ined by the interactions o f thousands o f credit suppliers
and assumes th a t interest income is com pounded at the calcu-
and dem anders makes consistently accurate rate forecasting vir-
lated YTM.
tually impossible. A d d in g to the forecasting problem is the fact
In addition, the DR uses the face value o f a financial instrum ent th a t any particular interest rate attached to a loan or security is
to calculate its yield or rate o f return, a simple approach th a t com posed o f m ultiple elements or building blocks, including

o Risk-free real Risk premium s to

Financial calculators and spreadsheets such as Excel will give this yield
to maturity figure directly after entering the bond's purchase price, Nominal interest rate com pensate lenders
promised interest payments, sales or redemption price, and number of (published) (such as the w ho accept risky lOUs
time periods covered. (Note: the YTM for bonds is parallel to the APR m arket inflation- to cover th e ir default
for loans.) + (18.4)
interest rate adjusted (credit) risk, inflation
We should also note that in the real world many bonds (including those
on a risky return on risk, term or m aturity
issued by the U.S. Treasury) pay interest twice a year. This feature
changes the timing of various cash flows off each bond and affects the loan or governm ent risk, liquidity risk, call
YTM, The YTM formula becomes security bonds) risk, and so on
Expected cash flow Expected cash flow
in Period 1 in Period 2
Price — ----------------- ------ 1------------------- ---- Filmtoid
(1 + YTM/k)1 (1 + YTM/k)2
Expected cash flow and sale or redemption price W hat 2001 Australian drama finds the head o f Centabank
in Period n X k enthralled w ith a com puter program th a t forecasts interest
+ • • • H--------------------------------------------;-----------------------
(1 + YTM/k)nXk rate m ovem ents in the w orld's money markets?
where k is the number of times interest is paid each year. Thus, the total Answer: The Bank.
number of payment periods is n X k.

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 353
N o t only does the risk-free real interest rate change over tim e
w ith shifts in the dem and and supply fo r loanable funds, but the
perceptions o f lenders and borrowers in the financial m arket-
place concerning each o f the risk premiums th a t make up any
particular m arket interest rate on a risky loan or security also
change over tim e, causing m arket interest rates to move up or
down, often erratically.
Factoid
True or false— interest rates cannot be negative?
Answer: Contrary to popular belief they can go negative.
Some o f the most famous examples include (1) during the
G reat Depression o f the 1930s when governm ent securities
som etimes sold above par as frig htened depositors fled from
banks; (2) briefly in the fall o f 2003 in the m arket fo r repur-
chase agreements; and (3) briefly in the Treasury bill m arket
in 2008. (See w w w .new yorkfed.org/research.)
Risk Premiums
To cite some examples, when the econom y goes into a reces-
sion w ith declining business sales and rising unem ploym ent,
many lenders will conclude th a t some businesses will fail and
some individuals will lose th e ir jobs, increasing the risk o f bor-
rower default. The default-risk premium com ponent o f the
interest rate charged a risky borrow er will increase, raising the
borrow er's loan rate (all other factors held constant). Similarly,
an announcem ent o f rising prices on goods and services may
trig g e r lenders to expect a trend tow ard higher inflation, reduc-
ing the purchasing pow er o f th e ir loan income unless they
dem and from borrowers a higher inflation-risk premium to com -
pensate fo r their projected loss in purchasing power. According
to the so-called Fisher effect nominal (published) interest rates
are equal to the sum o f the real interest rate (or purchasing
pow er return) on a loan plus the expected
rate o f inflation over the life o f a loan.
T reasury Yield Curve
Many loan and security interest rates Percent
Yield Curves
A nother key com ponent o f each interest rate is the maturity,
or term, premium. Longer-term loans and securities often carry
higher m arket interest rates than shorter-term loans and securi-
ties due to m aturity risk because o f greater o p p o rtun itie s fo r
loss over the life o f a longer-term loan. The graphic picture o f
how interest rates vary w ith d iffe re n t m aturities o f loans viewed
at a single p o in t in tim e (and assuming th a t all other factors,
such as credit risk, are held constant) is called a yield curve.
Exhibit 18.3 charts different U.S. Treasury yield curves p lo tte d
in O cto b e r 2009 and O cto b e r 2010. The m aturities o f Treasury
securities (in months and years) are p lo tte d along the horizon-
tal axis o f the chart and their yields to m aturity (YTMs) appear
along the vertical axis.
Yield curves constantly change th e ir shape because the yields o f
the financial instrum ents included in each curve change all the
tim e. For example, we notice in Exhibit 18.3 th a t the relatively
steep yield curve prevailing in O cto b e r 2009 had becom e a
som ewhat flatter, more shallow yield curve about one year later.
Moreover, different yields tend to change at different speeds
w ith short-term interest rates tending to rise or fall faster than
long-term interest rates. As illustrated in Exhibit 18.3 long-term
interest rates (principally distributed along the right-hand por-
tion o f the yield curve) had m oved slightly dow nw ard during the
O cto b e r 2009 to O cto b e r 2010 period, while short-term interest
rates (predom inantly arrayed along the left-hand portion o f the
yield curve) had m oved over a som ewhat w ider range during the
same tim e period. Thus, relative changes in short-term interest
rates versus long-term interest rates clearly vary over tim e.
This rate variation or changing yield "sp read" based on m aturity
is very evident in the picture presented to us in Exhibit 18.4. In
this exhibit, which plots the 3-m onth U.S. Treasury bill rate com -
pared to 10-year Treasury bond rates, we d e te ct a significant
sensitivity o f short-versus long-term yield spreads to changes in

also contain a prem ium fo r liquidity risk, 4 . 0 - ..........................

because some financial instrum ents are 3.5-

m ore d iffic u lt to sell quickly at a favor-

able price to another lender. A n o th e r
rate -d e te rm in in g fa c to r is call risk, which
arises when a b o rro w e r has the rig h t to
pay o ff a loan early, possibly reducing
the lender's expected rate o f return if
m arket interest rates have fallen. Finan-
cial instrum ents w ith a greater call risk
te n d to carry higher interest rates, o th e r
factors held equal. Source: Federal Reserve Bank of St. Louis, Monetary Trends, October 19, 2010.

354 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Interest Rates
Percent
18-...........
i
i i — * * • • • « » • • • » » • • • • • • ■ • • • • • • • « • • • » •
The spread between short-term and long-term interest rates
Exhibit 18.4
on treasury securities (October 2010).
Source: Federal Reserve Bank of St. Louis, Monetary Trends, November 2010.
the economy. For example, in periods o f recession (such as hap-
pened in 1991, 2001, and 2007-2009 w ith the econom y facing
substantial decline), short-term interest rates tended to fall rela-
tive to long-term interest rates and the yield "sp read" or "g a p "
betw een short and long m aturities often tended to widen. In
contrast, a period o f econom ic prosperity usually begins w ith a
fairly w ide gap between long- and short-term interest rates, but
th a t interest-rate gap tends to narrow and som etim es becomes
negative.
In summary, yield curves will display an upward slope (i.e., a
rising yield curve) when long-term interest rates exceed short-
term interest rates. This often happens when all interest rates
are rising but short-term rates have started from a lower level
than long-term rates. M odern financial theory tends to associate
upward-sloping yield curves w ith rising interest rates and w ith
expansion in the economy.
Yield curves can also slope downward (i.e., a falling yield curve)
w ith short-term interest rates higher than long-term rates. Such
a negatively sloped yield curve suggests th a t interest rates will
begin falling and the econom y may soon head into a recession.
Finally, horizontal yield curves prevail when long-term interest
rates and short-term rates are approxim ately at the same level
so th a t investors receive the same yield to m aturity no m atter
w hat m aturity o f investm ent security they purchase. A horizontal
yield curve suggests th a t interest rates may be stable fo r a tim e
w ith little change occurring in the slope o f the curve.
The Maturity Gap and the Yield Curve
Typically managers o f financial institutions th a t focus on lending
fare som ewhat b e tte r w ith an upward-sloping yield curve than
they do under a horizontal or dow nw ard-sloping yield curve.
The upward-sloping yield curve is usually more favorable for
the p ro fita b ility o f lending institutions because th e ir loans and
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques
security holdings on the asset side o f
their balance sheet tend to have longer
m aturities than th e ir sources o f funds
(liabilities).
Thus, m ost lending institutions experience
a positive maturity gap between the
average m aturity o f th e ir assets and the
average m aturity o f th e ir liabilities. If the
yield curve is upward sloping, then reve-
nues from longer-term assets will outstrip
expenses from shorter-term liabilities.
The result will normally be a positive net
interest margin (interest revenues greater
than interest expenses), which tends to
generate higher earnings. In contrast, a
relatively fla t (horizontal) or negatively sloped yield curve often
generates a small or even negative net interest margin, putting
dow nw ard pressure on the earnings o f financial firms th a t bor-
row short and lend long.
Rsesponses to Interest Rate Risk
As noted at the outset, changes in m arket interest rates can
dam age a financial firm 's p ro fita b ility by increasing its cost
o f funds, by lowering its returns from earning assets, and by
reducing the value o f the owners' investm ent (net w orth or
equity capital). Moreover, recent decades have ushered in a
period o f volatile interest rates, confronting financial managers
w ith a more unpredictable environm ent to w ork in. A dram atic
exam ple o f the huge losses associated w ith interest-rate risk
exposure occurred some years ago in M innesota when First
Bank System, Inc., o f M inneapolis b o u g h t unusually large quanti-
ties o f governm ent bonds. First Bank's m anagem ent had fo re -
cast a decline in interest rates. Unfortunately, bond prices fell
as interest rates rose, and First Bank reported a loss o f about
$500 m illion, resulting in the sale o f its headquarters building
(see Bailey [2]).
Factoid
As the 21st century opened and m arket interest rates fell to
record lows, interest rate risk threatened to severely im pact
the net asset values o f w hat m ajor co m p e tito r o f banks?
Answer: M oney m arket funds, which were often forced to
lower th e ir fees in order to avoid reducing the net value o f
th e ir assets below the accepted m arket standard o f $ 1 . 0 0
per share; a few m oney m arket funds were forced to actually
"break the buck" during the 2007-2009 credit crisis.
■ 355
Asset-Liability Committee (ALCO)
In recent decades managers o f financial institutions have aggres-
sively sought ways to insulate th e ir asset and liability portfolios
and their profits from the ravages o f changing interest rates. For
example, many banks now conduct their asset-liability m anage-
m ent strategies under the guidance o f an asset-liability commit­
tee, or ALCO.
A well-run ALCO meets regularly (quarterly, monthly, or even
more frequently) to manage the financial firm's interest rate risk
(IRR) and other risk exposures as well. The com m ittee is expected
to have a firm grasp o f the organization's principal goals, usually
centered on the maximization o f shareholder wealth, maintain-
ing adequate profitability, and achieving sufficient capitalization.
These are often stated as specific numerical targets (e.g., an
ROA o f 1.5 percent and an equity-to-assets ratio o f at least 10
percent). The AO L regularly conveys to the board o f directors the
firm's financial condition plus suggestions for correcting identi-
fied weaknesses. The com m ittee lays out a plan for how the firm
should be funded, the quality o f loans that it should take on, and
the proper limits to its off-balance-sheet risk exposure. The ALCO
estimates the firm's risk exposure to its net interest margin and
net w orth ratios, develops strategies to keep th a t risk exposure
within well-defined limits, and may em ploy simulation analysis to
test alternative m anagement strategies.
18.4 ONE OF THE GOALS OF INTEREST
RATE HEDGING: PROTECT
THE NET INTEREST MARGIN
In dealing w ith interest rate risk, one im p o rta n t goal is to
insulate profits— net incom e— from the dam aging effects o f
fluctuating interest rates. No m atter which way interest rates go,
managers o f financial institutions w ant stable profits th a t achieve
the level o f p ro fita b ility desired.
To accomplish this goal, m anagem ent must concentrate on
those elem ents o f the institution's p o rtfo lio o f assets and liabili-
ties th a t are m ost sensitive to interest rate m ovements. Norm ally
this includes loans and investments on the asset side o f the
balance sheet— earning assets— and borrow ings on the liability
side. In order to pro te ct profits against adverse interest rate
changes, then, m anagem ent seeks to hold fixed the financial
firm 's net interest margin (NIM), expressed as follows:
(
Interest incom e Interest expense on
from loans - deposits and other
and investments borrow ed funds
NIM
Total earning assets
N et interest income
(18.5)
Total earning assets
356 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
For example, suppose a large international bank records
$4 billion in interest revenues from its loans and security invest-
ments and $ 2 . 6 billion in interest expenses paid out to attract
borrow ed funds. If this bank holds $40 billion in earning assets,
its net interest margin is
($4 billion - $2.6 billion)
NIM X 100 = 3.50 percent
$40 billion
N ote how narrow this net interest margin (which is fairly close
to the average fo r the banking industry) is at just 3.5 percent,
which is not this bank's p ro fit from borrow ing and lending funds
because we have not considered noninterest expenses (such as
em ployee salaries, taxes, and overhead expenses). Once these
expenses are also deducted, the manager o f this bank gener-
ally has very little margin fo r error against interest rate risk. If
m anagem ent does find a 3.5 percent net interest margin accept-
able, it will probably use a variety o f interest-rate risk hedging
m ethods to p ro te ct this NIM value, thereby helping to stabilize
net earnings.
If the interest cost o f borrow ed funds rises faster than income
from loans and securities, a financial firm 's NIM will be
squeezed, w ith likely adverse effects on p ro fits . 3 If interest rates
fall and cause income from loans and securities to decline faster
than interest costs on borrow ings, the NIM will again be
squeezed. In other words, yield curves do not usually move in
parallel fashion over tim e, so th a t the spread between b o rro w -
ing costs and interest revenues is never constant. M anagem ent
must struggle continuously to find ways to ensure th a t b o rro w -
ing costs do not rise significantly relative to interest income and
threaten the margin o f a financial firm .
Interest-Sensitive Gap Management
as a Risk-Management Tool
A m ong the m ost popular interest rate hedging strategies in use
today is interest-sensitive gap management. Gap m anage-
m ent techniques require m anagem ent to perform an analysis
o f the m aturities and repricing o p p o rtu n itie s associated w ith
interest-bearing assets and w ith interest-bearing liabilities.
If m anagem ent feels its institution is excessively exposed to
interest rate risk, it will try to match as closely as possible the
3 In recent years, as noted by Alden Toevs [7], the net interest income of
U.S. banks has accounted for about 60 to 80 percent of their net earn­
ings. Toevs also found evidence of a substantial increase in the volatility
of net interest income over time, encouraging managers of financial
institutions to find better methods for managing interest-rate risk. One
interesting management strategy that became prominent near the close
of the 20th century and into the new century has been to deemphasize
interest rate-related sources of revenue and to emphasize noninterest
rate-related revenue sources (e.g., fee income).

CONCEPT CHECK
18.3. W hat forces cause interest rates to change? W hat
kinds o f risk do financial firm s face when interest
rates changes?
18.4. W hat makes it so d ifficu lt to correctly forecast inter-
est rate changes?
18.5. W hat is the yield curve, and why is it im p o rta n t to
know about its shape or slope?
18.6. W hat is it th a t a lending institution wishes to pro te ct
from adverse m ovem ents in interest rates?
18.7. W hat is the goal o f hedging?
18.8. First National Bank Bannerville has posted interest
revenues o f $63 million and interest coasts from all
o f its borrow ings o f $42 m illion. If this bank pos-
In this case, the revenue from earning assets will change in the
same direction and by approxim ately the same p ro p o rtio n as
the interest cost o f liabilities.
W hat is a repriceable asset? A repriceable liability? The most
fam iliar examples o f repriceable assets include loans th a t are
about to mature or will soon to come up fo r renewal or repric-
ing, such as variable-rate business and household loans (includ-
ing credit card accounts and adjustable-rate home m ortgages
(ARMs)). If interest rates have risen since these loans were first
made, the lender is likely to renew them only if it can g e t a rate
o f return th a t approxim ates the higher yields currently expected
on other financial instruments o f com parable quality. Similarly,
loans th a t are m aturing will provide the lender w ith newly
released funds available to reinvest in new loans at today's inter-
est rates.
In contrast, repriceable liabilities include a depository institu-

sesses $700 million in total earning assets, w hat is tion's certificates o f deposit (CDs) about to mature or eligible

First National's net interest margin? Suppose the to be renewed, where the financial firm and its custom er must

bank's interest revenues and interest costs double, negotiate new deposit interest rates th a t capture current m arket

while its earning assets increase by 50 percent. conditions. O ther examples include floating-rate deposits whose

W hat will happen to its net interest margin?
volum e o f assets th a t can be repriced as interest rates change
w ith the volum e o f liabilities whose rates can also be adjusted
w ith m arket conditions during the same tim e period.
yields move up or down autom atically w ith m arket interest rates;
savings accounts th a t may be likely to be w ithdraw n at any tim e
to seek out more favorable returns; interest-bearing checkable
deposits (such as N O W accounts); and nondeposit money mar-
ket borrow ings whose interest rates are often adjusted several
tim es daily to reflect the latest m arket developm ents.

For example, a financial firm can hedge itself against interest W hat happens when the am ount o f repriceable assets does
rate changes— no m atter which way rates m ove— by making not equal the am ount o f repriceable liabilities? Clearly, a gap
sure fo r each tim e period th a t the then exists between these interest-sensitive assets and interest-
sensitive liabilities. The gap is the portion o f the balance sheet
Dollar am ount o f repriceable Dollar am ount o f repriceable
affected by interest rate risk:
(interest-sensitive) (interest-sensitive)
assets liabilities Interest-sensitive gap = Interest-sensitive assets ^
(18.6) - Interest-sensitive liabilities

Examples of Repriceable (Interest-Sensitive) Assets and (Interest-Sensitive) Liabilities and Nonrepriceable Assets
and Liabilities
Repriceable Repriceable Nonrepriceable Assets Nonrepriceable Liabilities
(Interest-Sensitive) Assets (Interest-Sensitive) Liabilities

Short-term securities issued Borrowings from the money Cash in the vault and deposits Demand deposits (which pay
by governm ents and private m arket (such as federal funds at the Central Bank (legal no interest rate or a fixed
borrowers (about to mature) or RP borrowings) reserves) interest rate)

Short-term loans made to Short-term savings accounts Long-term loans made at a Long-term savings and
borrow ing customers (about fixed interest rate retirem ent accounts
to mature)

Variable-rate loans and M oney-m arket deposits Long-term securities carry- Equity capital provided by the
securities (whose interest rates are ing fixed rates Buildings and financial institution's owners
adjustable frequently equipm ent

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 357
If interest-sensitive assets in each planning period (day, week,
m onth, etc.) exceed the volum e o f interest-sensitive liabilities
subject to repricing, the financial firm is said to have a positive
gap and to be asset sensitive. Thus:
Asset-sensitive Interest-sensitive assets
= ,i
(positive) gap - Interest-sensitive liabilities >
For example, a bank w ith interest-sensitive assets o f $500 million
and interest-sensitive liabilities o f $400 m illion is asset sensi-
tive with a positive gap o f $100 million. If interest rates rise,
this bank's net interest margin will increase because the interest
revenue generated by assets will increase more than the cost of
borrow ed funds. O ther things being equal, this financial firm will
experience an increase in its net interest income. On the other
hand, if interest rates fall when the bank is asset sensitive, this
bank's NIM will decline as interest revenues from assets drop
by more than interest expenses associated w ith liabilities. The
financial firm w ith a positive gap will lose net interest income if
interest rates fall.
In the opposite situation, suppose an interest-sensitive bank's
liabilities are larger than its interest-sensitive assets. This bank
then has a negative gap and is said to be liability sensitive. Thus:
Liability-sensitive Interest-sensitive assets
= (18.9)
(negative) gap -In te re st-se n sitive liabilities <
A financial institution holding interest-sensitive assets o f $150
m illion and interest-sensitive liabilities o f $ 2 0 0 m illion is liability
sensitive, w ith a negative gap o f $50 m illion. Rising interest rates
will lower this institution's net interest margin, because the ris-
ing cost associated w ith interest-sensitive liabilities will exceed
increases in interest revenue from interest-sensitive assets.
Falling interest rates will generate a higher interest margin and
probably greater earnings as well, because borrow ing costs will
decline by more than interest revenues.
Actually, there are several ways to measure the interest-
sensitive gap (IS GAP). One m ethod is called simply the D ol-
lar IS GAP. For example, as we saw above, if interest-sensitive
assets (ISA) are $150 m illion and interest-sensitive liabilities
(ISL) are $200 m illion, then the Dollar IS GAP = ISA - ISL
= $150 m illion - $200 m illion = - $ 5 0 million. Clearly, an insti-
tu tio n whose Dollar IS GAP is positive is asset sensitive, while a
negative Dollar IS GAP describes a liability-sensitive condition.
An Asset-Sensitive Financial A Liability-Sensitive
Firm Has: Financial Firm Has:
Positive Dollar IS GAP Negative Dollar IS GAP
Positive Relative IS GAP Negative Relative IS GAP
Interest Sensitivity Ratio Interest Sensitivity Ratio less
greater than one than one
358 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
We can also form the Relative IS GAP ratio:
Relative _ IS GAP _ -$ 5 0 m illio n
-0 .3 3
IS GAP Size o f financial institution $150m illion
(measured, fo r example,
by total assets)
0 8
(18.10)
0
A Relative IS GAP greater than zero means the in stitu tio n is
asset sensitive, w hile a negative Relative IS GAP describes a
liability-sensitive financial firm . Finally, we can sim ply com -
pare the ratio o f ISA to ISL, som etim es called the Interest
Sensitivity Ratio (ISR). Based on the figures in our previous
exam ple,
. ... „ . /ir. n% ISA $150 million
Interest Sensitivity Ratio (ISR) = — — = — — — — — = 0.75
ISL $200 million
(18.11)
In this instance an ISR o f less than 1 tells us we are looking at
a liability-sensitive institution, while an ISR greater than unity
points to an asset-sensitive institution.
Only if interest-sensitive assets and liabilities are equal is a
financial institution relatively insulated from interest rate risk. In
this case, interest revenues from assets and funding costs will
____ _ change at the same rate. The interest-sensitive gap is zero, and
0 the net interest margin is protected regardless o f which way
interest rates go. As a practical matter, however, a zero gap
does not elim inate all interest rate risk because the interest rates
attached to assets and liabilities are not perfectly correlated
in the real w orld. Loan interest rates, fo r example, tend to lag
behind interest rates on many m oney m arket borrowings. So
interest revenues often tend to grow more slowly than interest
expenses during econom ic expansions, while interest expenses
tend to fall more rapidly than interest revenues during econom ic
downturns.
G apping m ethods used today vary greatly in com plexity and
form . All m ethods, however, require financial managers to make
some im p o rta n t decisions:
1. M anagem ent must choose the tim e period during which the
net interest margin (NIM) is to be managed (e.g., six months
or one year) to achieve some desired value and the length
o f subperiods ("m a tu rity buckets") into which the planning
period is to be divided.
2. M anagem ent must choose a ta rg e t level fo r the net inter-
est m argin— th a t is, w hether to freeze the margin roughly
where it is or perhaps increase the NIM.
3. If m anagem ent wishes to increase the NIM, it must either
develop a correct interest rate forecast or find ways to real-
locate earning assets and liabilities to increase the spread
between interest revenues and interest expenses.
 4. M anagem ent must determ ine the volum e o f interest- The foregoing exam ple reminds us th a t the net interest margin
sensitive assets and interest-sensitive liabilities it wants the o f a financial-service provider is influenced by m ultiple factors:
financial firm to hold.
1. Changes in the level o f interest rates, up or down.

2. Changes in the spread between asset yields and liability

Computer-Based Techniques
costs (often reflected in the changing shape o f the yield,
Many institutions use com puter-based techniques in which their curve between long-term rates and short-term rates).
assets and liabilities are classified as due or repriceable today,
3. Changes in the volum e o f interest-bearing (earning) assets a
during the com ing week, in the next 30 days, and so on. M an-
financial institution holds as it expands or shrinks the overall
agem ent tries to match interest-sensitive assets w ith interest-
scale o f its activities.
sensitive liabilities in each o f these maturity buckets in order to
im prove the chances o f achieving the financial firm 's earnings
4. Changes in the volum e o f interest-bearing liabilities th a t are
used to fund earning assets as a financial institution grows
goals. For example, a financial firm 's latest com puter run m ight
or shrinks in size.
reveal the follow ing:
5. Changes in the mix o f assets and liabilities th a t m anage-
(dollars in millions) m ent draws upon as it shifts between floating and fixed-rate
assets and liabilities, between shorter and longer m aturity
Interest- Interest-
assets and liabilities, and betw een assets bearing higher
Maturity Size of Cumulative
Buckets Assets Liabilities Gap Gap versus lower expected yields (e.g., a shift from less cash
to more loans or from higher-yielding consumer and real
1 day $40 $30 + 10 + 10
estate loans to lower-yielding commercial loans).
(next 24 hours)
Table 18.1 provides a more detailed example o f interest-sensitive
Day 2-day 7 120 160 -4 0 -3 0
gap m anagement techniques as they are applied to asset and
Day 8 -d a y 30 85 65 + 2 0 - 1 0
liability data fo r an individual bank. In it, m anagement has arrayed
Day 31-day 90 280 250 +30 + 2 0 (with the help o f a com puter) the am ount o f all the bank's assets
and liabilities, grouped by the future tim e period when those
Day 91-d a y 120 455 395 +60 +80
assets and liabilities will reach m aturity or their interest rates will
• • • • •
be subject to repricing. Note th a t this bank is liability sensitive
• • • • • during the com ing week and over the next 90 days and then
• • • • • becomes asset sensitive in later periods. Consciously or uncon-
sciously, m anagement has positioned this institution fo r falling
It is obvious from the table above th a t the time period over interest rates over the next three months and for rising interest
which the gap is measured is crucial to understanding this finan- rates over the longer horizon.
cial institution's true interest-sensitive position. For example,
A t the b o tto m o f Table 18.1, we calculate this financial firm 's
w ithin the next 24 hours, the institution in this exam ple has
net interest incom e to see how it will change if interest rates
a positive gap; its earnings will benefit if interest rates rise
rise. N et interest incom e can be derived from the fo llo w in g
betw een today and tom orrow . However, a forecast o f rising
form ula:
m oney m arket interest rates over the next week w ould be bad
N et interest income = Total interest income
news because the cum ulative gap fo r the next seven days is
- Total interest cost = [Average interest yield on
negative, which will result in interest expenses rising by more
rate-sensitive assets X Volume o f rate-sensitive assets
than interest revenues. If the interest rate increase is expected
+ Average interest yield on fixed (non-rate-sensitive)
to be substantial, m anagem ent should consider taking coun-
assets X Volume o f fixed assets] - [Average interest (18.12)
termeasures to p ro te ct earnings. These m ight include selling
cost on rate-sensitive liabilities X Volume o f interest-
longer-term CDs rig h t away or using futures contracts to earn
sensitive liabilities + Average interest cost on fixed
a p ro fit th a t will help offset the margin losses th a t rising inter-
(non-rate-sensitive) liabilities X Volume o f fixed
est rates will alm ost surely bring in the com ing week. Looking
(non-rate-sensitive) liabilities]
over the rem ainder o f the table, it is clear the institution will
fare much b e tte r over the next several months if m arket interest For example, suppose the yields on rate-sensitive and fixed
rates rise, because its cum ulative gap eventually turns positive assets average 10 percent and 11 percent, respectively, while
again. rate-sensitive and non-rate-sensitive liabilities cost an average o f

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 359
Table 18.1 Sam ple Interest-Sensitivity A nalysis (G A P M anagem ent) fo r a Bank

Volume of Asset and Liability Items Maturing or Subject to Repricing within the Following Maturity Buckets (in millions of dollars)

Total for
All Assets,
Liabilities, and
Next Net Worth
Next 31-90 Next More than on the Bank's
Asset and Liability Items One Week 8-30 Days Days 91-360 Days One Year Balance Sheet

Assets
Cash and deposits owned $100 $100

M arketable securities 200 $50 $80 $ 1 1 0 $460 900

Business loans 750 150 220 170 2 10 1,500
Real estate loans 500 80 80 70 170 900
Consumer loans 100 20 20 70 90 300
Farm loans 50 10 40 60 40 200

Buildings and equipm ent 2 00 200

Total repriceable
(interest sensitive) assets $1,700 $310 $440 $480 $1,170 $4,100
Liabilities end Net
Worth
Checkable deposits $800 $ 1 0 0 $900
Savings accounts 50 50 100

M oney m arket deposits 550 150 700

Long-term tim e deposits 100 2 00 450 150 300 1 ,2 0 0

Short-term borrow ings 300 100 400

O ther liabilities 100 100

N et w orth 700 700

Total repriceable
(interest-sensitive)
liabilities and net w orth $1,800 $600 $450 $150 $1,100 $4,100
Interest-sensitive gap - $ 1 0 0 -$ 2 9 0 - $ 1 0 +$330 +$70
(repriceable assets -
repriceable liabilities)

Cum ulative gap - $ 1 0 0 -$ 3 9 0 -$ 4 0 0 -$ 7 0 - 0

Ratio o f interest-sensitive 94.4% 51.7% 97.8% 320% 106.4%

assets to interest-sensitive
liabilities

This bank is Liability Liability Liability Asset Asset

sensitive sensitive sensitive sensitive sensitive

The bank's net interest Interest Interest Interest Interest Interest

margin will likely be rates rise rates rise rates rise rates fall rates fall
squeezed if

Suppose th a t interest yields on interest-sensitive assets currently average 10%, while interest-sensitive liabilities have an average
cost o f 8 %, In contrast, fixed assets yield 11% and fixed liabilities cost 9%. If interest rates stay at these levels, the bank's net
interest income and net interest margin measured on an annualized basis will be as follows:

360 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 Volume of Asset and Liability Items Maturing or Subject to Repricing within the Following Maturity Buckets (in millions of dollars)

Total for
All Assets,
Liabilities, and
Next Net Worth
Next 31-90 Next More than on the Bank's
Asset and Liability Items One Week 8-30 Days Days 91-360 Days One Year Balance Sheet

Next 31-90 Next 91-360 More than One

One Week Next 8-30 Days Days Days Year
Total interest incom e on 0.10 x $1,700 0.10 x $310 0.10 X $440 0.10 X $480 0.10 x $1,170
an annualized basis
+ 0 .1 1 x + 0 .1 1 x +0.11 X + 0 .1 1 x + 0 .1 1 x
[4,100 - 1,700] [4,100 - 310] 4,100 - 440] [4,100 - 480] [4,100 - 1,170]

Total interest costs on an -0 .0 8 X $1,800 -0 .0 8 x -0 .0 8 X -0 ,0 8 X -0 .0 8 x

annualized basis
- 0 .0 9 x $600 - 0.09 x $450 - 0.09 X $150 - 0,09 x $1,100 - 0.09 x
[4,100 - 1,800] [4,100 - 600] [4,100 - 45] [4,100 - 150] [4,100 - 1,100]

Annualized net interest = $83 = $84.9 =$82.10 =$80.20 =$81.30

income

Annualized net interest $83 - 4,100 $84.9 - 4,100 $82.10 - 4,100 $78.7 - 4,100 $81.3 - 4,100
margin
= 2 .0 2 % =2.07% = 2 .0 0 % = 1,92% = 1.98%

Suppose the interest rates attached to rate-sensitive assets and liabilities rise tw o full percentage points on an annualized basis to
1 2 % and 1 0 %, respectively.

Total interest income on 0.12 x $1,700 0.12 X $310 0.12 X $440 0.12 X $480 0.12 X $1,170
an annualized basis
+0.11 X [4 ,1 0 0 - + 0 ,1 1 x +0.11 X +0.11 X + 0 .1 1 x

Total interest cost on an 1,700] - 0.10 x [4,100 - 310] [4,100 - 440] +[4,100 - 480] [4,100 - 1,170]
annualized basis
$1,800 - 0.09 x - 0 .1 0 X 600 -0 .1 0 X 450 - 0 .1 0 X 150 - 0 .1 0

[4,100 - 1,800] - 0 .0 9 X [4,100 - 600] -0 .0 9 -0 .0 9 X 1,100 - 0.09

X [4,100 - 450] [4,100 - 150] [4,100 - 1,100

Annualized net interest = $81 = $79.10 =$81.90 = $85.30 =$82.70

income

Annualized net interest $81 - 4,100 $79.1 + 4,100 $81.9 - 4,100 $85.3 - 4,100 $82.7 - 4,100
margin
= 1.98% = 1.93% = 2 .0 0 % =2.08% = 2 .0 2 %

We note by com paring annualized interest income and margins fo r each tim e period (m aturity bucket) th a t this bank's net interest
income and margin will tend to fall if it is liability sensitive when interest rates go up. W hen the bank is asset sensitive and m arket
interest rates rise, the net interest incom e and margin will tend to increase.

8 percent and 9 percent, respectively. During the com ing week
the bank holds $1,700 million in rate-sensitive assets (out o f an
asset to ta l o f $4,100 million) and $1,800 m illion in rate-sensitive
liabilities. Suppose, too, th a t these annualized interest rates
remain steady. Then this institution's net interest income on an
annualized basis will be
0.10 X $1,700 + 0.11 X [4,100 - 1,700] - 0.08 X $1,800 - 0.09
X [4,100 - 1,800] = $83 million
However, if the m arket interest rate on rate-sensitive assets rises
to 12 percent and the interest rate on rate-sensitive liabilities
rises to 10 percent during the first week, this liability-sensitive
institution will have an annualized net interest income o f only
0.12 X $1,700 + 0.11 X [4,100 - 1,700] - 0.10 X $1,800
- 0.09 X [4,100 - 1,800] = $81 m illion
Therefore, this bank will lose $2 million in net interest income
on an annualized basis if m arket interest rates rise in the com ing

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 361
week. M anagem ent must decide w hether to accept th a t risk or interest rates rise, b u t lose net interest income if m arket interest
to counter it w ith hedging strategies or tools. rates decline.

A useful overall measure o f interest rate risk exposure is the Some financial firm s shade th e ir interest-sensitive gaps tow ard
cumulative gap, which is the total difference in dollars between either asset sensitivity or liability sensitivity, depending on
those assets and liabilities th a t can be repriced over a desig- their degree o f confidence in th e ir own interest rate forecasts.
nated period o f tim e. For example, suppose th a t a bank has This is often referred to as aggressive GAP management. For
$ 1 0 0 m illion in earning assets and $ 2 0 0 million in liabilities example, if m anagem ent firm ly believes interest rates are going
subject to an interest rate change each m onth over the next to fall over the current planning horizon, it will probably allow
six months. Then its cum ulative gap must be -$ 6 0 0 m illion— interest-sensitive liabilities to clim b above interest-sensitive
th a t is: ($100 m illion in earning assets per m onth X 6 ) assets. If interest rates do fall as predicted, liability costs will
— ($200 m illion in liabilities per m onth X 6 ) = -$ 6 0 0 million. drop by more than revenues and the institution's NIM will grow.
The cum ulative gap concept is useful because, given any specific Similarly, a confident forecast o f higher interest rates will trig -
change in m arket interest rates, we can calculate approxim ately ger many financial firms to becom e asset sensitive, knowing
how net interest income will be affected by an interest rate th a t if rates do rise, interest revenues will rise by more than
change. The key relationship is this: interest expenses. O f course, such an aggressive strategy cre-
ates greater risk. Consistently correct interest rate forecasting
Change in Overall change in Size o f the
is impossible; m ost financial managers have learned to rely on
net interest = interest rate X cum ulative gap
hedging against, not forecasting, changes in m arket interest
incom e (in percentage points) (in dollars)
rates. Interest rates th a t move in the w rong direction can m ag-
(18.13)
nify losses. (See Table 18.2.)
For example, suppose m arket interest rates suddenly rise by
1 full percentage point. Then the bank in the exam ple given Many financial-service managers have chosen to a d o p t a purely
above will suffer a net interest income loss o f approxim ately defensive GAP m anagem ent strategy:

(+0.01) X (-$ 6 0 0 million) = - $ 6 million Defensive Interest-Sensitive GAP M anagem ent

Set interest-sensitive GAP as close to zero as
Aggressive Interest-Sensitive GAP Management possible to reduce the expected vo la tility o f
net interest income

Expected
Changes in Best Aggressive Problems with Interest-Sensitive GAP
interest Rates Interest-Sensitive Management's
(Management's GAP Position to Most Likely Management
Forecast) Be in: Action
W hile interest-sensitive gap m anagem ent works beautifully in
Rising m arket Positive IS GAP Increase interest- theory, practical problem s in its im plem entation always leave
interest rates sensitive assets financial institutions w ith at least some interest-rate risk e xp o -
Decrease interest- sure. For exam ple, interest rates paid on liabilities (which often
sensitive liabilities are predom inantly short term ) te n d to move faster than interest

Falling m arket Negative IS GAP Decrease interest- rates earned on assets (many o f which are long term ). Then,
interest rates sensitive assets to o , changes in interest rates attached to assets and liabilities
do not necessarily move at the same speed as do interest rates
Increase interest-
sensitive liabilities in the open m arket. In the case o f a bank, fo r exam ple, de p o sit
interest rates typically lag behind loan interest rates.

If m anagem ent anticipates an increase in interest rates, it may
be able to head o ff this pending loss o f income by shifting some
assets and liabilities to reduce the size o f the cum ulative gap
or by using hedging instrum ents (such as financial futures con-
tracts, to be discussed in C hapter 8 ). In general, financial insti-
tutions w ith a negative cum ulative gap will benefit from falling
interest rates but lose net interest incom e when interest rates
rise. Institutions w ith a positive cum ulative gap will benefit if
Some financial institutions have developed a weighted interest-
sensitive gap approach th a t takes into account the tendency o f
interest rates to vary in speed and m agnitude relative to each
other and w ith the up and down cycle o f business activity. The
interest rates attached to assets o f various kinds often change
by d iffe re n t amounts and at different speeds than many o f the
interest rates attached to liabilities— a phenom enon called
basis risk.

362 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The Weighted Interest-Sensitive Gap: Dealing with Basis Risk
Original Balance Interest-Rate Balance Sheet Refigured to
Sheet Entries Sensitivity Weight Reflect interest Rata Sensitivities

Asset items sensitive to

interest rate movements:
Federal funds loans $50 X 1 .0
—
$50.00
G overnm ent securities and 25 X 1.3 32.50
other investments
Loans and leases 125 X 1.5 —
187.50
Total rate-sensitive assets $ 2 0 0 $270.00

Liability items sensitive to

interest rate movements:
Interest-bearing deposits $159 X 0 .8 6
—
$137,00
O ther borrow ings in the money 64 X 0.91 — 58.00
m arket
Total rate-sensitive liabilities $223 $195.00

The interest-sensitive GAP -$ 2 3 i + $75

How net interest income would change if the federal funds rate in the money market increases by 2 percentage points:
Original Balance Sheet Refigured Balanced Sheet
Predicted m ovem ent in net interest income -$ 0 .4 6 +$1.50
(= — $23 X 0.02) (= +$75 X 0.02)

Table 18.2 Eliminating an Interest-Sensitive Gap

With Positive The Risk Possible Management Responses

Interest-sensitive assets > interest-
sensitive liabilities (asset sensitive)
Losses if interest rates fall because
the net interest margin will be
reduced.
1. Do nothing (perhaps interest rates will rise or
be stable).
2. Extend asset m aturities or shorten liability
maturities.
3. Increase interest-sensitive liabilities or reduce
interest-sensitive assets.

With Negative Gap The Risk Possible Management Responses

Interest-sensitive assets < interest-
sensitive liabilities (liability sensitive)
Losses if Interest rates rise because
the net interest margin will be
reduced.
1. Do nothing (perhaps interest rates will fall or
be stable).
2. Shorten asset m aturities or lengthen liability
maturities.
3. Decrease interest-sensitive liabilities or
increase interest-sensitive assets.

For exam ple, suppose a bank has the current am ount and
d is trib u tio n o f interest-sensitive assets and liabilities shown in
the table at the b o tto m o f page 234 w ith rate-sensitive assets
to ta lin g $ 2 0 0 m illion and rate-sensitive liabilities am ounting to
$223 m illion, yielding an interest-sensitive GAP o f- $ 2 3 on its
present balance sheet. Its federal funds loans generally carry
interest rates set in the open m arket, so these loans have an
interest rate sensitivity w e ig h t o f 1 .0 — th a t is, we assume the
bank's fed funds rate tracks m arket rates one fo r one. In this
bank's investm ent security p o rtfo lio , however, suppose there
are some riskier, som ew hat more rate-volatile investm ents
than m ost o f the security interest rates re p o rte d daily in the
financial press. Therefore, its average security yield moves
up and dow n by som ew hat m ore than the interest rate on

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 363
 Factoid
Financial institutions th a t hold large volumes o f home m o rt-
gage loans tend to be especially vulnerable to interest rate
risk due, in part, to the long average m aturities o f these
loans. A prom inent exam ple is tw o o f the largest home-
m ortgage finance companies in the w orld, which were
created by the U.S. governm ent and then privatized. W ho
are these tw o giant m ortgage banking firms th a t have run
into serious trou ble recently?
Answer: The Federal National M ortgage Association (FNMA,
or Fannie Mae) and the Federal Home Loan M ortgage
C orporation (FHLMC, or Freddie Mac), both o f which have
recently passed under governm ent control and may eventu-
ally be disposed of.
federal funds loans; here the interest-rate sensitivity w e ig h t
is estim ated to be 1.3. Loans and leases are the m ost rate-
volatile o f all w ith an interest rate sensitivity w e ig h t half again
as volatile as federal funds rates at an estim ated 1.5. On the
liability side, d e p o sit interest rates and some m oney m arket
borrow ings (such as bo rro w in g from the central bank) may
change m ore slowly than m arket interest rates. In this exam ple,
we assume deposits have a rate-sensitive w e ig h t o f 0 .8 6 and
m oney m arket borrow ings are slightly m ore volatile at 0.91,
close to b u t still less than the v o la tility o f federal funds interest
rates.
We can simply m ultiply each o f the rate-sensitive balance-sheet
items by its appropriate interest rate sensitivity indicator, which
acts as a w eight. M ore rate-volatile assets and liabilities will
weigh more heavily in the refigured (weighted) balance sheet
we are constructing in the previous table. N otice th a t after m ul-
tip lyin g by the interest rate weights we have created, the new
w eighted balance sheet has rate-sensitive assets o f $270 and
rate-sensitive liabilities o f $195. Instead o f a negative (liability-
sensitive) interest rate gap o f -$ 2 3 , we now have a positive
(asset-sensitive) rate gap o f +$75.
Thus, this institution's interest-sensitive gap has changed
direction and, instead o f being hurt by rising m arket interest
rates, fo r exam ple, this financial firm w ould actually b e n e fit
from higher m arket interest rates. Suppose the federal funds
interest rate rose by 2 percentage points (+0.02). Instead o f
declining by -$ 0 .4 6 , this bank's net interest incom e increases
by $1.50. Clearly, m anagem ent w ould have an entirely d iffe r-
ent reaction to a forecast o f rising interest rates w ith the new
w e ig h te d balance sheet than it w ould have w ith its original,
364 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
CONCEPT CHECK
18.9. Can you explain the concept o f gap management?
18.10. W hen is a financial firm asset sensitive? Liability
sensitive?
18.11. Com merce National Bank reports interest-sensitive
assets o f $870 m illion and interest-sensitive liabili-
ties o f $625 m illion during the com ing m onth. Is
the bank asset sensitive or liability sensitive? W hat
is likely to happen to the bank's net interest mar-
gin if interest rates rise? If they fall?
18.12. People's Savings Bank has a cum ulative gap fo r
the com ing year o f +$135 m illion, and interest
rates are expected to fall by tw o and a half per-
centage points. Can you calculate the expected
change in net interest income th a t this th rift insti-
tu tio n m ight experience? W hat change will occur
in net interest income if interest rates rise by one
and a quarter percentage points?
18.13. How do you measure the dollar interest-sensitive
gap? The relative interest-sensitive gap? W hat is
the interest sensitivity ratio?
18.14. Suppose Carroll Bank and Trust reports interest-
sensitive assets o f $570 million and interest-
sensitive liabilities o f $685 million. W hat is the
bank's dollar interest-sensitive gap? Its relative
interest-sensitive gap and interest-sensitivity ratio?
18.15. Explain the concept o f weighted interest-sensitive
gap. How can this concept aid m anagem ent in
measuring a financial institution's real interest-
sensitive gap risk exposure?
conventionally constructed balance sheet. Indeed, when it
comes to assessing interest rate risk, things are not always as
they appear!
M oreover, the p o in t at which certain assets and liabilities
can be repriced is n o t always easy to identify. For exam ple,
checkable deposits and savings accounts may have th e ir inter
est rates adjusted up or dow n at any tim e . A nd the choice
o f planning periods over which to balance interest-sensitive
assets and liabilities is highly arbitrary. Some item s always
fall betw een the cracks in se ttin g planning periods, and
th e y could cause tro u b le if interest rates m ove against the
financial firm . Wise asset-liability m anagers use several d if-
fe re n t lengths o f planning periods ("m a tu rity buckets") in
m easuring th e ir possible exposure to changing m arket interest
rates.
Finally, interest-sensitive gap m anagem ent does not con-
sider the im pact o f changing interest rates on the owners'
(stockholders') position in the financial firm as represented by
the institution's net worth. M anagers choosing to pursue an
aggressive interest rate sensitive gap policy may be able to
expand th e ir institution's net interest m argin, b u t at the cost o f
increasing the v o la tility o f net earnings and reducing the value
o f the stockholders' investm ent (net w orth). Effective asset-
lia b ility m anagem ent dem ands th a t financial managers w ork
to achieve desirable levels o f both net interest incom e and net
w orth.
The standard form ula fo r calculating the duration (D) o f an indi-
vidual financial instrum ent, such as a loan, security, deposit, or
nondeposit borrow ing, is
n
^ X Expected CF in Period t X Period t/(1 + YTM)'
t= i
D =
Expected CF in Period t
(1 + YTM)'
(18.14)
D stands fo r the instrum ent's duration in years and fractions o f a
year; t represents the period o f tim e in which each flo w o f cash
o ff the instrum ent, such as interest or dividend income, is to be
received; CF indicates the volum e o f each expected flo w o f cash
in each tim e period (t); and YTM is the instrum ent's current yield
to m aturity. We note th a t the denom inator o f the above form ula
is equivalent to the instrum ent's current m arket value (price). So,
the duration form ula can be abbreviated to this form :

18.5 THE CONCEPT OF DURATION n

^ E x p e c te d CF X Period t/(1 + YTM ) 11
AS A RISK-MANAGEMENT TOOL (18.15)
C urrent M arket Value or Price

In the preceding sections o f this chapter we exam ined a key For example, suppose th a t a bank grants a loan to one o f its
m anagem ent to o l— interest-sensitive gap management— th a t customers fo r a term o f five years. The custom er promises the
enables managers o f financial institutions to com bat the pos- bank an annual interest paym ent o f 10 percent (that is, $ 1 0 0 per
sibility o f losses to th e ir institution's net interest margin or year). The face (par) value o f the loan is $1,000, which is also its
spread due to changes in m arket interest rates. U nfortunately, current m arket value (price) because the loan's current yield to
changing interest rates can also do serious dam age to another m aturity is 10 percent. W hat is this loan's duration? The form ula
aspect o f a financial firm 's perform ance— its net worth, the w ith the proper figures entered w ould be this:
value o f the stockholders' investm ent in the in stitution. Just 5
because the net interest m argin is p ro te cte d against interest 2 $ 1 0 0 X t/(1 + .10)' + $1,000 X 5/(1 + .10 ) 5
t=i
rate risk d o e sn 't mean an institution's net w o rth is also shel-
$ 1,000
tered from loss, and fo r m ost com panies net w o rth is more
$4,169.87
im p o rta n t than th e ir net interest m argin. This requires the
$ 1,000
application o f yet another m anagerial to o l— duration gap
management. We turn now to look at the concept o f duration D Loan = 4.17 years

and its many valuable uses.
What Is Duration?
Duration is a value- and tim e -w eighted measure o f m aturity
th a t considers the tim in g o f all cash inflows from earning assets
and all cash outflow s associated w ith liabilities. It measures the
average m aturity o f a prom ised stream o f future cash payments
(such as the paym ent streams th a t a financial firm expects to
receive from its loans and security investments or the stream o f
interest payments it must pay out to its depositors). In effect,
duration measures the average tim e needed to recover the
funds com m itted to an investm ent.
We can calculate duration o f this loan a little more simply by
setting up the table below to figure the com ponents o f the fo r-
mula. As before, the duration o f the loan is $4,169.87/$1,000.00,
or 4.17 years.
We recognize from C hapter 5 th a t the net w orth (NW) o f any
business or household is equal to the value o f its assets less the
value o f its liabilities:
NW = A - L (18.16)
As m arket interest rates change, the value o f both a finan-
cial institution's assets and its liabilities will change, resulting
in a change in its net w orth (the owner's investm ent in the
institution):

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 365
 Present Value of
Period of Expected Cash Time Period Present Value of
Expected Expected Cash Flow (at 10% Cash Is to Be Expected Cash
Cash Flows Flow from Loan YTM in this Case) Received (t) Flows X t
r 1 $ 100 $90.91 1 $ 90.91

2 100 82.64 2 165.29

Expected Interest
< 3 100 75.13 3 225.39
Income from loan
4 100 68.30 4 273.21

<
5 100 62.09 5 318.46

Repayment o f loan 5 1 ,0 0 0 620.92 5 3,104.61

principal

Price or D enom inator o f Formula = $1,000.00 PV o f Cash Flows X t = $4,169.87

A N W = A A - AL (18.17) where AP -j- P represents the percentage change in market price

and Ai -s- (1 + 0 is the relative change in interest rates associated
P ortfolio theory teaches us th a t
with the asset or liability. D represents duration, and the negative
1. A rise in m arket rates o f interest will cause the m arket value sign attached to it reminds us that market prices and interest rates
(price) o f both fixed-rate assets and liabilities to decline. on financial instruments move in opposite directions. For example,
2. The longer the m aturity o f a financial firm 's assets and consider a bond held by a savings institution that carries a dura-
liabilities, the more they will tend to decline in m arket value tion o f four years and a current market value (price) o f $ 1 ,0 0 0 .
(price) when m arket interest rates rise. Market interest rates attached to comparable bonds are about
10 percent currently, but recent forecasts suggest th a t m arket
Thus, a change in net w orth due to changing interest rates
rates may rise to 11 percent. If this forecast turns o u t to be cor-
will vary depending upon the relative m aturities o f a financial
rect, w hat percentage change will occur in the bond's m arket
institution's assets and liabilities. Because duration is a measure
value? The answer is:
o f m aturity, a financial firm w ith longer-duration assets than
liabilities will suffer a greater decline in net w orth when m arket AP
= - 4 years X (0.01 )/(1 + 0.10) = -0 .0 3 6 4 , or - 3.64 percent
interest rates rise than a financial institution whose asset dura-
tion is relatively short term or one th a t matches the duration o f
Equation (18.18) tells us th a t the interest-rate risk o f financial
its liabilities w ith the duration o f its assets. By equating asset
instrum ents is directly proportional to th e ir durations. A financial
and liability durations, m anagem ent can balance the average
instrum ent whose duration is 2 will be tw ice as risky (in term s o f
m aturity o f expected cash inflows from assets w ith the average
price volatility) as one w ith a duration o f 1 .
m aturity o f expected cash outflow s associated w ith liabilities.
Thus, duration analysis can be used to stabilize, or immunize,
the m arket value o f a financial institution's net w orth (NW).
Convexity and Duration
The relationship between an asset's change in price and its

Price Sensitivity to Changes in Interest
Rates and Duration
The im portant feature o f duration from a risk-m anagem ent
p o in t o f view is th a t it measures the sensitivity o f the m arket
value o f financial instrum ents to changes in interest rates. The
percentage change in the m arket price o f an asset or a liability
is equal to its duration tim es the relative change in interest rates
attached to th a t particular asset or liability. That is,
AP A/
— ~ - D X ----------- (18.18)
P d + 0
change in yield or interest rate is captured by a key term in
finance th a t is related to duration— convexity. Convexity refers
to the presence o f a nonlinear relationship between changes
in an asset's price and changes in m arket interest rates. It is a
num ber designed to aid p o rtfo lio managers in measuring and
controlling the m arket risk in a p o rtfo lio o f assets. An asset or
p o rtfo lio bearing both a low duration and low convexity nor-
mally displays relatively small m arket risk.
C onvexity increases w ith the duration (maturity) o f an asset. It
tells us th a t the rate o f change in any interest-bearing asset's
price (m arket value) fo r a given change in interest rates varies

366 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
according to the prevailing level of interest rates. For example, be insolvent!), a financial in stitu tio n seeking to m inim ize the
an interest-bearing asset's price m ovem ent tends to be greater effects o f interest rate fluctuations wou Id need to adjust fo r
at low interest rates than it does at high interest rates. Price risk leverage:
is greater when interest rates are low than when they are high.
Leverage D ollar-w eighted D ollar-w eighted
Moreover, the low er the degree o f convexity (i.e., low er curva-
adjusted = duration - duration o f
ture in the price-interest rate relationship fo r a given asset), the
duration o f asset liabilities
low er the price vo la tility o f th a t asset tends to be. p o rtfo lio p o rtfo lio
gap
As an illustration suppose th a t the interest rate or yield attached Total liabilities
to a 30-year bond decreases from 6.5 percent to 6 percent. X — -----:------------ (18.21)
Total assets
Then this bond's price will rise by about 8 points (i.e., by about
$8 per $1,000 in face value). In contrast, suppose the asset's
Equation (18.21) tells us th a t the value o f liabilities must change
interest rate falls from 10 percent to 9.5 percent; then its m arket
by slightly more than the value o f assets to elim inate a financial
price will rise by just slightly more than 4 points (about $4 per
firm 's overall interest-rate risk exposure.
$1,000 in face value). Moreover, if we hold the m aturity and
yield constant, convexity will fall as the asset's prom ised return The larger the leverage-adjusted duration gap, the more sensi-

(coupon rate) rises. Financial managers using asset-liability man- tive will be the net w orth (equity capital) o f a financial institution
to a change in interest rates. For example, if we have a positive
agem ent techniques to p ro te ct the value o f a financial firm's
asset must keep in mind th a t asset values change differently leverage-adjusted duration gap, a parallel change in all inter-

according to their duration, their prom ised (coupon) rates o f est rates will result in the value o f liabilities changing by less (up

return, and the prevailing level o f m arket interest rates (the con- or down) than the value o f assets. In this case, a rise in interest

vexity fa cto r ) . 4 rates will tend to lower the m arket value o f net w orth as asset
values fall fu rth e r than the value o f liabilities. The owner's equity
in the institution will decline in m arket value terms. On the other
18.6 USING DURATION TO HEDGE hand, if a financial firm has a negative leverage-adjusted dura-

AGAINST INTEREST RATE RISK tion gap, then a parallel change in all interest rates will generate
a larger change in liability values than asset values. If inter-
est rates fall, liabilities will increase more in value than assets
A financial-service provider interested in fully hedging against
and net w orth will decline. Should interest rates rise, however,
interest rate fluctuations wants to choose assets and liabilities
liability values will decrease faster than asset values and the net
such th a t
w orth position will increase in value.
The dollar-w eighted duration The dollar-w eighted duration
We can calculate the change in the m arket value o f a financial
o f the asset p o rtfo lio o f liabilities
institution's net w orth if we know its dollar-w eighted aver-
(18.19)
age asset duration, its dollar-w eighted average liability dura-
so th a t the duration gap is as close to zero as possible (see tion, the original rate o f discount applied to the institution's
Table 18.3): cash flows, and how interest rates have changed during the
period we are concerned about. The relevant form ula is based
D ollar-w eighted D ollar-w eighted upon the balance-sheet relationship we discussed earlier in
_ . duration duration Equation (18.17):
Duration qap =
3 o f asset o f liability
p o rtfo lio p o rtfo lio A N W = A A - AL

(18.20) Because A A /A is approxim ately equal to the product o f asset

Ai
Because the dollar volum e o f assets usually exceeds the d o l- duration tim es the change in interest rates -D a X
(1 + 0
lar volum e o f liabilities (otherwise the financial firm w ould
and is AL/L approxim ately equal to liability duration tim es the
Ai
change in interest rates -D , X , it follow s th a t
1 + i
4 As noted above, convexity is related to duration. Specifically, we can
approximate the degree of curvature in the interest rate-asset price Ai Ai
ANW Da x x A —D l X
relationship using d + 0 d + 0

Convexity = (Duration) — (Change in duration/Change in interest rates). (18.22)

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 367
Table 18.3 Use of Duration A nalysis to Hedge Interest Rate M ovem ents

A. Calculate the dollar-w eighted average duration o f a financial firm 's earning assets and liabilities from the follow ing
Tim e-w eighted distribution o f expected cash
D ollar-w eighted
inflows from loans and securities
asset duration
Present value o f loans and securities held
in years

H, (Expected cash inflows X Time period received)

2 (1 + Discount rate ) 1
t= 1
Da =
" Expected cash inflows
t= i (1 + Discount rate)*

D ollar-w eighted Tim e-w eighted distribution o f expected cash

liability outflow s due to interest expenses
duration in Present value o f liabilities
years

2, (Expected cash outflow s X Time period paid out)

2
t=1 (1 + Discount rate ) 1
D, =
" Expected cash outflow s
t= i (1 + Discount rate ) 11

B. Plan the acquisition o f earning assets and liabilities so that, as closely as possible,

D ollar-w eighted D ollar-w eighted ^ Total liabilities

0
asset duration liability duration Total assets

in order to p ro te ct the value o f net w orth (equity capital).

In words,
Change in Change in
Changein value -A v e ra g e -A v e ra g e
interest rate Total interest rate Total
o f a financial institution's duration X ____________ X duration X (18.23)
(1 + O riginal assets (1 + O riginal liabilities
net w orth o f assets o f liabilities
discount rate) discount rate)

For example, suppose th a t a financial firm has an average dura- Clearly, this institution faces a substantial decline in the value o f
tion in its assets o f three years, an average liability duration of its net w orth unless it can hedge itself against the projected loss
tw o years, total liabilities o f $ 1 0 0 m illion, and to ta l assets o f due to rising interest rates.
$120 m illion. Interest rates were originally 10 percent, but sud-
Let's consider an exam ple o f how duration can be calculated
denly they rise to 12 percent.
and used to hedge a financial firm 's asset and liability portfo lio.
n this example: We take advantage o f the fact th a t the duration o f a p o rtfo lio o f

Change in the assets and o f a p o rtfo lio o f liabilities equals the value-w eighted
+ 0.02 average o f the duration o f each instrum ent in the p o rtfo lio . We
value o f -3 X X $120 million
(1 + 0 . 10) can start by ( 1 ) calculating the duration o f each loan, deposit,
net w orth
and the like; (2 ) w eighting each o f these durations by the
+0.02
-2 X X $100 million — -$ 2 .9 1 million m arket values o f the instruments involved; and (3) adding all
(1 + 0 . 10)

368 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
value-w eighted durations to g e th e r to derive the duration o f a Duration is a measure o f average maturity, which fo r this bank's
financial institution's entire portfo lio. p o rtfo lio o f assets is about three years. The bank can hedge
against the dam aging effects o f rising deposit interest rates by
For exam ple, suppose m anagem ent o f a bank finds th a t it holds
making sure the dollar-w eighted average duration o f its liabili-
a U.S. Treasury $1,000 par bond w ith 10 years to final m aturity,
ties is also approxim ately three years . 5 In this way the present
bearing a 10 percent coupon rate w ith a current price o f $900.
value o f bank assets will balance the present value o f liabilities,
Based on the form ula shown in Equation (18.15), this bond's
approxim ately insulating the bank from losses due to fluctuating
duration is 7.49 years.
interest rates.
Suppose this bank holds $90 m illion o f these Treasury
The calculation o f d u ra tio n fo r lia b ilitie s proceeds in the
bonds, each w ith a duration o f 7.49 years. The bank
same way as asset durations are calculated. For exam ple,
also holds o th e r assets w ith durations and m arket values as
suppose this same bank has $100 m illion in n e g o tia b le CDs
follow s:
o u tsta n d in g on which it m ust pay its custom ers a 6 p e rce n t
annual yield over th e next tw o calendar years. The d u ra tio n o f
Actual or Estimated these CDs w ill be d e te rm in e d by the d is trib u tio n o f cash pay-
Market Values of Asset
m ents m ade over th e next tw o years in present-value term s.
Assets Held Assets Durations
Thus:
Treasury bonds $90 million 7.49 years
$6 X 1 $6X2 $100 X 2
Commercial loans 100 million 0.60 year Duration o f _ (1.06)1 (1.06)2 (1.06)2
1.943 years
Consumer loans 50 million 1 .2 0 years negotiable CDs $100

Real estate loans 40 million 2.25 years We w ould go th ro u g h the same calculation fo r the rem ain-

Municipal bonds 20 million 1.50 years ing liabilities in this exam ple, as illustrated in Table 18.4. This
in stitu tio n has an average liab ility duration o f 2.669 years,
substantially less than the average duration o f its asset p o rt-
W eighting each asset duration by its associated dollar
fo lio , which is 3.047 years. Because the average m aturity o f
volum e, we calculate the duration o f the asset p o rtfo lio as
its liabilities is shorter than the average m aturity o f its assets,
follows:
this financial firm 's net w o rth will decrease if interest rates rise
n
Duration o f M arket value and increase if interest rates fall. Clearly, m anagem ent has
2 each asset in X o f each asset positioned this in stitu tio n in the hope th a t interest rates will fall
D ollar-w eighted • ___ ^

I_ the p o rtfo lio in the p o rtfo lio in the period ahead. If there is a substantial p ro b a b ility inter-
asset p o rtfo lio
Total m arket value est rates will rise, m anagem ent may w ant to hedge against
duration
o f all assets dam age from rising interest rates by lengthening the average
(7 .49 years X $90 m illion in Treasury bonds m aturity o f its liabilities, shortening the average m atu rity o f its
assets, or em ploying hedging tools (such as financial futures,
+ 0.60 year X $100 m illion in commercial loans options, or swaps, as discussed in the next chapter) to cover
this duration gap.
+ 1.20 years X $50 m illion in consumer loans

+ 2.25 years X $40 m illion in real estate loans

+ 1.50 years X $20 m illion in municipal bonds)

($90 m illion + $100 m illion + $50 million
5 As noted earlier, we must adjust the duration of the liability port­
+ $40 m illion + $20 million) folio by the value of the ratio of total liabilities to total assets
because asset volume typically exceeds the volume of liabilities. For
_ $914.10 million example, suppose the bank described in the example above has
$300 million an asset duration of three years and its total assets are $100 mil­
lion while total liabilities are $92 million. Then management will
= 3.047 years (18.24)
want to achieve an approximate average duration for liabilities of
3.261 years (or asset duration X total assets -h total liabilities =
3 years X $100 million -r- $92 million = 3.261 years).

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 369
 REAL BANKS, REAL DECISIONS
DURATION GAP MANAGEMENT AT THE
WORLD'S LARGEST MORTGAGE BANK
The w orld's leading m ortgage banking institution— the Fed-
eral National M ortgage Association (FNMA), b e tte r known
as Fannie Mae— reports its duration gap on a m onthly basis.
Fannie is a crucial institution supporting the U.S. housing
market. It issues notes and bonds to raise new capital and
then uses the proceeds to purchase residential m ortgages
from private lenders and to package home loans into pools
th a t support the issuance o f m ortgage-backed securities.
Fannie has contributed significantly to making more families
eligible to receive loans in order to purchase new homes.
As m arket interest rates plum m eted early in the 21st century
and the volum e o f home m ortgage financings soared, FN M A
experienced a significant shift in the average m aturity of
its assets and liabilities. Lengthening liabilities and shorter-
term assets generated a negative duration gap o f about
14 months at the close o f 2002. Fannie's assets were rolling
over into cash more than a year sooner than its liabilities. If
m arket interest rates had continued to fall, the value o f Fan-
nie's net w orth w ould also have continued to decline as lon-
ger-term liabilities increased in value relative to shorter-term
assets. Investors in the financial markets reacted negatively to
FNMA's announcem ent o f a w idening negative duration gap
and its stock price fell fo r a tim e.
Fannie strives to maintain a duration gap between negative
6 m onths and positive 6 months. By 2002 Fannie Mae had its
duration gap in line w ith this objective— a negative 6 months.
By Septem ber 2007 its m onthly duration gaps fell w ithin the
- 1 m onth to + 1 m onth range and, in fact, was listed as zero.
Fannie faced an uncertain future, however, in the wake o f a
serious global credit crisis and possible revocation o f U.S.
governm ent support. (Fannie publishes its duration gap cal-
culations on its website at www.fanniemae.com.)

Table 18.4 Calculating the Duration of a Bank's Assets and Liabilities (Dollars in Millions)
Interest Average Interest Average
Rate Duration Rate Duration
Composition Attached of Each Attached of Each
of Assets Market to Each Category Composition of Liabilities Market to Each Liability
(uses of Value of Category of Assets and Equity Capital Value of Liability Category
funds) Assets of Assets (in years) (sources of funds) Liabilities Category (in years)

U.S. Treasury $90 1 0 .0 0 % 7.490 N egotiable CDs $100 6 .0 0 % 1.943

securities

Municipal 20 6 .0 0 1.500 O ther tim e deposits 125 7.20 2.750

bonds

Commercial 100 1 2 .0 0 0.600 Subordinated notes 50 9.00 3.918

loans

Consumer 50 15.00 1 .2 0 0 Total liabilities 275

loans

Real estate 40 13.00 2,250 Stockholders' equity capital 25

loans

Total $300 Average Total $300 Average in

in Years Years 2.669
3.047

$90 $20 $100 $50 $40

Duration o f assets = x 7.49 + -F-— x 1.50 + T -— x 0.60 + x 1.20 + -F-— x 2.25
$300 $300 $300 $300 $300
3.047 years
$100 $125 $50
Duration o f liabilities = X 1.943 + t t t t X 2.750 + T ir r X 3.198 = 2.669 years
$275 $275 $275

370 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
 C urrent leverage-adjusted _ Average asset Average liability ^ Total liabilities
duration gap duration duration Total assets

$275
= 3.047 years - 2.669 years X — — = +0.60 year
4>o(JU

Management Interpretation
The positive duration gap o f +0.60 year means th a t the bank's net w orth will decline if interest rates rise and increase if interest
rates fall. M anagem ent may be anticipating a decrease in the level o f interest rates. If there is significant risk o f rising m arket inter-
est rates, however, the asset-liability m anagem ent com m ittee will w ant to use hedging tools to reduce the exposure o f net w orth
to interest rate risk.

How much will the value o f this bank's net worth change fo r any given change in interest rates? The appropriate form ula is as follows:

Change in value _ q Ar Ar
A - -D L
o f net w orth A (1 + r) d + r)
where A is total assets, DA the average duration o f assets, r the initial interest rate, A r the change in interest rates, L total liabilities,
and D l the average duration o f liabilities.

Example: Suppose interest rates on both assets and liabilities rise from 8 to 10 percent. Then filling in the asset and liability figures
from the table above gives this result:

Change in
(+ 002 )
value o f 3.047 years X — ------ X $300 m illion — -2 .6 6 9 years X — — ____ X $275 million
y ( 1 + 0.08) (1 + 0.08)
net w orth
= -$ 1 6 .9 3 m illion + $13.59 m illion = -$ 3 .3 4 m illion

This institution's net w orth w ould fall by approxim ately $3.34 m illion if interest rates increased by 2 percentage points.

Suppose interest rates fall from 8 percent to 6 percent, w hat w ould happen to the value o f the above institution's net worth?
Again, substituting in the same form ula:

Change in value ( - 0 . 02 ) ( - 0 .02) „

— -3 .0 4 7 years X X $300 m illion — -2 .6 6 9 years X - — — — X $275 million
o f net w orth (1 + 0.08) 1 + .08

= $16.93 m illion - $13.59 m illion = +$3.34 million

In this instance, the value o f net w orth w ould rise by about $3.34 m illion if all interest rates fell by 2 percentage points.

The above form ula reminds us th a t the im pact o f interest rate changes on the m arket value o f net w orth depends upon three cru-
cial size factors:

A. The size o f the duration gap (DA — DL), w ith a larger duration gap indicating greater exposure o f a financial firm to interest
rate risk.

B. The size o f a financial institution (A and L), w ith larger institutions experiencing a greater change in net w orth fo r any given
change in interest rates.

C. The size o f the change in interest rates, w ith larger rate changes generating greater interest rate risk exposure.
M anagem ent can reduce a financial firm 's exposure to interest rate risk by closing up the firm 's duration gap (changing DA, DL, or
both) or by changing the relative am ounts o f assets and liabilities (A and L) outstanding.
For example, suppose in the previous exam ple the leverage-adjusted duration gap, instead o f being + 0.60 year, is zero. If the
average duration o f assets (DA) is 3.047 years (and assets and liabilities equal $300 and $275 m illion, respectively) this w ould mean
the institution's average liability duration (DL) must be as follows:

C urrent Average asset Average liability

everage-adjusted duration duration Total liabilities
X
duration (Da) (D l) Total assets
gap

(Continued)

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 371
Table 18.4 C o n tin u e d
or
_ $275
0 = 3.047 - Average liability duration (DL) X
4>oU(J

Then
Average liability _ ^
duration (DL)
Suppose, once again, market interest rates all rise from 8 percent to 10 percent. Then the change in the value of net worth would
be as shown below:

Change in
( + 0 . 02 )
value of = -3.047 years X —--- ■X $300 million -3.324 years X X $275 million
y ( 1 + 0.08) (1 + 0.08)
net worth
= -$16.93 million + $16.93 million = 0
As expected, with asset and liability durations perfectly balanced (and adjusted for differences in the amounts of total assets ver­
sus total liabilities), the change in net worth must be zero. Net worth doesn't move despite the rise in market interest rates.
It shouldn't surprise us to discover that if market interest rates drop from, say, 8 percent to 6 percent, net worth will also not
change if asset and liability durations are perfectly balanced. Thus:

Change in
( - 0 . 02 ) ( - 0 -02 ) „
value of — -3.047 years X —---- —— - X $300 mi ion -3.324 years X ------- — X $275 mi lion
y ( 1 + 0.08) y 1 + .08
net worth
= +$16.93 million - $16.93 million = 0
The change in the value of the financial firm's net worth must be zero because assets and liabilities, adjusted for the difference in
their dollar amounts, exhibit a similar response to interest rate movements.

In summary, the impact of changing market interest rates on net (duration gap = 0). They may be willing to take some chances in
worth is indicated by entries in the following table: an effort to maximize the shareholders' position. For example,

The Financial Expected

If the Financial Institution's And If Institution's Change in Management
Leverage-Adjusted Duration Interest Net Worth Interest Rates Action Possible Outcome
Gap Is: Rates: Will:
Rates will rise Reduce DA and Net worth increases
Liabilities Rise Decrease increase DL (moving (if management's
Positive DA > DL X closer to a negative rate forecast is
Assets Fall Incrgease
duration gap). correct).
Liabilities Increase
Negative DA < DL X Rates will fall Increase DA and Net worth Increases
Assets Decrease reduce DL (moving (if management's
closer to a positive rate forecast is
Liabilities Rise No Change
Zero DA = DL X duration gap). correct).
Assets Fall No Change

In the final case, with a leverage-adjusted duration gap of zero,

the financial firm is immunized against changes in the value
of its net worth. Changes in the market values of assets and
liabilities will simply offset each other and net worth will remain
where it is.
Of course, more aggressive financial-service managers may not
like the seemingly "wimpy" strategy of portfolio immunization
18.7 THE LIMITATIONS OF DURATION
GAP MANAGEMENT
While duration is simple to interpret, it has limitations. For one
thing, finding assets and liabilities of the same duration that fit
into a financial-service institution's portfolio is often a frustrating
task. It would be much easier if the maturity of a loan or security

372 Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
equaled its duration; however, for financial instruments paying
out gradually over time, duration is always less than calendar
maturity. Only in the case of instruments like zero-coupon secu­
rities, single-payment loans, and Treasury bills does the duration
of a financial instrument equal its calendar maturity. The more
frequently a financial instrument pays interest or pays off princi­
pal, the shorter is its duration. One useful fact is that the shorter
the maturity of an instrument, the closer the match between its
maturity and its duration is likely to be.
Some accounts held by depository institutions, such as check­
able deposits and passbook savings accounts, may have a
pattern of cash flows that is not well defined, making the cal­
culation of duration difficult. Moreover, customer prepayments
distort the expected cash flows from loans and so do customer
defaults (credit risk) when expected cash flows do not happen.
Moreover, duration gap models assume that a linear relationship
CO N CEPT CH ECK
18.16. What is duration?
18.17. How is a financial institution's duration gap
determined?
18.18. What are the advantages of using duration as an
asset-liability management tool as opposed to
interest-sensitive gap analysis?
18.19. How can you tell if you are fully hedged using
duration gap analysis?
18.20. What are the principal limitations of duration gap
analysis? Can you think of some way of reducing
the impact of these limitations?
18.21. Suppose that a savings institution has an aver­
age asset duration of 2.5 years and an average
liability duration of 3.0 years. If the savings/insti-
tutiori holds total assets of $560 million and total
liabilities of $467 million, does it have a significant
leverage-adjusted duration gap? If interest rates
rise, what will happen to the value of its net worth?
18.22. Stilwater Bank and Trust Company has an aver­
age asset duration of 3.25 years and an average
liability duration of 1.75 years. Its liabilities amount
to $485 million, while its assets total $512 million.
Suppose that interest rates were 7 percent and
then rise to 8 percent. What will happen to the
value of the Stilwater bank's net worth as a result
of a decline in interest rates?
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques
exists between the market values (prices) of assets and liabilities
and interest rates, which is not strictly true.
A related problem with duration analysis revolves around the
concept of convexity. Duration gap analysis tends to be reason­
ably effective at handling interest rate risk problems if the yield
curve (i.e., the maturity structure of interest rates) changes by
relatively small amounts and moves in parallel steps with short­
term and long-term interest rates changing by about the same
proportion over time. However, if there are major changes
in interest rates and different interest rates move at different
speeds, the accuracy and effectiveness of duration gap manage­
ment decreases somewhat. Moreover, yield curves in the real
world typically do not change in parallel fashion—short-term
interest rates tend to move over a wider range than long-term
interest rates, for example—and a big change in market inter­
est rates (say, one or two percentage points) can result in a
distorted reading of how much interest rate risk a financial man­
ager is really facing. Duration itself can shift as market interest
rates move, and the durations of different financial instruments
can change at differing speeds with the passage of time.
Fortunately, recent research suggests that duration balancing
can still be effective, even with moderate violations of the tech­
nique's underlying assumptions. We need to remember, too,
that duration gap analysis helps a financial manager better man­
age the value of a financial firm to its shareholders (i.e., its net
worth). In this age of mergers and continuing financial-services
industry consolidation, the duration gap concept remains a valu­
able managerial tool despite its limitations.
SUMMARY*•
The managers of financial-service companies focus heavily today
on the management of risk—attempting to control their exposure
to loss due to changes in market rates of interest, the inability
of borrowers to repay their loans, regulatory changes, and other
risk-laden factors. Successful risk management requires effec­
tive tools that provide managers with the weapons they need to
achieve their institution's goals. In this chapter several of the most
important risk-management tools for financial firms were dis­
cussed. The most important points in the chapter include:
• Early in the history of banking managers focused principally
upon the tool of asset management—emphasizing control
and selection of assets to achieve institutional goals because
liabilities were assumed to be dominated by customer deci­
sions and government rules.
• Later, liability management tools emerged in which managers
discovered they could achieve a measure of control over the
■ 373
 liabilities on their balance sheet by changing interest rates
and other terms offered to the public, in order to raise new
funds.
• More recently, many financial firms have practiced funds
management, discovering how to coordinate the manage­
ment of both assets and liabilities in order to achieve institu­
tional goals.
• One of the strongest risk factors financial-service managers
have to deal with every day is interest rate risk. Managers
cannot control market interest rates, but instead they must
learn how to react to interest rate changes in order to control
their risk exposure.
• One of the most popular tools for handling interest rate risk
exposure is interest-sensitive gap management, which focuses
upon protecting or maximizing each financial firm's net inter­
est margin or spread between interest revenues and interest
costs. Managers determine for any given time period whether
their institution is asset sensitive (with an excess of interest
rate-sensitive assets) or liability sensitive (with more rate-
sensitive liabilities than rate-sensitive assets). These interest-
sensitive gaps are then compared with the financial firm's inter­
est rate forecast, and management takes appropriate action.
• Managers soon discovered that interest-sensitive gap man­
agement didn't necessarily protect a financial firm's net
worth—value of shareholders' investment in the institu­
tion. This job required the development of duration gap
management.
• Based on the concept of duration—a value- and time-
weighted measure of maturity— the managers of financial
institutions learned how to assess their exposure to loss in
net worth from relative changes in the value of assets and
liabilities when market interest rates change. This technique
points to the importance of avoiding large gaps between
average asset duration and average liability duration.

KEY TERMS
asset-liability management, 350 yield to maturity (YTM), 352 duration gap management, 365
asset management, 350 bank discount rate, 353 duration, 365
liability management, 350 maturity gap, 355 convexity, 366
funds management, 351 net interest margin, 356 duration gap, 367
interest rate risk, 351 interest-sensitive gap management, 356 portfolio immunization, 372

374 Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

PROBLEMS AND PROJECTS

1. A government bond is currently selling for $1,195 7. New Comers State Bank has recorded the following
and pays $75 per year in interest for 14 years when it financial data for the past three years (dollars in millions):
matures. If the redemption value of this bond is $1,000,
what is its yield to maturity if purchased today for Current Previous Two Years
$1,195? Year Year Ago

2. Suppose the government bond described in Problem 1 Interest revenues $82.00 $80.00 $78.00
above is held for five years and then the savings institu­ Interest expenses 64.00 66.00 68.00
tion acquiring the bond decides to sell it at a price of
Loans (excluding 450.00 425.00 400.00
$940. Can you figure out the average annual yield the nonperforming)
savings institution will have earned for its five-year invest­
Investments 200.00 195.00 200.00
ment in the bond?
Total deposits 450.00 425.00 400.00
3. U.S. Treasury bills are available for purchase this week
at the following prices (based upon $100 par value) and Money market 150.00 125.00 100.00
with the indicated maturities: borrowings

a. $97.25, 182 days
b. $95.75, 270 days
c. $98.75, 91 days
Calculate the bank discount rate (DR) on each bill if
it is held to maturity. What is the equivalent yield to
maturity (sometimes called the bond-equivalent or
coupon-equivalent yield) on each of these Treasury bills?
What has been happening to the bank's net interest
margin? What do you think caused the changes you have
observed? Do you have any recommendations for New
Comers' management team?
8 . The First National Bank of Dogsville finds that its asset
and liability portfolio contains the following distribution
of maturities and repricing opportunities:

4. Farmville Financial reports a net interest margin of 2.75 Next More

percent in its most recent financial report, with total Coming Next 30 31-90 Than
interest revenue of $95 million and total interest costs Week Days Days 90 Days
of $82 million. What volume of earning assets must the
Loans $200.00 $300.00 $475.00 $525.00
bank hold? Suppose the bank's interest revenues rise by
5 percent and interest costs and earning assets increase Securities 21.00 26.00 40.00 70.00
9 percent. What will happen to Farmville's net interest Interest-
margin? sensitive
assets
5. If a credit union's net interest margin, which was 2.50
percent, increases 10 percent and its total assets, which Transaction $320.00 $0.00 $0.00 $0.00
deposits
stood originally at $575 million, rise by 20 percent, what
change will occur in the bank's net interest income? Time accounts 100.00 290.00 196.00 100.00

6 . The cumulative interest rate gap of Poquoson Sav­ Money market 136.00 140.00 100.00 65.00
ings Bank increases 60 percent from an initial figure of borrowings
$25 million. If market interest rates rise by 25 percent Interest-
from an initial level of 3 percent, what changes will occur sensitive
in this thrift's net interest income? liabilities

C h ap ter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 375
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

When and by how much is the bank exposed to interest

Expected Cash Inflows Annual Period in Which
rate risk? For each maturity or repricing interval, what
of Principal and Interest Cash Receipts Are
changes in interest rates will be beneficial and which will Payments Expected
be damaging, given the current portfolio position?
341,555 Three years from today
9. Sunset Savings Bank currently has the following interest-
sensitive assets and liabilities on its balance sheet with 62,482 Four years from today
the interest-rate sensitivity weights noted. 9,871 Five years from today

Rate Sensitivity Deposits and money market borrowings are expected to

Interest-Sensitive Assets $ Amount Index require the following outflows:

Federal fund loans $50.00 1 .0 0

Expected Cash Outflows Annual Period during Which
Security holdings 50.00 1 .2 0 of Principal and Interest Cash Payments Must Be
Payments Made
Loans and leases 350.00 1.45
Rate Sensitivity $1,295,500 Current year
Interest-Sensitive Liabilities $ Amount Index 831,454 Two years from today
Interest-bearing deposits $250.00 0.75 123,897 Three years from today
Money-market borrowings 90.00 0.95 1,005 Four years from today
What is the bank's cureent interest-sensitive gap? Adjust­ Five years from today
ing for these various interest rate sensitivity weights what
If the discount rate applicable to the previous cash flows
is the bank's weighted interest-sensitive gap? Suppose
is 4.25 percent, what is the duration of Snowman's port­
the federal funds interest rate increases or decreases 50
folio of earning assets and of its deposits and money
basis points. How will the bank's net interest income be
market borrowings? What will happen to the bank's total
affected (a) given its current balance sheet makeup and
returns, assuming all other factors are held constant, if
(b) reflecting its weighted balance sheet adjusted for the
interest rates rise? If interest rates fall? Given the size
foregoing rate-sensitivity indexes?
of the duration gap you have calculated, in what type
10. Sparkle Savings Association has interest-sensitive of hedging should Snowman engage? Please be spe­
assets of $400 million, interest-sensitive liabilities of cific about the hedging transactions needed and their
$325 million, and total assets of $500 million. What is expected effects.
the bank's dollar interest-sensitive gap? What is Sparkle's
12. G iven the cash inflow and outflow figures in Problem 11
relative interest-sensitive gap? What is the value of its
for Snowman Bank, N.A., suppose that interest rates
interest sensitivity ratio? Is it asset sensitive or liability
began at a level of 4.25 percent and then suddenly rise
sensitive? Under what scenario for market interest rates
to 4.75 percent. If the bank has total assets of $20 billion,
will Sparkle experience a gain in net interest income?
and total liabilities of $18 billion, by how much would the
A loss in net interest income?
value of Snowman's net worth change as a result of this
11. Snowman Bank, N.A., has a portfolio of loans and securi­ movement in interest rates? Suppose, on the other hand,
ties expected to generate cash inflows for the bank as that interest rates decline from 4.25 percent to 3.5 per­
follows: cent. What happens to the value of Snowman's net worth
in this case and by how much in dollars does it change?
Expected Cash Inflows Annual Period in Which
of Principal and Interest Cash Receipts Are What is the size of its duration gap?
Payments Expected 13. Conway Thrift Association reports an average asset
$1,275,600 Current year duration of 7 years and an average liability duration
of 4 years. In its latest financial report, the association
746,872 Two years from today
recorded total assets of $ 1 . 8 billion and total liabilities of

376 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

$1.5 billion. If interest rates began at 5 percent and then
suddenly climbed to 6 percent, what change will occur
in the value of Conway's net worth? By how much would
Conway's net worth change if, instead of rising, interest
rates fell from 5 percent to 4.5 percent?
14. A financial firm holds a bond in its investment portfolio
whose duration is 15 years. Its current market price is
$975. While market interest rates are currently at 6 per­
cent for comparable quality securities, a decrease in inter­
est rates to 5.75 percent is expected in the coming weeks.
What change (in percentage terms) will this bond's price
experience if market interest rates change as anticipated?
15. A savings bank's weighted average asset duration is 8
years. Its total liabilities amount to $925 million, while
its assets total 1.25 billion dollars. What is the dollar-
weighted duration of the bank's liability portfolio if it has
a zero leverage-adjusted duration gap?
16. Blue Moon National Bank holds assets and liabilities
whose average durations and dollar amounts are as
shown in this table:
Asset and Liability Items Avg. Duration Dollar
(years) Amount
(millions)
Investment-grads bonds 15.00 $65.00
Commercial loans 3.00 400.00
Consumer loans 7.00 250.00
18. Carter National Bank holds $15 million in government
bonds having a duration of 12 years. If interest rates
suddenly rise from 6 percent to 7 percent, what per­
centage change should occur in the bonds' market
price?
Internet Exercises
1. At www.almprofessional.com you will find a network
devoted to articles and discussions of the asset-liability
management field. Visit the site and find an article
entitled "Principles for the Management of Interest Rate
Risk." What are the major sources of interest rate risk
according to this article?
2. If you would like to view the current yield curve go to
www.bloomberg.com/markets/rates/index.html. What
are the current yields on 3-month Ttreasury bills, 5-year
Treasury notes, and 30-year Ttreasury bonds? Describe
the shape of the yield curve.
3. If you want to learn more about duration, go to www
.bionicturtle.com/how-to/article/modified-vs-
macaulay-duration/ and read through this How-To learn­
ing segment. Define modified duration, and describe
why it is useful.
4. See if you can find the meaning of modified duration on
the Web. Where did you find it, and what did you find?
(Hint: Try the website in Internet Exercise 3.)

Deposits 1.25 600.00 5. Duration gap management is a powerful analytical tool

Nondeposit borrowings 0.50 50.00
What is the weighted-average duration of Blue Moon's
asset portfolio and liability portfolio? What is its
leverage-adjusted duration gap?
17. A government bond currently carries a yield to maturity
of 6 percent and a market price of $1,168,49. If the bond
promises to pay $ 1 0 0 in interest annually for five years,
what is its current duration?
for protecting net worth of a financial institution from
damage due to shifting interest rates. Asset-liability
managers have found this tool surprisingly resilient and
robust even when its basic assumptions are not fully met.
Go to www.ots.treas.gov/docs/4/422196.pdf, and
see how bank regulators in the U.S. Treasury understand
duration gaps.

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 377
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

CASE ASSIGNMENT FOR CHAPTER 18

ANALYSIS OF INTEREST RATE SENSITIVITY find net interest income (Nil) as a percentage of total
assets (TA). This is one calculation of NIM. You may have
In Chapter 18, the focus is interest rate risk management. noticed from a footnote in Chapter 6 that sometimes
Regulatory agencies began to collect relevant information in NIM is calculated using total assets as the denominator,
the 1980s when large numbers of thrift institutions failed due and sometimes total earning assets (TEA) is used as the
to their interest rate risk exposure at a time when market rates denominator as illustrated in Equation (18.5). To trans­
were increasing both in level and volatility. You will find Interest form the first measure of NIM(NII/TAA) to the second
Rate Risk Analysis or Interest Sensitivity Reports included in both measure using TEA, we need to collect one more item
the UBPR and the Bank Holding Company Performance Report from the FDIC's website. Using the directions in Chapter
(BHCPR). Both reports are available at www.ffiec.gov. This is 5's assignment, go to the FDIC's Statistics for Depository
one area where measurement within banks and BHCs is more Institutions, www2.fdic.gov/sdi/, and collect from the
sophisticated than the measures used by regulatory agencies. Memoranda section of Assets and Liabilities the earning
For instance, to date none of the regulatory agencies require assets as a percentage of total assets for your BHC and its
their financial institutions to submit measures of duration gaps. peer group for the two periods. We will add this informa­
tion to this spreadsheet to calculate NIM (NII/TEA)
Part One: NIM: A Comparison to Peers as follows:
A. Open your Excel Workbook and access the spreadsheet
with Comparisons with Peer Group. On line 36, you

B C*’ ; Real Numbers for Real Banks Chapter 7 - Microsoft Excel

File Insert Page Layout Formulas Data Review View Acrobat 0 Tell me what you want to do...
CO <--->1
<& Cut X *
fib
♦•CO
Calibri T 11 * A* A — |= &/ * Wrap Text General N o rm al Bad G ood N eu tra l C a lc u la tio n C^ x
EB EEd £
ES3EM
IFg Copy ~ 0 Fi
Paste B I U - S3 - <5* - ^ - Merge & Center ”
C fJ o/ • «--0 .00 Conditional Format as | Ex p lan ato ry ... In p u t L in k e d C e ll N o te Insert Delete Format
- ~ ’ 00 -».o ▼
x# Format Painter Formatting » Table - ▼ w - £ ci
Clipboard r; Font r* Alignment Number G Styles Cells

A 54 'r i X */ U In t e r e s t S e n s it iv ity A n a ly s is

A B C D E F G H | 1 J K | L M N | O P Q | R S T
54 In t e r e s t S e n s it iv it y A n a ly s is BB& T P e e r G ro u p BB& T P e e r G ro u p
55 D ate 31-12-2010 31-12-2010 31-12-2009 31-12-2009
56 T o ta l Ea rn in g A s s e ts (TEA) 82.87% 85.18% 83.75% 84.32%
57 NIM u sin g TEA a s d e n o m in a to r 0.70% 0.89% 0.66% -0.07%
58
59

Basic Information Y ear-to -Y ear C o m p ariso n s C o m p a ris o n s w ith P e e r G ro u p © <i

Ready

Note: The above spreadsheet has been filled-in with the information for BB&T for 2009 and 2010 for illustrative purposes as directed below:

B. Use your formula functions to generate the percentages in percent in 2009 to 0.89 percent in 2010. The difference in NIMs
row 57. For instance, cell B57 = B36/B56. across years was 3 basis points for BB&T in comparison to 96
basis points for the peer group. The percentage change in
C. Once you have collected the data on NIM, write one para­ NIMs was 6.5 percent for BB&T in comparison to 1353.88 per­
graph discussing interest rate sensitivity for your bank rela­ cent for the peer group. The smaller difference/percentage
tive to the peer group across the two time periods based change for BB&T relative to the peer group's average for 2010
on the NIM. Discuss what is revealed by the variation of could have occurred for a number of reasons; however, it is
indicative that BB&T was less exposed to interest rate changes
NIM across time. See the following illustrative paragraph for
than the average institution over this period.
BB&T using 2009 and 2010 information.
Part Two: Interest-Sensitive Gaps and Ratios
Interest Sensitivity Analysis: Ex-Post Comparison
with Peers. While the FDIC's website is powerful in providing basic data
concerning assets, liabilities, equity, income, and expenses for
The variation of NIM for an institution across time is affected
individual banks and the banking component of BHCs, it does
by the interest rate risk exposure of the institution. BB&T's NIM
not provide any reports on interest sensitivity. For individual
increased from 0.66 percent in 2009 to 0.70 percent in 2010
banks such information is available in the UBPR, and for BHCs
while the average for their peer group increased from -0.07
information is available in the BHCPR. (Note that these data

378 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

are for the entire BHC and not an aggregation of the chartered A . Using the BHCPR created for your BHC fill in rows 73 and
bank and thrifts that we have used to this point.) We will access 74. You will find net assets repriceable in one year-to-total
the BHC reports at www.ffiec.gov and create a report for the assets in the Liquidity and Funding section and the dollar
most recent year-end. You will use information from this report
amount of average assets on page 1 of the report. Add
to calculate one-year interest-sensitive GAPs (Equation (18.7)
and one-year Relative IS GAP ratios Equation (18.11) for the two your information to the spreadsheet as follows:
most recent years.

0 c*- * Real Numbers for Real Banks Chapter 7 - Microsoft ExceLxIsx - Excel

File Insert Page Layout Formulas Data Review View Acrobat 0 Tell me what you want to do...
co
cX) Cut
▼
♦•CO
Calibri T 11 w A A — — - Ip ' Wrap Text General N o rm al Bad G ood N eu tra l C a lc u la tio n
ffl
Paste IF(=) Copy ~
I________ l
E Fil
Conditional Format as
*CI
B I U - EO - <2* - ^ - Merge & Center ” 5- 2 ~_ 0/ * «-.o oo Ex p lan ato ry ... In p u t L in k e d C e ll N o te Insert Delete Format
* 00 ->.0
x Format Painter Formatting ▼ Tables ▼ ▼
Clipboard ri Font Alignment Number r; Styles Cells

A 71 w fx In t e r e s t - s e n s it iv it y d a ta fro m U B H C P R -L iq u id ity and F u n d in g

A B C D E F G H 1 J K L M
L N o P JL Q R S
71 In t e r e s t - s e n s it iv it y d a ta fro m U B H C P R -L iq u id ity a n d F u n d in g BB&T BB&T
72 D ate 31-12-2010 31-12-2009
73 14.72% 9.92%
74 A v e ra g e a s s e ts (fo u n d to p o f Page 1 BH CPR) $15,96,69,581 $15,54,59,535
75 In t e r e s t - s e n s it iv e gap $2,35,03,362 $1,54,21,586
76
77

Basic Inform ation Y e a r-to -Y e a r C o m p a ris o n s C o m p ariso n s with Peer G roup © ■ H

Ready

The above spreadsheet has been filled in with the information for BB&T for 2009 and 2010 for illustrative purposes as directed below:

B. Having acquired the above information, you have the Rela­ and 14.72 percent in 2010 while its interest-sensitivity gap
tive IS gap in row 73 and you will calculate the $ interest- was $15.5 billion for 2009 and over $23.5 billion for 2010. This
sensitive gap by multiplying the Relative IS gap by average indicates that BB&T is asset sensitive and its exposure to inter­
est rate changes increased during 2010. Using a one-year time
assets.
frame, we may explore the effects on net interest income from
C. Write one paragraph discussing the interest rate risk expo­ changes in market interest rates using the one-year Interest Sen­
sure for your BHC, Is it asset or liability sensitive at the sitive Gap for 2010 and the following equation:
conclusion of each year? What are the implications of the Change in Nil = (Change in interest rate) * ($ gap)
changes occurring across the years? Using Equation (18.13), If market interest rates increase by one full percentage point, the
discuss the effects on net interest income if market interest increase in net interest income is forecast as close to $235 million.
rates increase or decrease by one full percentage point. See If market interest rates decrease by one full percentage point, the
decrease in net interest income is forecast as nearly $235 million.
the following illustrative paragraph for BB&T using 2009
BB&T will benefit most from increasing interest rates.
and 2 0 1 0 information.

Interest Sensitivity Analysis—Implications

from Interest-Sensitive GAPs and Relative IS GAP
Ratios
Bank holding companies' profits are affected by the inter­
est rate risk exposures of their balance sheets. The relative
interest-sensitivity gap ratio for BB&T was 9.92 percent in 2009

Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 379
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

Selected References
To examine the nature and impact of interest rate movements, 6 . Rose, Peter S. "Defensive Banking in a Volatile Economy—
see, for example: Hedging Loan and Deposit Interest Rates." The Canadian
Banker 93, no. 2 (April 1986), pp. 52-59.
1. Wu, Tao. "What Makes the Yield Curve Move." FRBSF Eco­
nomic Letter, Federal Reserve Bank of San Francisco, no. 7. Toevs, Alden L. "Gap Management: Managing Interest-
2003-15 (June 6 , 2003), pp. 1-3. Rate Risk in Banks and Thrifts." Economic Review, Federal
Reserve Bank of San Francisco, no. 2 (Spring 1983), pp.
To explore the need for asset-liability management techniques
20-35.
and their potential effectiveness and importance, see especially:
To understand how changing market interest rates influence the
2. Bailey, Jess. "Minnesota Bank Begins to Shed Its U.S.
behavior of banks and other financial firms, see especially:
Bonds." The Wall Street Journal, December 20, 1988, p. 3.
8. Federal Deposit Insurance Corporation. "A Changing Rate
3. Gerson, Vicki. "Starting on the Same Page," Bank Systems
Environment Challenges Bank Interest-Rate Risk Manage­
and Technology 42, issue #4, p. 42.
ment." Supervisory Insights, Washington, D.C., 2005 (www
4. Lopez, Jose A. "Supervising Interest Rate Risk Manage­ .fdic.gov/regulations/examinations/supervisory/insights).
ment." FRBSF Economic Letter, Federal Reserve Bank of
9. Wynne, Mark A., and Patrick Roy. "Has Greater Globaliza­
San Francisco, no. 2004-26 (September 17, 2004), pp. 1-3.
tion Made Forecasting Inflation More Difficult?" Economic
5. Sierra, Gregory E., and Timothy J. Yeager. "What Does Letter, Federal Reserve Bank of Dallas, 4, no. 5 (July 2009),
the Federal Reserve's Economic Value Model Tell Us about pp. 1 - 8 .
Interest-Rate Risk at U.S. Community Banks?" Review, Fed­
eral Reserve Bank of St. Louis, November/December 2004,
pp. 45-60.
To /earn more about gap management techniques, see these
studies:

380 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Illiquid Assets
Learning Objectives
After completing this reading you should be able to:

Evaluate the characteristics of illiquid markets. Compare illiquidity risk premiums across and within asset
categories.
Examine the relationship between market imperfections
and illiquidity. Evaluate portfolio choice decisions on the inclusion of
illiquid assets.
Assess the impact of biases on reported returns for illiquid
assets.

Explain the unsmoothing of returns and its properties.

Excerpt is Chapter 13 of Asset Management: A Systematic Approach to Factor Investing, by Andrew Ang.

381
19.1 CHAPTER SUMMARY
After taking into account biases induced by infrequent trading
and selection, it is unlikely that illiquid asset classes have higher
risk-adjusted returns, on average, than traditional liquid stock
and bond markets. However, there are significant illiquidity pre­
miums within asset classes. Portfolio choice models incorporat­
ing illiquidity risk recommend only modest holdings of illiquid
assets and that investors should demand high-risk premiums for
investing in them.
19.2 LIQUIDATING HARVARD
A ing excess returns (or "alpha") was limited. In these markets,
No one thought it could happen to Harvard.
In 2008, Harvard University's endowment—the world's largest—
fell victim to the worldwide plunge in asset prices triggered by
the financial crisis. In contrast to its 15% average annual returns
since 1980, Harvard's endowment suffered its worst decline in
history, falling 22% between July 1 and October 31, 2008. More
than $ 8 billion in value had been wiped out in three months.
Concerned with the impending budget shortfall due to the
collapse in the endowment, Harvard University President
Drew Faust and Executive Vice President Edward Forst sounded
the alarm by sending a memo to the Council of Deans on
December 2, 2008. They asked each school to cut expenses
and compensation and to scale back ambitions in the face of
reduced revenue. As bad as the reported losses were, they
cautioned that the true losses were even worse: "Yet even the
sobering figure is unlikely to capture the full extent of actual
losses for this period, because it does not reflect fully updated
valuations in certain managed asset classes, most notably
private equity and real estate. " 12
Harvard relied on endowment earnings to meet a large share of
university expenses. In its fiscal year ending June 30, 2008, more
than one-third of operating revenue came from endowment
income. For some of the university's individual departments, the
proportion was even higher: the Radcliffe Institute for Advanced
Study derived 83% of its revenue from the endowment, the
Divinity School 71%, and the Faculty of Arts and Sciences 52%.
Harvard Management Company (HMC), the funds manager of
Harvard's endowment, was one of the early adopters of the
endowment model, which recommends that long-term investors
1 This is based on "Liquidating Harvard," Columbia CaseWorks
ID #100312.
2 Financial Update to the Council of Deans, December 2, 2008, from
Faust and Forst.
382 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
hold lots of illiquid, alternative assets, especially private equity
and hedge funds. Advocated by David Swensen in his influential
book, Pioneering Portfolio Management, the endowment model
was based on the economic concept of diversification originally
attributable to Harry Markowitz (1952). Through diversification,
a portfolio of many low-correlated assets has a risk-return trade­
off superior to that of conventional portfolios consisting of only
stocks and bonds. Swensen went further and advocated holding
large proportions of illiquid private equity and hedge funds. Not
only were these assets supposed to have low correlations to
stocks and bonds, but they potentially carried an illiquidity risk
premium.
Swensen argued that in liquid markets, the potential for mak­
crowded with thousands of active managers vying for an edge,
information is freely available and almost everyone has access
to it. Illiquid asset markets, like venture capital and private
equity, had large potential payoffs for investors who had supe­
rior research and management skills. Swensen argued that
alpha was not competed away in illiquid assets because most
managers have short horizons. University endowments, with
their longer horizons, would seem to have an advantage in
illiquid assets. Swensen recommended that long-term institu­
tions with sufficient resources who can carefully select expert
managers in alternative, illiquid assets could achieve superior
risk-adjusted returns.
Dutifully following Swensen's advice, many endowments, includ­
ing Harvard, loaded up with illiquid assets during the 1990s.
In 2008, HMC held 55% of its portfolio in hedge funds, private
equity, and real assets. Only 30% was in developed-world equi­
ties and fixed income, with the remainder of its portfolio in
emerging-market equities and high-yield bonds.
In its desperate need for cash, HMC tried to sell some of its
$1.5 billion private equity portfolio, which included marquee
names such as Apollo Investment and Bain Capital. But buyers
in secondary markets demanded huge discounts. Nina Munk, a
journalist writing in Vanity Fair, recounts a surreal conversation
between the CIO of HMC, Jane Mendillo, and a money man­
ager specializing in alternative investments: 3
FUNDS MANAGER: Hey look, I'll buy it back from you. I'll
buy my interest back.
MENDILLO: Great.
FUNDS MANAGER: Here, I think it's worth you know, today
the [book] value is a dollar, so I'll pay you 50 cents.
MENDILLO: Then why would I sell it?
3 Nina Munk, "Rich Harvard, Poor Harvard," Vanity Fair, August 2009.
 FUNDS MANAGER: Well, why are you? I don't know.
You're the one who wants to sell, not me. If you guys
want to sell, I'm happy to rip your lungs out. If you are
desperate, I'm a buyer.
MENDILLO: Well, we're not desperate.
But in truth Harvard was desperate.
The reaction to Faust and Forst's cost-cutting memo was swift
and sharp. Faculty, students, and alumni were incredulous. Alan
Dershowitz, a famous professor at Harvard Law School, said: 4
"Apparently nobody in our financial office has read the story in
Genesis about Joseph interpreting Pharaoh's dream. . . . You know,
during the seven good years you save for the seven lean years."
All the short-term decisions for Harvard leaders and Mendillo
at HMC were painful: slashing budgets, hiring freezes, and the
postponement of the university's planned Allston science com­
plex. Asset-liability management for Harvard University had
failed. In the longer term, was the endowment model with illiq­
uid, alternative assets still appropriate?
19.3 ILLIQUID ASSET MARKETS
Sources of Illiquidity
Vayanos and Wang (2012) provide a taxonomy of how illiquidity
arises due to market imperfections:
1. Clientele effects and participation costs
Entering markets can be costly; investors often must spend
money, time, or energy to learn their way around and gain
the necessary skills. In many large, illiquid asset markets,
only certain types of investors with sufficient capital, exper­
tise, and experience can transact.
2. Transaction costs
These include commissions, taxes, and, for certain illiquid
assets, the costs of due diligence, title transfers, and the
like, as well as the bread-and-butter costs incurred for trad­
ing. It also includes fees paid to lawyers, accountants, and
investment bankers. Academics sometimes assume that
investors can trade whenever they want as long as they pay
(sometimes a substantial) a transaction cost, but this is not
always true because of . . .
3. Search frictions
For many assets, you need to search to find an appropri­
ate buyer or seller. Only certain investors have the skills to
4 Quoted by Munk, N., "Rich Harvard, Poor Harvard," Vanity Fair,
August 2009.
value a complicated structured credit product, for example.
Few investors have sufficient capital to invest in skyscrapers
in major metropolitan areas. You might have to wait a long
time to transact.
4. Asymmetric information
Markets can be illiquid because one investor has superior
knowledge compared with other investors. Fearing they'll
be fleeced, investors become reluctant to trade. When
asymmetric information is extreme—all the products are
lemons, and no one wants to buy a lemon—markets break
down. 5 Many liquidity freezes are caused by these situa­
tions. The presence of asymmetric information also causes
investors to look for nonpredatory counterparties, so infor­
mation is a form of search friction.
5. Price impact
Large trades will move markets.
6 . Funding constraints
Many of the investment vehicles used to invest in illiquid
assets are highly leveraged. Even investing in a house
requires substantial leverage for most consumers. If access
to credit is impaired, investors cannot transact in illiquid
asset markets.
Characteristics of Illiquid Markets
Illiquid asset markets are characterized by many, and sometimes
all, of the market imperfections on this list. I refer to these
effects as "illiquidity." On the basis of this reasoning, all assets
are at least somewhat illiquid—even the large-cap equities that
trade many times every second—but of course some assets are
much more illiquid than others. Illiquidity manifests as infrequent
trading, small amounts being traded, and low turnover. Inter­
vals between trades in illiquid markets can extend to decades.
Table 19.1, adapted from Ang, Papanikolaou, and Westerfield
(2013), lists average intervals between trading and turnover for
several asset classes. 6 First, note th a t. . .
Most Asset Classes Are Illiquid
Except for "plain-vanilla" public equities and fixed income,
most asset markets are characterized by long periods,
sometimes decades, between trades, and they have very
5 The lemons market was first described by George Akerlof (1970), who
was awarded the Nobel Prize in 2001.
6 See Ang, Papanikolaou, and Westerfield (2013) for additional refer­
ences behind the numbers in Table 19.1 and other references in this
section.
C h ap ter 19 Illiquid Assets ■ 383
Table 19.1
Asset Class Typical Time between Transactions Annualized Turnover

Public Equities Within seconds Well over 100%

OTC (Pinksheet) Equities Within a day, but many stocks over a week Approx 35%
Corporate Bonds Within a day 25-35%
Municipal Bonds Approx 6 months, with 5% of muni bonds trading more Less than 10%
infrequently than once per decade
Private Equity Funds last for 10 years; the median investment duration is Less than 10%
4 years; secondary trade before exit is relatively unusual
Residential Housing 4-5 years, but ranges from months to decades Approx 5%
Institutional Real Estate 8 -1 1 years Approx 7%
Institutional Infrastructure 50-60 years for initial commitment, some as long as 99 years Negligible
Art 40-70 years Less than 15%

low turnover. Even among stocks and bonds, some subas­
set classes are highly illiquid. Equities trading in pink-sheet
over-the-counter markets may go for a week or more without
trading. The average municipal bond trades only twice per
year, and the entire muni-bond market has an annual turnover
of less than 10%. In real estate markets, the typical holding
period is four to five years for single-family homes and eight
to eleven years for institutional properties. Holding periods
for institutional infrastructure can be fifty years or longer, and
works of art sell every forty to seventy years, on average. Thus
most asset markets are illiquid in the sense that they trade
infrequently and turnover is low.
Illiquid Asset Markets Are Large
The illiquid asset classes are large and rival the public equity
market in size. In 2012, the market capitalization of the
NYSE and NASDAQ was approximately $17 trillion. The
estimated size of the U.S. residential real estate market is
$16 trillion, and the direct institutional real estate market is
$9 trillion. In fact, the traditional public, liquid markets of
stocks and bonds are smaller than the total wealth held in
illiquid assets.
Investors Hold Lots of Illiquid Assets
Illiquid assets dominate most investors' portfolios. For individu­
als, illiquid assets represent 90% of their total wealth, which is
mostly tied up in their house—and this is before counting the
largest and least liquid component of individuals' wealth, human
capital. There are high proportions of illiquid assets in rich inves­
tors' portfolios, too. High net worth individuals in the United
States allocate 10% of their portfolios to "treasure" assets like
fine art and jewelry. This rises to 20% for high net worth individ­
uals in other countries. 7
The share of illiquid assets in institutional portfolios has
increased dramatically over the past twenty years. The National
Association of College and University Business Officers reported
that, in 2 0 1 1 , the average endowment held a portfolio weight of
more than 25% in alternative assets versus roughly 5% in the
early 1990s. A similar trend is evident among pension funds. In
1995, they held less than 5% of their portfolios in illiquid alterna­
tives, but today the figure is close to 2 0 % . 8
Liquidity Dries Up
Many normally liquid asset markets periodically become illiquid.
During the 2008 to 2009 financial crisis, the market for com­
mercial paper (or the money market)—usually very liquid—expe­
rienced "buyers' strikes" by investors unwilling to trade at any
price. This was not the first time that the money market had
frozen: trading in commercial paper also ceased when the Penn
Central railroad collapsed in 1970. In both cases, the money
market needed to be resuscitated by the Federal Reserve, which
stepped in to restore liquidity.
During the financial crisis, illiquidity also dried up in the repo mar­
ket (which allows investors to short bonds), residential and com­
mercial mortgage-backed securities, structured credit, and the
auction rate security market (a market for floating rate municipal
bonds). The last example was one of the first markets to become
7 See "Profit or Pleasure? Exploring the Motivations Behind Trea­
sure Trends," Wealth Insights, Barclays Wealth and Investment
Management, 2012.
8 See Global Pension Asset Study, Towers Watson, 2011.

384 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
illiquid at the onset of the financial crisis in 2008 and at the time of
writing in 2013 is still frozen. This market is dead in its present form.
Illiquidity crises occur regularly because liquidity tends to
dry up during periods of severe market distress. The Latin
American debt crisis in the 1980s, the Asian emerging market
crisis in the 1990s, the Russian default crisis in 1998, and of
course the financial crisis of 2008 to 2009, were all character­
ized by sharply reduced liquidity, and in some cases liquidity
completely evaporated in some markets. Major illiquidity crises
have occurred at least once every ten years, most in tandem
with large downturns in asset markets.
Summary
Illiquid asset classes as a whole are larger than the traditional
liquid, public markets of stocks and bonds. Even normally liquid
markets periodically become illiquid. Most investors' wealth
is tied up in illiquid assets. Thus asset owners must consider
illiquidity risk in the construction of their portfolios. Doing this
requires estimating risk-return trade-offs of illiquid assets, but
measuring illiquid asset returns is not straightforward.
19.4 ILLIQUID ASSET REPORTED
RETURNS ARE NOT RETURNS
As Faust and Forst note in their memo to Harvard's Coun­
cil of Deans, the true illiquid asset losses were greater than
the reported ones, which leads us to an important corollary.
Reported illiquid asset returns are not returns. Three key biases
cause people to overstate expected returns and understate the
risk of illiquid assets:
1. Survivorship bias,
2. Infrequent sampling, and
3. Selection bias.
In illiquid asset markets, investors must be highly skeptical of
reported returns.
Survivorship Bias
Survivorship bias results from the tendency of poorly performing
funds to stop reporting. Many of these funds ultimately fail—but
we only rarely count their failures. This makes true illiquid asset
returns worse than the reported data.
Here's an analogy: Suppose we wanted to test the hypothesis
that smoking is bad for you. We're going to run our tests only
on a sample of smokers that have puffed cigarettes for at least
twenty years and are in good health today. Lo and behold, we
conclude that this select group of smokers has a slightly better
mortality rate than the general population. Is this a valid conclu­
sion? Of course not! We have taken a biased sample of smokers
blessed with longevity who are, so far, invulnerable to the detri­
mental effects of tobacco. If you were to take up smoking today,
what are the odds that you would end up in this lucky group
twenty years later? Or would you die from emphysema (or heart
disease, or lung cancer, etc.) before the experiment could be
repeated in twenty years' time?
Surviving funds in illiquid asset management are like those lucky,
long-lived smokers. We observe the returns of surviving funds
precisely because they are still around, and they are generally
above average. All of the unlucky illiquid managers disappear and
thus stop reporting returns. Of course, these nonsurvivors have
below-average returns. 9 Industry analysis of buy-out funds, ven­
ture capital funds, or [insert your favorite illiquid asset class] tends
to encompass only firms that have survived over the period of the
analysis. But do we know that the small venture capital firm we're
investing in today will be around ten years later? Existing firms
and funds, by dint of being alive today, tend to have better-than-
average track records. This produces reported returns of these
illiquid assets that are too good to be true.
The only way to completely remove the effect of survivorship
bias is to observe the entire population of funds. Unfortunately,
in illiquid asset markets we never observe the full universe.
We can gauge the impact of survivorship bias with mutual funds,
which are required to report their returns to the Securities and
Exchange Commission because they fall under the 1940 Invest­
ment Act. This allows us to see the whole mutual fund universe,
at least when the funds become registered, and to compute the
effect of survivorship bias. Survivorship bias knocks at least 1%
to 2 % off the estimates of expected returns of mutual funds if
we fail to include dead funds in our sample. However, industry
often bases its conclusion only on funds in existence at a given
point in time. When we separately compare defunct and live
funds, the survivorship effect can go above 4%. Take these as
lower bounds for illiquid asset managers.
There are data biases other than survivorship bias: for funds spe­
cializing in very illiquid assets, reporting returns to database
vendors is almost always voluntary. This introduces reporting
biases Survivorship bias results when your fund is in the
. 1 0
9 Jorion and Goetzmann (1999) argue that survivorship bias partly
explains the high equity premium: Countries where we have long his­
tories of equity returns are, by definition, those countries where equity
investments have prospered.
10 See Ang, Rhodes-Kropf and Zhao (2008).
C h ap ter 19 Illiquid Assets ■ 385
database now and you stop reporting returns because you
know your returns are going to be low. Reporting bias also
occurs when you don't start reporting your returns in the first
place because your fund never achieves a sufficiently attractive
track record.
Infrequent Trading
With infrequent trading, estimates of risk—volatilities, correlations,
and betas—are too low when computed using reported returns.
To illustrate the effect of infrequent trading, consider Figure 19.1.
Panel A plots prices of an asset that starts at $1. Each circle
denotes an observation at the end of each quarter. I produced
the graphs in Figure 19.1 by simulation and deliberately chose
one sample path where the prices have gone up and then down
to mirror what happened to equities during the 2000s' Lost
Decade. The prices in Panel A appear to be drawn from
a series that does not seem excessively volatile; the standard
deviation of quarterly returns computed using the prices in
Panel A is 0.23.
The true daily returns are plotted in Panel B of Figure 19.1.
These are much more volatile than the ones in Panel B. Prices go
below 0.7 and above 3.0 in Panel B with daily sampling, whereas
the range of returns in Panel A is between 1.0 and 2.5 with quar­
terly sampling. The volatility of quarterly returns, computed from
(overlapping) daily data in Panel B is 0.28, which is higher than
the volatility of quarterly-sampled returns of 0.23 in Panel A.
For a full comparison, Panel C plots both the quarterly and daily
sampled returns and just overlays Panels A and B in one picture.
Infrequent sampling has caused the volatility estimate using the
quarterly sampled returns to be too low. The same effect also
happens with betas and correlations—risk estimates are biased
downward by infrequent sampling.
A A
Unsmoothing Returns
To account for the infrequent trading bias, we need to go from
Panel A of Figure 19.1, which samples quarterly, to Figure B,
which samples daily. That is, the quarterly observed returns are
too smooth, and we need to tease out the true, noisier returns.
This process is called unsmoothing or de-smoothing, and the
first algorithms to do this were developed by David Geltner1
11 See Geltner (1993) and Graff and Young (1996) for infrequent obser­
vation bias on the effect of betas and correlations, respectively. Geltner
estimates that betas are understated by a factor of 0.5 for real estate
returns. This is not a "small sample" problem, which goes away when
our sample becomes very large; it is a "population" problem as the next
section explains.
386 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
(1991), a noted professor of real estate at MIT, and Stephen
Ross and Randall Zisler (1991). Ross is the same professor
who developed multifactor models and Zisler is a real estate
professional who started his career as an academic. Ross and
Zisler's work originally grew out of a series of reports written for
Goldman Sachs in the late 1980s. This methodology has been
extended in what is now an extensive literature.
Unsmoothing is a filtering problem. Filtering algorithms are
normally used to separate signals from noise. When we're
driving on a freeway and talking on a cell phone, our phone
call encounters interference—from highway overpasses and
tall buildings—or the reception becomes patchy when we pass
through an area without enough cell phone towers. Telecommu­
nication engineers use clever algorithms to enhance the signal,
which carries our voice, against all the static. The full transmis­
sion contains both the signal and noise, and so the true signal
is less volatile than the full transmission. Thus standard filtering
problems are designed to remove noise. The key difference is
that unsmoothing adds noise back to the reported returns to
uncover the true returns.
To illustrate the Geltner-Ross-Zisler unsmoothing process,
denote the true return at the end of period t as rt, which is
unobservable, and the reported return as rt, which is observable.
Suppose the observable returns follow
'-/ = c + <K'_, + et, (19.1)
where 4>is the autocorrelation parameter and is less than one in
absolute value. Equation (19.1) is an AR(I) process, where "AR"
stands for autoregressive and the " 1 " denotes that it captures
autocorrelation effects for one lag. Assuming the observed
returns are functions of current and lagged true returns (this is
called a "transfer function" or an "observation equation" in the
parlance of engineers), we can use Equation (19.1) to invert out
the true returns. If the smoothing process only involves averag­
ing returns for this period and the past period, then we can
filter the observed returns to estimate the true returns, rt, from
observed returns, r*t using:
_ _ L *_ _1 _ •
^ 1-<|>r' (19.2)
Equation (19.2) unsmooths the observed returns. If our assump­
tion on the transfer function is right, the observed returns
implied by Equation (19.2) should have zero autocorrelation.
Thus, the filter takes an autocorrelated series of observed
returns and produces true returns that are close to IID (or not
forecastable). Note that the variance of the true returns is higher
than the observed returns:
var(/p =
(19.3)
 Panel A Panel B
Quarterly Sampling Daily Sampling
3.5 __________________________________________

3 -

0.5 -

0 J -----------1----------- 1----------- 1----------- 1----------- 1----------- r

Panel C
Daily vs Quarterly Sampling

Figure 19.1

C h ap ter 19 Illiquid Assets ■ 387

since \4>\ < 1 , so we are adding variance to the observed returns
to produce estimates of the true returns.
Another way to interpret the unsmoothing process in Equa­
tions (19.1) and (19.2) is that it is equivalent to assuming that the
smoothed, or reported, return follows:
rt = 0 - w r t + <K-v (19.4)
and thus the unsmoothed return at time t, rt is a weighted aver­
age of the unsmoothed, or true, return at time t, rt, and the
lagged unsmoothed return in the previous period, rt_-1. Thus the
smoothed returns only slowly update—they partly reflect what
is happening in the true returns, but there are lags induced from
the appraisal process.
The unsmoothing process has several important properties:
1. Unsmoothing affects only risk estimates and not expected
returns.
Intuitively, estimates of the mean require only the first and
last price observation (with dividends take "total prices,"
which count reinvested dividends) . 1 2 Smoothing spreads
the shocks over several periods, but it still counts all the
shocks. In Figure 19.1, we can see that the first and last
observations are unchanged by infrequent sampling; thus
unsmoothing changes only the volatility estimates.
2. Unsmoothing has no effect if the observed returns are
uncorrelated.
In many cases, reported illiquid asset returns are autocor-
related because illiquid asset values are appraised. The
appraisal process induces smoothing because appraisers
use, as they should, both the most recent and comparable
sales (which are transactions) together with past appraised
values (which are estimated, or perceived, values). The arti­
ficial smoothness from the appraisal process has pushed
many in real estate to develop pure transactions-based,
rather than appraisal-based indexes. 1 3 Autocorrelation also
results from more shady aspects of subjective valuation
procedures—the reluctance of managers to mark to market
in down markets.
12 Technically taking means of both the right and left sides in
Equation (19.2) results in the same means in large samples.
13 This literature includes both repeat-sales methodologies (see
Goetzmann (1992)) and constructing indexes using only transactions
(see Gatzlaff and Geltner (1998) and Fisher, Geltner, and Pollakowski
(2007)). Some of these methods adjust for the different characteristics
of individual homes in creating these indices, like whether an apartment
or a house is for sale, whether it is close to the water or far, or whether
the house has two stories or one. These are called hedonic adjustments.
These methods have been applied to create indexes in other illiquid
markets, like art (Goetzmann (1993) and Moses and Mei (2002)), stamps
(Dimson and Spaenjers (2011)), and wine (Krasker (1979) and Masset and
388 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
In many cases, we expect the true illiquid asset returns to
be autocorrelated as well. 1 4 Illiquid asset markets— like real
estate, private equity, timber plantations, and
infrastructure—are markets where information is not avail­
able to all participants, information does not spread rapidly,
and capital cannot be immediately deployed into new
investments. Informationally inefficient markets with slow-
moving capital are characterized by persistent returns. 1 5
3. Unsmoothing is an art.
The unsmoothing example in Equations (19.1) and (19.2) uses
the simplest possible auto correlated process, an AR(I), to
describe reported returns. Many illiquid assets have more
than first-order lag effects. Real estate, for example, has a
well-known fourth-order lag working with quarterly data aris­
ing from many properties being reappraised only annually. 1 6 *
A good unsmoothing procedure takes a time-series model
that fits the reported return data well and then with a general
transfer function assumption, the filter for true returns in
Equation (19.2) becomes a very complicated function of pres-
ent and past lagged observed returns. Doing this properly
requires good statistical skills. It also requires underlying eco­
nomic knowledge of the structure of the illiquid market to
interpret what is a reasonable lag structure and to judge how
much unsmoothing is required.
Unsmoothed Real Estate Returns
To illustrate the effects of unsmoothing, Figure 19.2 plots
direct real estate returns from the National Council of Real
Weisskopf (2010)). The aggregation process in constructing indexes of
illiquid asset returns induces further smoothing. Indexes combine many
individual indications of value, either market transactions or appraised
values, and typically the values are appraised at different points through­
out the year. Note that if (f> — 0, then Equations (2) and (3) coincide and
unsmoothed returns are exactly the same as reported returns. Figure 19.1,
which shows the effects of infrequent observations, is produced with a
year-on-year autocorrelation of 0.4.
14 When the true returns are auto correlated, the horizon matters in stat­
ing volatilities, correlations, and Sharpe ratios. From point 1, the means
are unaffected. See Lo (2002) for formulas to convert the risk measures
for different horizons.
15 See Duffie (2010) and Duffie and Strulovici (2012).
16 This is noted in the seminal Geltner (1991) and Ross and Zisler (1991)
papers.
17 We want an ARMAfp, q) model, which captures the effect of p lagged
autocorrelated terms (the "AR" effect for p lags) and where innovations
to those returns in past periods continue to have an effect on present
returns. The latter are referred to as moving average terms (the "MA"
effects for q lags). Both Geltner (1991) and Ross and Zisler (1991) con­
sider richer time-series processes than just an AR(1). Okunev and White
(2003) and Getmansky, Lo, and Makarov (2004) develop unsmoothing
algorithms to hedge fund returns with higher-order autocorrelation
corrections.
 ■ Unsmoothed Returns
Figure 19.2 Sm oothed and unsmoothed real estate returns.
Estate Investment Fiduciaries (NCREIF), which constructs an
institutional property index from data reported by its mem­
bers . 1 8 Because this is an appraisal index, NCREIF real estate
returns are highly autocorrelated. From March, 1978 to
December, 2011, the first-order autocorrelation of NCREIF
returns is 0.78. The raw reported data is shown in the solid
line. I graph unsmoothed returns in the squares applying the
filter of Equations (19.1) and (19.2). All returns are at the quar­
terly frequency.
Unsmoothing produces a dramatic effect. The minimum
reported return during the real estate downturn in the early
1990s is -5.3% during the quarter ending December 1991. The
corresponding unsmoothed return is -22.6% . During the finan­
cial crisis, NCREIF returns reached a low of -8.3% in December
2008. The unsmoothed return during this quarter is -36.3% .
The volatility of the raw NCREIF returns is 2.25% per quarter,
whereas the volatility of the unsmoothed returns is 6.26% per
quarter. This approximates the volatility of stock returns, which is
around 7.5% per quarter. Correlation (and hence beta) estimates
are also affected by unsmoothing: the correlation of raw NCREIF
returns with the S&P 500 is 9.2% and this rises to 15.8% once
the unsmoothing correction is applied.
Selection Bias
Sample selection bias results from the tendency of returns only
to be observed when underlying asset values are high.
18 Unsmoothing corrections produces similar effects in other illiquid
markets. Campbell (2008), for example, estimates that unsmoothing
increases the volatility of art market returns from 6.5% to 11.5%.
------- Raw Data (Smoothed)
Buildings tend to be sold when their values are high—otherwise,
many sellers postpone sales until property values recover. This
causes more transactions to be observed when the underlying
real estate values are high.
In private equity, selection bias is acute. In buyout funds, com­
panies are taken public only when stock values are high. Many
venture capital investments are structured over multiple rounds.
Better-performing companies tend to raise more money in more
rounds. The venture capitalist tends to sell a small company, and
the transaction is recorded, when the company's value is high.
Distressed companies are usually not formally liquidated, and
these "zombie" companies are often left as shell companies.
When observing old companies without recent transactions, it is
not clear whether these companies are alive and well or whether
they are zombies.
To illustrate the selection bias problem, consider Figure 19.3,
which is adapted from Korteweg and Sorensen (2010). Panel A
shows the full universe of returns of an illiquid asset marked by
dots. These returns (on the y-axis) are plotted contemporaneous
with market returns (on the x-axis). In the full universe, there is
no alpha, and the intercept of the line summarizing the relation­
ship between the illiquid asset and the market goes through
the origin (this line is called the security market line (SML; see
Chapter 1). The slope of the SML is the beta of the illiquid asset
and is a measure of risk.
Panel B illustrates the sample selection problem. Bad returns,
which are shaded gray, are not observed in the databases—
we record transactions only when prices are high. Now only
the black dots are reported. An estimated SML fitted to these
observed returns yields a positive alpha when the true alpha
C h ap ter 19 Illiquid Assets ■ 389
is zero. The slope of the fitted SML is flatter than the slope of Panel A
the true SML in panel A, and hence we underestimate beta.
When we compute the volatility of the observed returns, we
only count those returns that are high, and so the volatility
estimate is biased downward. Thus we overestimate expected
return, and we underestimate risk as measured by beta and
volatility.

The statistical methodology for addressing selection bias was

developed by James Heckman (1979), who won the Nobel Prize
in 2 0 0 0 for inventing these and other econometric techniques.
Studies that use models to correct for these biases do not take
such an extreme view as Figure 19.3, they allow the threshold
above which returns are observed to vary over time and depend
on company or property-1 eve I characteristics. 1 9 The model of
risk is sometimes extended to multifactor models (see Chapters
1 and 2 ), rather than just using the market portfolio as the sole

risk factor.

The effect of selection bias can be enormous. Cochrane (2005)

estimates an alpha for venture capital log returns of over
90% not taking into account selection bias, which reduces to
-7% correcting for the bias. Korteweg and Sorensen (2005) Panel B

estimate that expected returns for the same asset class are
reduced downwards by 2% to 5% per month (arithmetic
returns) taking into account selection bias. The effect of selec­
tion bias in real estate is smaller, perhaps because the underly­
ing volatility of real estate returns is lower than private equity.
Fisher et al. (2003) implement selection bias corrections for
real estate. They estimate that average real estate returns
reduce from 1.7% to 0.3% and standard deviation estimates
increase by a factor of 1.5. The small means of real estate
returns are due to their sample period of 1984 to 2001, which
includes the real estate downturn in the early 1990s and in the
early 2000s. They miss the bull market in real estate during
the mid-2 0 0 0 s.

Summary
Treat reported illiquid asset returns very carefully. Survivors hav­
ing above-average returns and infrequent observations, and
the tendency of illiquid asset returns to be reported only when
underlying valuations are high, will produce return estimates
that are overly optimistic and risk estimates that are biased
downward. Put simply, reported returns of illiquid assets are too
good to be true. 19.5 ILLIQUIDITY RISK PREMIUMS
Illiquidity risk premiums compensate investors for the
19 See also Cochrane (2005) for selection bias models applied to venture inability to access capital immediately. They also com­
capital and Fisher et al. (2003) for real estate. Korteweg, Kraussl, and
Verwijmeren (2012) find that correcting for selection bias decreases the pensate investors for the withdrawal of liquidity during
Sharpe ratio of art from 0.4 to 0.1. illiquidity crises.

390 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Harvesting Illiquidity Risk Premiums
There are four ways an asset owner can capture illiquidity
premiums:
1. By setting a passive allocation to illiquid asset classes, like
real estate;
2. By choosing securities within an asset class that are more
illiquid, that is by engaging in liquidity security selection;
3. By acting as a market maker at the individual security
level; and
4. By engaging in dynamic strategies at the aggregate portfo­
lio level.
Economic theory states that there should be a premium for
bearing illiquidity risk, although it can be small. 2 0 In models
where illiquidity risk has small or no effect on prices, illiquidity
washes out across individuals. A particular individual may be
affected by illiquidity—illiquidity can crimp his consumption or
affect his asset holdings (as in the asset allocation model with
illiquidity risk that I present below)—but other agents will not be
constrained, or they trade at different times. Different agents
share risk among themselves, which mutes the impact of illiquid­
ity. Thus in equilibrium the effects of illiquidity can be
negligible. 21
Whether the illiquidity risk premium is large or small is an empir­
ical question.
Illiquidity Risk Premiums across
Asset Classes
Figure 19.4 is from Antti llmanen's (2011) wonderful book,
Expected Returns, and plots average returns on illiquidity esti­
mates. The average returns are computed from (reported) data
over 1990 to 2009. The illiquidity estimates represent llmanen's
opinions. Some private equity investments are more liquid than
certain hedge funds, and some infrastructure investments are
much less liquid than private equity, so it is hard to pigeon-hole
these asset classes in terms of illiquidity. Nevertheless, Figure 19.4
seems to suggest a positive relation between how illiquid an asset
class is and its expected return. Figure 19.4 represents "con­
ventional" views among most market participants that there is a
reward to bearing illiquidity across asset classes.
20 This large literature begins with a seminal contribution by Demsetz
(1968). See summary articles by Hasbrouck (2007) and Vayanos and
Wang (2012).
21 For models of this kind, see Constantinides (1986), Vayanos (1998),
Garleanu (2009), and Buss, Uppal, and Vilkov (2012). In contrast, Lo,
Mamaysky, and Wang (2004) and Longstaff (2009), among others, argue
that the illiquidity premium should be large.
This conventional view is flawed for the following reasons:
1. Illiquidity biases.
As previous sections show, reported data on illiquid assets
cannot be trusted. The various illiquidity biases—survivorship,
sampling at infrequent intervals, and selection bias—result in
the expected returns of illiquid asset classes being overstated
using raw data.
2. Ignores risk.
Illiquid asset classes contain far more than just illiquidity risk.
Adjusting for these risks makes illiquid asset classes far less
compelling. The NCREIF real estate index (despite the arti­
ficial rosiness of its raw returns) is beaten by a standard 60%
equity and 40% bond portfolio. The average hedge fund
and private equity fund, respectively, provide zero expected
excess returns. In particular, after adjusting for risk, most
investors are better off investing in the S&P 500 than in a
portfolio of private equity funds.
3. There is no "market index" for illiquid asset classes.
No investor receives the returns on illiquid indexes. An
asset owner never receives the NCREIF return on a real
estate portfolio, for example. The same is true for most
hedge fund indexes and private equity indexes. In liquid
public markets, large investors can receive index market
returns and pay close to zero in fees. In contrast, NCREIF
is not investable as it is impossible to buy all the underly­
ing properties in that index. Since all asset owners own
considerably fewer properties than the thousands included
in NCREIF, they face far more idiosyncratic risk. While this
large amount of idiosyncratic risk can boost returns in some
cases, it can also lead to the opposite result. Returns to illiq­
uid asset investing can be far below a reported index.
4. You cannot separate factor risk from manager skill.
Tradeable and cheap index funds in bond and stock mar­
kets allow investors to separate systematic returns (or factor
returns) from management prowess. In illiquid markets, no
such separation is possible: investing in illiquid markets is
always a bet on management talent. The agency issues in
illiquid asset markets are first-order problems. Agency prob­
lems can, and often do, overwhelm any advantages that an
illiquidity risk premium may bring.
Taking into account data biases, the evidence for higher average
returns as asset classes become more illiquid is decidedly mixed,
as Ang, Goetzmann, and Schaefer (2011) detail. 2 2 * But while
22 Nevertheless, there are common components in illiquidity conditions
across asset classes: when U.S. Treasury bond markets are illiquid, for
example, many hedge funds tend to do poorly. See, for example, Hu,
Pan, and Wang (2012).
C h ap ter 19 Illiquid Assets ■ 391
 18

16- ♦ Venture
Capital
14-
♦ Emerging Market Debt ♦ Buyouts
12 -
♦ Hedge Funds
♦ Emerging Market Equity ♦ Timber
10-
♦ High Yield bonds
♦ Global Infrastructure ♦ Fund of Funds
8
♦ US Real Estate
-

^ r-, i | c ♦ US Fixed Income

♦ Global Sovereigns
♦ Commodities
♦ Global REITS
♦ Cash Deposits ♦Developed Market Equity
4-

Most Liquid Increasing Illiquidity = > Most Illiquid

Fiaure 19.4 Asset class returns vs illiquidity

there do not seem to be significant illiquidity risk premiums
across classes, there are large illiquidity risk premiums within
asset classes.
Illiquidity Risk Premiums within Asset
Classes
Within all the major asset classes, securities that are more illiq­
uid have higher returns, on average, than their more liquid coun­
terparts. These illiquidity premiums can be accessed by dynamic
factor strategies which take long positions in illiquid assets and
short positions in liquid ones. As illiquid assets become more
liquid, or vice versa, the investor rebalances.
U.S. Treasuries
A well-known liquidity phenomenon in the U.S. Treasury market
is the on-the-run/off-the-run bond spread. Newly auctioned
Treasuries (which are "on the run") are more liquid and have
higher prices, and hence lower yields, than seasoned Treasuries
(which are "off the run" ) . 2 3 The spread between these two types
of bonds varies over time reflecting liquidity conditions in Trea­
sury markets. 2 4
There were pronounced illiquidity effects in Treasuries during
the 2008 to 2009 financial crisis. Treasury bonds and notes are
identical, except that the U.S. Treasury issues bonds with
original maturities of twenty to thirty years and notes originally
carry maturities of one to ten years. But after ten years, a Trea­
sury bond originally carrying a twenty-year maturity is the same
as a Treasury note. If the maturities are the same, whether this
particular security is bond or a note should make no difference.
During the financial crisis Treasury bond prices with the same
maturity as Treasury notes had prices that were more than 5%
lower—these are large illiquidity effects in one of the world's
most important and liquid markets.
Corporate Bonds
Corporate bonds that trade less frequently or have larger bid-
ask spreads have higher returns. Chen, Lesmond, and Wei (2007)
find that illiquidity risk explains 7% of the variation across yields
of investment-grade bonds. Illiquidity accounts for 22% of the
variation in junk bond yields; for these bonds, a one basis point
rise in bid-ask spreads increases yield spreads by more than two
basis points. 25 6
Equities
A large literature finds that many illiquidity variables predict
returns in equity markets, with less liquid stocks having higher
returns. 2 7 These variables include bid-ask spreads, volume, vol­
ume signed by whether trades are buyer or seller initiated, turn­
over, the ratio of absolute returns to dollar volume (commonly

25 See Musto, Nini, and Schwarz (2011).

23 The on-the-run bonds are more expensive because they can be used
as collateral for borrowing funds in the repo market. This is called "spe­ 26 See also Chapter 9, Bao, Pan, and Wang (2011), Lin, Wang, and Wu
cialness." See Duffie (1996). (2011), and Dick-Nielsen, Feldhutter, and Lando (2012).
24 See Goyenko, Subrahmanyam, and Ukhov (2011). 27 See the summary article by Amihud, Mendelson, and Pedersen (2005).

392 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
called the "Amihud measure" based on his paper of 2002), the
price impact of large trades, informed trading measures (which
gauge adverse, informed trading; see below), quote size and
depth, the frequency of trades, how often there are "zero"
returns (in more liquid markets returns will bounce up and
down), and return auto correlations (which are a measure of
stale prices) . 2 8 These are all illiquidity characteristics, which are
properties unique to an individual stock. There are also illiquidity
risk betas. These are covariances of stock returns with illiquidity
measures, like market illiquidity or signed volume.
Estimates of illiquidity risk premiums in the literature range
between 1 % and 8 % depending on which measure of illiquid­
ity is used. However, Ben-Rephael, Kadan, and Wohl (2008)
report that these equity illiquidity premiums have diminished
considerably—for some illiquidity measures the risk premiums
are now zero! In pink sheet stock markets, which are over-the-
counter equity markets, Ang, Shtauber, and Tetlock (2013) find
an illiquidity risk premium of almost 2 0 % compared to about 1 %
for comparable listed equities.
Illiquid Assets
There are higher returns to hedge funds that are more illiquid, in
the sense that they place more restrictions on the withdrawal of
capital (called lockups) or for hedge funds whose returns fall
when liquidity dries up. 2 9 Franzoni, Nowak, and Phalippou
(2 0 1 2 ) report that there are significant illiquidity premiums in
private equity funds—typically 3%. In real estate, Liu and Qian
(2 0 1 2 ) construct illiquidity measures of price impact and search
costs for U.S. office buildings. They find a 10% increase in these
illiquidity measures leads to a 4% increase in expected returns.
Why Illiquidity Risk Premiums Manifest
within but Not across Asset Classes
To my knowledge, we have yet to develop formal equilibrium
models explaining the large illiquidity risk premiums within asset
classes but not across asset classes.
Perhaps the reason is limited integration across asset classes.
There are significant impediments to switching capital and
investment strategies seamlessly even across liquid stock and
bond markets. 3 0 Investors put asset classes into different silos
28 Sorting stocks on all these variables results in spreads in average
returns. But some of these illiquidity measures produce spreads in
expected returns opposite to an illiquidity risk premium. Stocks with
higher than average (normalized) volume, for example, tend to have
lower future returns as shown by Gervais, Kaniel, and Mingelgrin (2001).
29 See Aragon (2007) and Sadka (2010), respectively.
30 See Kapadia and Pu (2012) for evidence of lack of integration across
stock and bond markets.
and rarely treat them consistently as a whole. This happens on
both the sell-side, where fixed income, equity desks, and other
divisions rarely talk with each other, and on the buy-side, where
each asset class is managed by separate divisions. (Canada
Pension Plan's factor investing strategy is a notable exception to
this.) The potential mispricing of illiquidity across asset classes
could reflect institutional constraints, slow-moving capital, and
limits to arbitrage. 31
On the other hand, perhaps asset class illiquidity risk premi­
ums might be small because investors overpay for illiquid asset
classes; they chase the illusion of higher returns and bid up the
prices of these illiquid assets until the illiquidity premiums go
away. Lack of integrated asset class markets cause investors
to make ill-informed decisions for illiquid asset classes. In con­
trast, within asset classes—especially the more liquid stock and
bond markets—illiquidity-shy investors are willing to pay for the
privilege to trade as soon as they desire. As investors compete
within an asset class, they covet and pay up for liquidity.
Market Making
A market maker supplies liquidity by acting as an intermediary
between buyers and sellers. 3 2 Liquidity provision is costly.
Market makers need capital to withstand a potential onslaught
of buy or sell orders, and at any time they can be transacting
with investors who have superior information. In compensation
for these costs, market makers buy at low prices and sell at
prices around "fair value." Investors transacting with the market
maker pay the bid-ask spread.
In liquid stock and bond markets, market making is now synony­
mous with high frequency trading by investors who build mas­
sive computer infrastructure to submit buy and sell orders within
fractions of a second. More than 70% of dollar trading volume
on U.S. equity exchanges is believed due to high frequency
traders. 3 3 Many successful hedge funds specialize in high fre­
quency trading.
Many asset owners cannot collect illiquidity risk premiums by
building high-frequency trading systems, nor would they wish to
enter this business (directly or indirectly). But there is a way large
asset owners can do a low-frequency version of market making.
Dimensional Funds Advisors (DFA) is a funds management com­
pany that started in 1981 by specializing in small-cap equities.
31 See Merton (1987), Duffie (2010), and Shleifer and Vishny (1997),
respectively.
32 O'Hara (1995) provides a summary of theoretical models of market
making.
33 See Zhang (2010).
C h ap ter 19 Illiquid Assets ■ 393
DFA's strategies have deep roots in academic factor models,
and its founders, David Booth and Rex Sinquefield, roped in the
big guns of the finance literature, Fama, French, and others, in
building the company. From the start, DFA positioned itself as a
liquidity provider of small stocks, and market makinq was an
integral part of its investment strategy. 3 4 When other investors
seek to urgently offload large amounts of small stocks, DFA
takes the other side and buys at a discount. Similarly, DFA
offers small-cap equities at a premium to investors who
demand immediate liquidity.
Large asset owners, like sovereign wealth funds and large pen­
sion funds, are in a position to act as liquidity providers, espe­
cially in more illiquid markets. They can accept large blocks of
bonds, shares, or even portfolios of property at discount and
sell these large blocks at premiums. They can do this by calcu­
lating limits within their (benchmark tracking error) constraints
on how much they are willing to transact. That is, they can
provide liquidity in different securities up to a certain amount
so that they do not stray too far from their benchmarks. Buyers
and sellers will come to them as they develop reputations for
providing liquidity.
Secondary Markets for Private Equity
and Hedge Funds
Exchanges for secondary transactions in hedge funds and pri­
vate equity have sprung up, but these markets are still very
thin. Many transactions do not take place on organized sec­
ondary market platforms.
There are two forms of secondary markets in private equity.
First, in secondary (and tertiary) market buyout markets, private
equity firms trade private companies with each other. These
markets have blossomed: in 2005, secondary buyouts repre­
sented around 15% of all private equity buy-out deals. 3 6 From
the perspective of asset owners (limited partners [LPs]), this
market provides no exit opportunities from the underlying pri­
vate equity funds and is at worst a merry-go-round of private
equity firms swapping companies in circular fashion. At best,
more transactions at market prices (assuming there is no fina­
gling between the transacting funds) allow asset owners to
better value their illiquid investments. The LPs are still stuck in
the fund, but they might receive some cash when a company in
their fund's portfolio is sold to another private equity firm.
34 See Keim (1999) and the Harvard Business School case study,
Dimensional Fund Advisors, 2002, written by Randolph Cohen.
35 An academic study of this market is Kleymenova, Talmor, and
Vasvari (2012).
n /
Report of the Committee on Capital Markets Regulation, 2006.
394 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
Secondary markets for LPs, which allow them to exit from pri­
vate equity funds, are much smaller and more opaque. Even
industry participants acknowledge this market "still remains rela­
tively immature . . . and still represents a very small percentage
of the primary market. " 3 7 Bid-ask spreads in these transactions
are enormous. As Cannon (2007) notes, the secondary market
for LPs was dominated in the 1990s by distressed sellers.
Specialized firms on the other side of these deals got discounts
of 30% to 50%; there was a reason these firms were called
"vultures." In the 2000s, discounts fell to below 20% but shot
up during the financial crisis. Harvard University found this out
when it tried to disinvest in private equity funds during 2008
and faced discounts of 50%.
Discounts for hedge funds are much smaller than private
equity. This reflects the fact that hedge funds investors can, in
most cases, access capital at predetermined dates after lock­
ups have expired and notice requirements have been satisfied
(unless the hedge fund imposes gates). Reflecting this greater
underlying liquidity, hedge fund discounts in secondary mar­
kets in 2007 and 2008 were around 6 % to 8 % . 3 8 (A few hedge
funds that are closed to new investors actually trade at
premiums.)
The nascent secondary markets for private equity and hedge
funds are tremendous opportunities for large asset owners to
supply liquidity. Secondary private equity is like second-hand
cars that are still brand new. When you drive a new car off the
lot, it immediately depreciates by a quarter, even though it
is exactly the same as a car sitting in the dealer's inventory.
Secondary private equity is still private equity, and you can get
it a lot cheaper than direct from the dealer.
Adverse Selection
A market maker faces a risk that a buyer has nonpublic infor­
mation, and the stock is selling at a price that is too high or
too low relative to true, fundamental value. A buyer knowing
that the stock will increase in value will continue to buy and
increase the price. In this case, the market maker has sold
too early and too low. This is adverse selection. Glosten and
Milgrom (1985) and Kyle (1985)—the papers that started the
market-making microstructure literature—developed theo­
ries of how the bid-ask spread should be set to incorporate
the effects of adverse selection. DFA provides some exam­
ples of how to counter adverse selection. To avoid being
exploited, DFA trades with counterparties that fully disclose
37 From the introduction to Luytens (2008) written by Andrew Sealey
and Campbell Lutyens.
38 See Ramadorai (2012).
their information on stocks. At the same time, DFA itself
operates in a trustworthy way by not front running or
manipulating prices . 3 9
Rebalancing
The last way an asset owner can supply liquidity is through
dynamic portfolio strategies. This has a far larger impact on
the asset owner's total portfolio than liquidity security selec­
tion or market making because it is a top-down asset allocation
decision.
Rebalancing is the simplest way to provide liquidity, as well as
the foundation of all long-horizon strategies. Rebalancing forces
asset owners to buy at low prices when others want to sell. Con­
versely, rebalancing automatically sheds assets at high prices,
transferring them to investors who want to buy at elevated
levels. Since rebalancing is counter-cyclical, it supplies liquidity.
Dynamic portfolio rules, especially those anchored by simple
valuation rules, extend this further—as long as they buy when
others want to sell and vice versa. It is especially important to
rebalance illiquid asset holdings too, when given the chance
(see also below).
Purists will argue that rebalancing is not strictly liquidity provi­
sion; rebalancing is an asset management strategy. Rebalanc­
ing, in fact, can only occur in the context of liquid markets. But
prices exhibit large declines often because of blowouts in asym­
metric information, or because funding costs rapidly increase
so that many investors are forced to offload securities—some
of the key elements giving rise to illiquidity listed at the start of
an earlier section. Brunnermeier (2009) argues that these effects
played key roles in the meltdown during the financial crisis. In
the opposite case, rebalancing makes available risky assets to
new investors, potentially with lower risk aversions than existing
clientele or those who chase past high returns, or to investors
who load up on risky assets when prices are high because they
have abundant access to leverage and they perceive asymmetric
information is low. In this general framework, rebalancing pro­
vides liquidity.
Large asset owners give up illiquidity premiums by sheepishly
tracking standard indexes. When indexes change their constitu­
ents, asset owners demand liquidity as they are forced to follow
these changes. Index inclusion and exclusion induce price
effects of 3% to 5%, and these effects have become stronger in
more recent data. 4 0 Large asset owners should be collecting
39 See Mackenzie (2006).
40 See the literature on index reconstitution effects summarized by Ang,
Goetzmann, and Schaeffer (2011).
index reconstitution premiums instead of paying them. They can
do this by using their own proprietary benchmarks. Candidate
indexes could emphasize illiquidity security characteristics but
more generally would be built around harvesting factor risk
premiums. Even an index without illiquidity tilts allows asset
owners to harvest a liquidity premium collected from all the
other investors forced to track standard indexes.
Summary
Of all the four ways to collect an illiquidity premium: (i) holding
passive allocations to illiquid asset classes, (ii) holding less liquid
securities within asset classes, (iii) market making at the indi­
vidual security level, and (iv) dynamic rebalancing at the aggre­
gate level; the last of these is simplest to implement and has the
greatest impact on portfolio returns.
19.6 PORTFOLIO CHOICE WITH
ILLIQUID ASSETS
In deciding on how much of their portfolios to devote to illiquid
assets, investors face many considerations specific to their own
circumstances. Investors have different horizons. Illiquid markets
don't have tradeable indices, so investors have to find talented
active portfolio managers. Then they face agency issues and
evaluating and monitoring portfolio managers requires skill.
Thus the premium for bearing illiquidity risk might be individual-
specific. Computing these illiquidity premiums requires asset
allocation models with liquid and illiquid assets. These models
also prescribe an optimal amount of illiquid assets to hold.
Practitioners generally use one-period investment models—
usually the restrictive Markowitz (1952) mean-variance model
with ad hoc adjustments (yes, most of the industry is still using
models from the 1950s)—which are inappropriate for illiquid
asset investing. The fact that you cannot trade an illiquid asset
now but will do so in the future makes illiquid asset investing a
dynamic, long-horizon problem. There are two important
aspects of illiquidity—large transaction costs and long times
between trading—that have been captured in portfolio choice
models with illiquid assets. 41
Asset Allocation with Transactions Costs
George Constantinides (1986) was the first to develop an asset
allocation model where the investor had to pay transaction costs.
Selling $100 of equities, for example, results in a final position of
41 Parts of this are based on Ang (2011) and Ang and Sorensen (2012).
C h ap ter 19 Illiquid Assets ■ 395
$90 with 10% transactions costs. Not surprisingly, the investor
trades infrequently—to save on transactions costs. Constantinides
proved that the optimal strategy is to trade whenever risky asset
positions hit upper or lower bounds. Within these bounds is an
interval of no trading. The no-trading band straddles the optimal
asset allocation from a model that assumes you can continuously
trade without frictions (the Merton 1971 model) . 4 2
The no-trade interval is a function of the size of the transac­
tions costs and the volatility of the risky asset. Constantinides
estimates that for transactions costs of 1 0 %, there are no-trade
intervals greater than 25% around an optimal holding of 25% for
a risky asset with a 35% volatility. (I bet Harvard wished it could
have received just a 1 0 % discount when it tried to sell its private
equity investments in 2008.) That is, the asset owner would not
trade between (0%, 50%)—indeed, very large fluctuations in the
illiquid asset position. Illiquid asset investors should expect to
rebalance very infrequently.
Constantinides' model can be used to compute an illiquid­
ity risk premium, defined as the expected return of an illiquid
asset required to bring the investor to the same level of utility
as in a frictionless setting. This is the risk premium the inves­
tor demands to bear the transactions costs and is a certainty
equivalent calculation. For transaction costs of 15% or more, the
required risk premium exceeds 5%. Compare this value with (the
close to) zero additional excess returns, on average, of the illiq­
uid asset classes in data.
A major shortcoming of the transaction costs models is that they
assume trade is always possible by paying a cost. This is not true
for private equity, real estate, timber, or infrastructure. Over a
short horizon, there may be no opportunity to find a buyer. Even
if a counterparty can be found, you need to wait for due dili­
gence and legal transfer to be completed and then the counter­
party can get cold feet . 4 3 Many liquid assets also experienced
liquidity freezes during the financial crisis where no trading—at
any price—was possible because no buyers could be found.
Asset Allocation with Infrequent Trading
In Ang, Papanikolaou, and Westerfield (2013), I develop an
asset allocation model in which the investor can transact illiquid
42 Chapter 4 discusses extensions of Constantinides (1986) to double
bands, contingent bands, and rebalancing to the edge or center of
the bands.
43 For some illiquid assets, investors may not be even willing to trans­
act immediately for one cent; some investments do not have liability
limited at zero. For example, on June 30, 2008, a real estate invest­
ment by CalPERS was valued at negative $300 million! See Corkery, M.,
C. Karmin, R. L. Rundle, and J. S. Lublin, "Risky, Ill-Timed Land Deals Hit
CalPERS," Wall Street Journal, Dec. 17, 2008.
396 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
assets only at randomly occurring liquidity events. This notion of
illiquidity is that usually illiquid assets are just that—illiquid and
cannot be traded. But when the liquidity event arrives, investors
can trade.
I model the arrival of liquidity events by a Poisson arrival process
with intensity A. The interval between liquidity events is 1/A. For
real estate or private equity, intervals between trading would
occur every ten years or so, so A = 1/10. As A increases to
infinity, the opportunities to rebalance become more and more
frequent and in the limit approach the standard Merton (1981)
model where trading occurs continuously. Thus A indexes a
range of illiquidity outcomes.
Poisson arrival events have been used to model search-based
frictions since Peter Diamond (1982), who won his Nobel Prize
in 2010. The following year, he was nominated to serve on the
Federal Reserve Board of Governors, but Republican opposition
blocked his confirmation.
Illiquidity risk causes the investor to behave in a more risk-averse
fashion toward both liquid and illiquid assets. Illiquidity risk
induces time-varying, endogenous risk aversion. Harvard discov­
ered in 2008 that although it is wealthy, it cannot "eat" illiquid
assets. Illiquid wealth and liquid wealth are not the same; agents
can only consume liquid wealth. Thus the solvency ratio of illiq­
uid to liquid wealth affects investors' portfolio decisions and
payout rules—it becomes a state variable that drives investors'
effective risk aversion.
The takeaways from the Ang, Papanikolaou and Westerfield
model are:
Illiquidity Markedly Reduces Optimal Holdings
Start with the bottom line in Panel A of Table 19.2, which
reports a baseline calibration where the investor holds 59% in
a risky asset that can always be traded. This weight is close to
the standard 60% equity allocation held by many institutions.
As we go up the rows, the asset becomes more illiquid. If the
risky asset can be traded on average every six months, which is
the second to last line, 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 alloca­
tion is 11%. For ten years, this reduces to 5%. Illiquidity risk has
a huge effect on portfolio choice.
Rebalance Illiquid Assets to Positions
below the Long-Run Average Holding
In the presence of infrequent trading, illiquid asset wealth can
vary substantially and is right-skewed. Suppose the optimal hold­
ing of illiquid assets is 0.2 when the liquidity event arrives. The
Table 19.2
Panel A
Average Time between
Liquidity Events (or
Average Turnover)
Investors do not load up on illiquid assets because these assets
have illiquidity risk and cannot be continuously traded to con­
struct an "arbitrage."
Optimal Rebalance Investors Must Demand High Illiquidity
Value Hurdle Rates

10 Years 0.05 How much does an investor need to be compensated for illi­
quidity? In Panel B of Table 19.2, I compute premiums on an
5 Years 0 .1 1
illiquid asset required by an investor to bear illiquidity risk. Let's
2 Years 0.24 define the illiquidity premium, or hurdle rate, as a certainty
1 Year 0.37 equivalent. Suppose an investor holds two liquid assets and
replaces one asset with another that is identical except for being
1/2 Year 0.44
illiquid. The illiquidity premium is the increase in the expected
Continuous Trading 0.59 return of the illiquid asset so that the investor has the same util­
Panel B ity as the case when all assets are liquid.
Average Time between When liquidity events arrive every six months, on average, an
Liquidity Events (or Illiquidity Risk investor should demand an extra 70 basis points. (Some hedge
Average Turnover) Premium funds have lockups around this horizon.) When the illiquid asset
10 Years 6 .0 % can be traded once a year, on average, the illiquidity premium
5 Years 4.3% is approximately 1%. When you need to wait ten years, on aver­
age, to exit an investment, you should demand a 6 % illiquidity
2 Years 2 0 . %
premium. That is, investors should insist that private equity
1 Year 0.9% funds generate returns 6 % greater than public markets to com­
1/2 Year 0.7% pensate for illiquidity. Most illiquid assets are not generating
excess returns above these hurdle rates.
Continuous Trading 0 .0 %
The Ang, Papanikolaou, and Westerfield (2013) model is highly
stylized. Given the other issues the model misses, like agency
investor could easily expect illiquid holdings to vary from 0 . 1 to conflicts of interest, cash flow management issues of capital
0.35, say, during nonrebalancing periods. Because of the right- calls and distributions, and asset-liability mismatches, the true
skew, the average holding of the illiquid asset is 0.25, say, and is illiquidity hurdle rates are even higher than those reported in
greater than the optimal rebalanced holding. The optimal trading Table 19.2.
point of illiquid assets is lower than the long-run average holding.

Summary
Consume Less with Illiquid Assets
Portfolio choice models with illiquid assets recommend holding
Payouts, or consumption rates, are lower in the presence of
only modest amounts of illiquid assets. Investors should demand
illiquid assets than when only comparable liquid assets are held
high illiquidity risk premiums.
by the investor. The investor cannot offset the risk of illiquid
assets declining when these assets cannot be traded. This is
an unhedgeable source of risk. The investor offsets that risk by
eating less. 19.7 LIQUIDATING HARVARD REDUX

There Are No Illiquidity "Arbitrages"
In a mean-variance model, two assets with different Sharpe
ratios and perfect correlations produce positions of plus or
minus infinity. This is a well-known bane of mean-variance
models, and professionals employ lots of ad hoc fixes, and
arbitrary constraints, to prevent this from happening. This does
not happen when one asset is illiquid—there is no arbitrage.
The Case for Illiquid Asset Investing
Large, long-term investors often cite their large amounts of
capital and their long horizons as rationales for investing in
illiquid assets. Size and patience are necessary but not sufficient
conditions for illiquid asset investing; these conditions simply
aren't adequate justifications in themselves. Since illiquid asset
classes do not offer high risk-adjusted returns, the case for

C h ap ter 19 Illiquid Assets ■ 397

passively them is not compelling. Illiquid investing also poses
huge agency problems; asset owners, for example, find it tough
to monitor external managers. Many institutions face "fief-
dom risk" as illiquid assets are run as separate empires within
an organization, detrimentally affecting how the aggregate
portfolio is allocated.
In addition, investors in illiquid markets face high idiosyncratic
risk because there is no "market" portfolio. It is exactly this
large idiosyncratic risk, however, that is the most compelling
reason for investing in illiquid assets.
Suppose you are a skilled investor (assume you have true alpha)
and have a choice between investing in (i) a market where prices
quickly reflect new information, almost everyone sees the same
information, and news gets spread around very quickly, or (ii)
a market where information is hard to analyze and even harder
to procure, only a select few have good information, and news
takes a long time to reach everyone. Obviously you pick (ii).
This, in a nutshell, is the Swensen (2009) justification for choos­
ing illiquid assets. The argument is not that illiquid asset classes
have higher risk-adjusted returns. Empirical evidence suggests
they don't.
Investing in illiquid assets allows an investor to transfer idiosyn­
cratic risk from liquid equity and bond markets, which are largely
efficient, to markets where there are large information asymme­
tries, transactions costs are punishing, and the cross-sections of
alpha opportunities are extremely disperse. These are the mar­
kets, in other words, where you can make a killing!
The Swensen case crucially relies on one word: "skilled."
Whereas skilled investors can find, evaluate, and monitor these
illiquid investment opportunities, assuming they have the
resources to take advantage of them, unskilled investors get
taken to the cleaners. If you are unskilled, you lose. Harvard,
Yale, Stanford, MIT, and a few other select endowments have
the ability to select superior managers in illiquid markets
because of their size, their relationships, and their commitment
to support these managers through long investment cycles.
What about the others? An endowment specialist says, "It's a
horror show. [Performance has] been flat to even negative. The
strong get stronger and the weak get stuck with non-top quar-
tile managers and mediocre returns and high fees . 4 4
Investment Advice for Endowments
Thomas Gilbert and Christopher Hrdlicka at the University
of Washington are probably the world's only endowment
44 Quoted by Stewart, J. B., "A Hard Landing for University Endow­
ments," New York Times, Oct. 12, 2012.
398 ■ Financial Risk M anager Exam P art II: Liquidity and Treasury Risk M easurem ent and M anagem ent
management theorists. In a 2012 paper, they provocatively
argue that the optimal allocation policy for successful universi­
ties is to hold large amounts of fixed income, not risky assets,
and by extension not illiquid risky assets.
Gilbert and Hrdlicka model universities as creators of "social div­
idends," which are research and teaching. Universities can invest
internally, in research and teaching projects, or they can invest
externally through the endowment. If the endowment is taking
on external risk—via equities, for example—this signals that the
university does not have enough good internal risky projects
generating social dividends. If the endowment is invested in safe
assets, through bonds, the university takes on risk through inter­
nal research and teaching projects. Gilbert and Hrdlicka argue
that a university endowment's large investment in risky assets is
a sign that it does not have enough fruitful research and teach­
ing assignments!
Harvard, with its large endowment heavily invested in risky
illiquid assets, would take issue with Gilbert and Hrdlicka. An
endowment allows a university to be more independent,
rather than depend entirely on grants from government or
private foundations. As Dershowitz argues, the endowment
could be used as a rainy day account to be tapped precisely
during times like 2008. Harvard's endowment has historically
yielded a predictable stream of cash for operating budgets,
but 2008 blew this predictability away. Harvard claims its
endowment allows for future generations to share in its riches,
saying, "Although their specific uses vary, endowment funds
have a common purpose: to support activities not just for one
year, or even one generation, but in perpetuity. 4 5 The price of
education, however, has been rising in real terms, and if
education is costlier in the future than in the present, being
stingy on research and teaching now makes no sense because
it substitutes a more expensive good in the future for a
cheaper one today . 4 6
Henry Hansmann, a professor at Yale Law School, describes
large private universities as "institutions whose business is to run
large pools of investment assets. . . . They run educational insti­
tutions on the side, that can expand and contract to act as buf­
fers for investment pools. " 4 7 * He contends that a large part of
why universities like large endowments is prestige, pursued as
its own objective. Journalist Kevin Carey puts it another way,
45 "About HSPH: Endowment Funds: What Are Endowment Funds?"
Harvard School of Public Health, http://www.hsph.harvard.edu/about/
what-are-endowment-funds
46 See Hansmann (1990).
47 "Q&A. Modest Proposal. An Economist Asks, Does Harvard Really
Need $15 Billion?" New York Times, Aug. 2, 1998.
echoing the cadences of the Book of Common Prayer when he
says that large endowments per se are "aspiration without limit,
accumulation without end . " 4 8
Liquidate Harvard?
Did Harvard generate excess returns, or an illiquidity risk pre­
mium, from its large investments in illiquid, alternative assets?
Yes. Harvard could extract value from illiquid asset investing
not because illiquid asset classes have a large risk premium but
because it is a skillful investor. And it is one of the few investors
able to do so.
But this didn't help Harvard solve its cash crunch. The worst
failing of Harvard was in basic asset-liability management. Even
without using the asset allocation models with illiquidity risk or
the advice given by Gilbert and Hrdlicka, Harvard should have
recognized that its assets did not match its liabilities. In technical
terms the duration of its liabilities was shorter than the duration
of its assets.
Harvard faced five choices:
1. Liquidate a portion of the endowment.
But a lot of the endowment is illiquid and cannot be sold.
48 Kevin Carey, "The 'Veritas' About Harvard," Chronicle of Higher
Education, Sept. 28, 2009.
2. Cut expenses.
Universities are like government bureaucracies: big,
bloated, and inefficient. You can hardly fire anyone. So
there is a limit to how much can be cut.
3. Increase donations.
It's embarrassing to ask for funds to replace those lost as a
result of mismanagement.
4. Increase other revenue.
Harvard could rescind its need-blind financial-aid policy. But
it turns out this doesn't save much money.
5. Borrow.
Harvard did (5). It issued $2.5 billion in bonds and more than
doubled its leverage ratio between 2008 and 2009. It did try
to cut expenses and deferred its Allston campus expansion.
Was the endowment a rainy day fund Joseph could use to save
his family and all of Egypt, as suggested by Dershowitz? No.
Harvard actually reduced its payout ratio in 2009, preferring to
keep as much of the endowment intact as it could. 4 9 Maybe
Hansmann is right in suggesting that prestige maximization is
the driving motivation in endowment management. After all,
everyone likes to be well-endowed.
49 Brown et al. (2013) show that most universities do the same thing:
they hoard endowments when bad times come.
C h ap ter 19 Illiquid Assets ■ 399
IN D EX

A dealer banks, 160

strategy, 350
active risk management, 126
asset purchases/funding, 122
adverse price impact, 38, 40-41
available assets
amortising loans, 299-300
bond
Ang, A., 397
buy/sellback and sell/buyback, 148
Ang, Papanikolaou, and Westerfield (2013) model, 396-397
lending and borrowing, 148
arbitrages, 397
purchase, 146
Ashanti Goldfields, 8
repo and reverse repo, 147
asset conversion, 91
selling, 146
asset-liability committee (ALCO), 181
buy/sellback transactions, 144
asset-liability management (ALM), 350
contracts types, 145
convexity and duration, 366-367
repo transactions, 144
definition, 350
reverse repo transactions, 144
duration gap
security borrowing, 145
limitations, 372-373
security lending, 144
management, 365, 367-372
sell/buyback transactions, 144
funding liquidity risk measurement, 38
available funds gap (AFG), 261
interest rate risk, 351
components, 353-355
forces determining, 351-352 B
measurement, 352-353 balanced liquidity management strategies, 93
responses to, 355-356 balance sheet risk, see funding liquidity risk
interest-sensitive gap management, 356 bank discount rate, 353
net interest margin (NIM), 356 bankers' acceptances, 59-60
price sensitivity to changes in interest rates, 366 Bank for International Settlements (BIS), 121
problems with interest-sensitive GAP management, 362-364 bank liquidity
risk-management tool, 365 fragility of commercial banking, 21-22
sample interest-sensitivity analysis (GAP Management), 360-362 liquidity transformation by banks, 20-21
strategies banks' global balance sheets, US dollar shortage
asset management strategy, 350 balance sheet expansion since 2000, 316
funds management, 351 cross-currency funding positions, 316-320
liability management strategy, 350-351 maturity transformation across banks' balance sheets, 320-323
asset liquidity management strategies, 91-92 structure of banks' operations, 313-316
asset management, 350 banks' international positions, 311-313

401
bank size and borrowing, 109-110 Central bank borrowing, 8
bank specific indicators, 52-54 Central bank reserve requirements, 111
Basel Committee on Banking Supervision (BCBS), 121, 289, 307 certificate of deposit (CD), 59
principles for sound liquidity risk management and supervision, clearing balance rules, 106
301-302 client intraday credit usage, 128
baseline scenario, 177 collateral markets, 131
basic (lifeline) banking, 239-240 economic function of markets, 28-29
BCBS recommended early warning indicators, 47 prime brokerage and hedge funds, 29
bid-ask spread, 38 risks in, 29-31
BIS international banking statistics, 328 securitization process, 26
black holes, liquidity, see also liquidity risk structure
diversity, importance of, 14 margin loans, 26-27
irrational exuberance, 13-14 repurchase agreements, 27
leveraging and deleveraging, 12-13 securities lending, 27
positive and negative feedback traders, 11-12 total return swaps, 27
regulation, impact of, 14 collateral pledging, 122
board of directors, 212 collateral requirements, 180
bond commercial paper, 60
buy/sellback and sell/buyback, 148 commercial paper market, 259-260
lending and borrowing, 148 Committee for European Banking Supervisors (CEBS), 290, 307
purchase, 146 Committee on Payment and Settlement Systems (CPSS), 121
repo and reverse repo, 147 Committee on Payments and Market Infrastructures (CPMI), 121
selling, 146 conditional pricing, 233
borrow, ability to, 7 consistency check and data limitations, 329-330
borrowed liquidity (liability) management strategies, 92-93 Constantinides, G., 395
borrowing, 92 Constantinides' model, 396
Federal reserve banks, 255-256 contingency funding plan (CFP), 10
liquidity, 92 actions in liquidity crisis, 210
business dial back, 180 capabilities and enhancements, 210
business risk, 70-71 design considerations
buy/sellback transactions, 144 align to business and risk profiles, 210-211
appropriate stakeholder groups, 211
broader risk management frameworks, 211
C communication plan, 211
call risk, 71 operational, actionable, but flexible playbook, 211
capital and performance metrics, 181 different types of institutions, 218
capital market investment instruments framework and building blocks
corporate bonds, 61 contingent actions, 214-215
corporate notes, 61 data and reporting, 218
municipal bonds, 60-61 governance and oversight, 212-213
municipal notes, 60-61 monitoring and escalation, 215-218
treasury bonds, 60 scenarios and liquidity gap analysis, 213-214
treasury notes, 60 liquidity and capital, 219
capital stress testing, 184 organizational structure of, 218-219
cash and treasury securities, 6 contingent liabilities, 180
cash balances, 125 contingent liquidity, 131
cash flow requirements, measurement, 173
classifications, 134 contingent liquidity risk management
liquidity risk reporting banks liquidity cushions unveiled by GFC, 302
asset and liability, 194 extant guidance focuses on size, 302
survival horizon, 197, 198 liquidity cushions, 301
treatment, 204 poor attribution of cost of carrying, 302-303
at risk, 150-154 pricing contingent liquidity risk, 304-305
taxonomy, 134 towards better management, 303-304
cash management, repurchase agreements and, 274-275 contracts types, 145

402 ■ Index
convexity, 366 deposits
core deposits, 226 conditional pricing, 233-237
corporate bonds by depository institutions
capital market investment instruments, 61 nontransaction (savings/thrift), 224
illiquidity risk premiums, 392 retirement savings, 224-225
corporate notes transaction (payments/demand), 222-224
capital market investment instruments, 61 insurance coverage by FDIC, 231-232
corporate treasury, 212 interest rates
cost of trade processing, 37 composition, 225-226
cost-plus pricing, 230 cost of different deposit accounts, 228-229
Counterparty Risk Management Policy Group III (CRMPGIII), 307 ownership, 226-228
counterparty stress, 129 LTP, 299-300
covered interest parity (CIP) marginal cost to set interest rates on, 232-233
factors, 335 outflows, 179-180
hedging demand, quantitative indicators, 339-343 ownership of, 226-228
limits to arbitrage, 338-339 pricing deposit
mechanics, 334 at cost plus profit margin, 230
regression results, 345-346 services, 229
tighter limits to arbitrage and basis, 344-345 total customer relationship vs. depository, pricing, 237-239
violations, 334 wholesale and retail, 7-8
yen/dollar case, 343-344 depth, characteristics of market liquidity, 38
crash of 1987, 12 Dershowitz, A., 383
credit availability risk, 266 dimensional funds advisors (DFA), 393
credit crisis, 2 discount window, 255
credit/default risk, 69-70 distorts profit assessment, 297
cross-currency swaps, 335 duration, 365
currency, 176 duration gap, 367
customer relationship doctrine, 248 limitations, 372-373
customer stress, 129 management, 365, 367-372
cyclical component, 95 duration, maturity management
cyclical element, 95 immunization, 77-78
portfolio immunization, 78

D
daily maximum intraday liquidity usage, 127-128 E
data aggregation, 126 early warning indicators (EWI)
daylight overdraft (DOD), 42, 120, 131 bank specific indicators, 52-54
dealer banks BCBS recommended, 47
failure mechanisms beyond, 46
derivatives counterparties, 164-165 dashboard, 46
flight of prime brokerage clients, 162-164 dimensions, 49
flight of short-term creditors, 161-162 key supervisory guidelines, 46, 48
loss of cash settlement privileges, 165 market indicators, 51
internal hedge funds, 157 M.E.R.l.T.
off-balance-sheet financing, 160-161 environments, both normal and stressed, 50
over-the-counter derivatives, 158-160 escalation, 50
policy responses, 165-166 forward looking bias/view, 49-50
prime brokerage and asset management, 160 industry practices, 51
securities dealing, 158 integrated systems, 50
trading, 158 measures, 47, 49
underwriting, 158 reporting, 50
deleveraging, 12-13, 18 spanning various time horizons, 50
deposit behavioral characteristics, 180 thresholds, 50-51
depositors, 156 regulatory emphasis in recent times, 46
Depository Trust and Clearing Corporation (DTCC), 159 risk identification and, 47, 49

Index ■ 403
e-banking, 227 solvency, 41
e-commerce, 227 transactions measurement
endowments, investment advice, 398-399 adverse price impact, 40-41
equities transaction cost liquidity risk, 39-40
illiquidity risk premiums, 392-393 funding optimization, 183
private, 394 funds approach, sources and uses, 94-96
Eurocurrency deposit, 258 funds management, 351
market, 258-259 funds transfer pricing, 184
eurocurrency deposits, 59, 92
European Commission (EC), 290, 307 G
expected rate of return, 65
Geltner, D., 386
Geltner-Ross-Zisler unsmoothing process, 386

F Gilbert, T., 398

global financial crisis (GFC), 46, 288, 310, 334
Faust, D., 382
Goldman Sachs Global Core Excess, 38
federal agency securities, 59 Greenspan, A., 14
Federal Deposit Insurance Corporation (FDIC), 231-232
Federal funds borrowings, 92
H
Federal funds market (Fed funds), 109, 250-252
Federal Home Loan Bank (FHLB), 92 Hansmann, H., 398
advances from, 256 Harvard Management Company (HMC), 382
hedge funds
feedback traders, positive and negative, 11-12
cash, 39
financial market utilities (FMUs) risk
collateral, 131 collateral markets, prime brokerage and, 29
dynamic, 11
contingent liquidity, 131
funding liquidity management, 39
liquidity savings mechanism, 131
management, 129-130 funding liquidity risk, 24
monitoring, 130-131 funding liquidity risk measurement, 39
issues, 8
net debit caps, 130-131
settlement windows, 131 secondary markets for, 394

financial market utility, 131 unpledged assets, 39

unused borrowing capacity, 39
financial stress, 129
holding period yield (HPY), 65
foreign exchange (FX) swaps, 335
Forst, E., 382 Hrdlicka, C .( 398
fragility, commercial banking, 21-22
funding liquidity I
bank liquidity illiquid assets
fragility of commercial banking, 21-22 consume less with, 397
liquidity transformation by banks, 20-21 liquidating HARVARD, 382-383
definition, 18 liquidating HARVARD redux
hedge funds, 24 case for investing, 397-398
liquidity transformation, 19-20 investment advice, endowments, 398-399
maturity transformation, 18-19 markets
measurement characteristics of, 383-385
asset-liability management, 38 sources of, 383
Goldman Sachs Global Core Excess, 38 portfolio choice with asset allocation
hedge funds, 39 infrequent trading, 396-397
money market mutual funds, 23-24 transactions costs, 395-396
structured credit and off-balance-sheet funding, 22-23 rebalance, long-run average holding, 396-397
systematic, 24-25 returns are not returns
and system risk infrequent trading, 386
interconnectedness, 43 selection bias, 389-390
and market liquidity, 42 survivorship bias, 385-386
and plumbing, 42 unsmoothing returns, 386-389

404 ■ Index
illiquidity international interest, 121
asymmetric information, 383 measurement, 126
causes of, 38 measures for understanding flows
clientele effects and participation costs, 383 other cash transactions, 127
crises, 385 settlement positions, 127
funding constraints, 383 time sensitive obligations, 127
hurdle rates, 397 total bank intraday credit lines available and usage, 127
optimal holdings reduction, 396 total intraday credit lines to clients and counterparties, 127
price impact, 383 total payments, 127
risk premiums quantifying measurement and monitoring risk levels
across asset classes, 391-392 client intraday credit usage, 128
within asset classes, 392-393 daily maximum intraday liquidity usage, 127-128
market making, 393-395 intraday credit relative to tier 1 capital, 128
rebalancing, 395 payment throughput, 128
search frictions, 383 stress testing role, 128-129
sources of, 383 uses and sources, 121, 123, 124
transaction costs, 383 asset purchases/funding, 122
immunization, 77-78 cash balances, 125
impact factors, 178, 179 collateral pledging, 122
inflation risk, 72 funding of nostro accounts, 122
infrequent trading, 396-397 intraday credit, 125
illiquid assets returns are not returns, 386 liquid assets, 125
The Institute for International Finance (IIF), 307 other term funding, 125
interconnectedness, 43 outgoing wire transfers, 122
interest-bearing transaction deposits, 223 overnight borrowings, 125
interest rate settlements, at PCS systems, 122
asset-liability management, 351 inventory management by dealers, 37
components, 353-355 investments, 56
forces determining, 351-352 advantages and disadvantages, 58
measurement, 352-353 capital market instruments, 57
responses to, 355-356 corporate bonds, 61
deposits corporate notes, 61
composition, 225-226 municipal bonds, 60-61
cost of different deposit accounts, 228-229 municipal notes, 60-61
ownership, 226-228 treasury bonds, 60
risk, 69, 262, 266, 351 treasury notes, 60
interest-sensitive gap management, 356 factors affecting
internal audit, 182 business risk, 70-71
internal hedge funds, dealer banks, 157 call risk, 71
international eurocurrency deposits, 59 credit/default risk, 69-70
intraday credit, 125 expected rate of return, 65
intraday credit relative to tier 1 capital, 128 inflation risk, 72
intraday liquidity, 132 interest rate risk, 69
intraday liquidity risk, 132 liquidity risk, 71
intraday liquidity risk management pledging requirements, 72-73
FMU risk prepayment risk, 71-72
collateral, 131 tax exposure, 65-69
contingent liquidity, 131 maturity management tools
liquidity savings mechanism, 131 duration, 77-78
management, 129-130 yield curve, 76-77
monitoring, 130-131 maturity strategies
net debit caps, 130-131 back-end load maturity policy, 75
settlement windows, 131 Barbell strategy, 75
governance of, 125-126 front-end load maturity policy, 74-75

Index ■ 405
investments (continued) vs. capital, 183
ladder/spaced-maturity policy, 73-74 definition, 2, 18
rate expectations approach, 75-76 demand for and supply of, 88-90
money market instruments, 57 problems in financial firms, 90
bankers' acceptances, 59-60 sources of
certificate of deposit (CD), 59 ability to borrow, 7
commercial paper, 60 cash and treasury securities, 6
federal agency securities, 59 central bank borrowing, 8
international eurocurrency deposits, 59 hedging issues, 8
short-term municipal obligations, 60 securitization, 8
treasury bills, 57 trading book positions, 6-7
treasury bonds, 59 wholesale and retail deposits, 7-8
treasury notes, 59 vs. yield, 182-183
portfolio haircuts, 179 liquidity coverage ratio (LCR), 9
recent development, instruments liquidity crisis team, 212
securitized assets, 61-63 liquidity dashboard, 183
structured notes, 61 liquidity gap, 94
securities held by banks, 63-64 liquidity generation capacity (LGC)
security portfolio, 57 AFS bonds, 143
irrational exuberance, 13-14 classification, 142
definition, 141
security-linked liquidity, 142
L security-unlinked liquidity, 142
lagged reserve accounting (LRA), 103 liquidity indicator approach, 94, 100-101
legal reserves, 103 liquidity management, 206-207
clearing balance rules, 106 Liquidity Management Information Systems (LMIS), 288, 292-293
required reserves calculation, 104-106 liquidity managers strategies
reserve computation, 103-104 asset liquidity management strategies, 91-92
reserve maintenance, 104 balanced liquidity management strategies, 93
reserve requirements, 104 borrowed liquidity (liability) management strategies, 92-93
leverage guidelines for, 93
asset volatility and, 37 liquidity needs estimation
definition, 31 funds approach, sources and uses, 94-96
derivatives, 35-36 liquidity gap, 94
liquidity black holes, 12-13 liquidity indicator approach, 100-101
margin loans and leverage, 33 structure of funds method, 97-100
measurement, 31 ultimate standard, 101-103
short positions, 34 liquidity options, 135-136
structured credit, 36-37 liquidity position metrics, 181
liability management, 92, 248, 350 prospective, 181
strategy, 350-351 liquidity risk, 71
liquid asset, 91, 125 adjusted VaR, 5
buffer, 174 bid-offer spread, market liquidity., 6
liquidating HARVARD, 382-383 credit crisis, 2
liquidating HARVARD redux definition, 137, 138
case for investing, 397-398 in funding
investment advice, endowments, 398-399 regulation, 9-10
liquidity, 88 reserve requirements, 9
black holes (see also liquidity risk) sources of, 6-9
diversity, importance of, 14 funding cost risk, 137
irrational exuberance, 13-14 market liquidity measurement, 4
leveraging and deleveraging, 12-13 quantitative measurement
positive and negative feedback traders, 11-12 causes of, 138
regulation, impact of, 14 sources of, 138

406 ■ Index
 solvency from, 2
in trading
bid-offer, 2
predatory trading, 3
transparency, importance of, 3
unwinding position optimally, 5-6
liquidity risk reporting
cash flow
asset and liability, 194
survival horizon, 197, 198
treatment, 204
cumulative liquidity report, 195
daily liquidity report, 188-192
deposit tracker report, 188
firm-specific funding yield curve, 201
frequency of reporting, 202-203
funding concentration report, 192-193, 198
funding maturity gap ("mismatch") report, 192
group treasury qualitative reporting, 203
liability profile, 193, 200
liquid securities list, 193
maturity gap report, 196
stress test reports, 203-207
summary and qualitative reports, 201-202
UK liquidity reporting requirements, 203
undrawn commitment report, 193
wholesale pricing and volume, 200-201
liquidity savings mechanism, 131
liquidity stress test
analytics, 183
and asset liability management, 184
assumptions development
business dial back, 180
collateral requirements, 180
contingent liabilities, 180
deposit behavioral characteristics, 180
deposit outflows, 179-180
impact factors, 178, 179
investment portfolio haircuts, 179
unsecured wholesale funding, 180
baseline scenario, 177
and capital stress testing, 184
design components, 176
funding optimization, 183
and funds transfer pricing, 184
governance and controls
asset-liability committee (ALCO), 181
internal audit, 182
model risk management, 182
risk management, 182
treasury, 182
liquid asset buffer, 174
liquidity dashboard, 183
liquidity optimization
liquidity vs. capital, 183
liquidity vs. yield, 182-183
organizational scope
currency, 176
liquidity transfer restrictions, 175
regulatory jurisdiction, 176
outputs of model, 180
capital and performance metrics, 181
liquidity position metrics, 181
prospective liquidity position metrics, 181
stress testing assumptions, 181
planning horizon, 176
position data collection and aggregation, 183
regulatory report generation, 183
with related risk models, integration of, 184
scenario development
historical scenarios, 177
hypothetical scenarios, 177-178
stressed inflows, 174
stressed liquid asset buffer, 174
stressed outflows, 174
sustainable infrastructure, 183
testing techniques
deterministic models, 177
historical statistical techniques, 176
Monte Carlo simulation, 177
liquidity transfer pricing (LTP)
application, 289
contingent liquidity risk management
banks liquidity cushions unveiled by GFC, 302
extant guidance focuses on size, 302
liquidity cushions, 301
poor attribution of cost of carrying, 302-303
pricing contingent liquidity risk, 304-305
towards better management, 303-304
definition, 288
governance of, 288-289
governing, 290-291
Liquidity Management Information Systems (LMIS), 292-293
management
internal funding structure, centralised vs. decentralised, 291
oversight, 292
policies, 291
trading book funding policies and identifying funding
requirements, 291-292
need for more guidance on, 290
on-balance sheet funding liquidity risk management
matched-maturity marginal cost of funds, 297-298
maturity transformation, 294
pooled "average" cost of funds approach, 295
poor LTP practices, 294
pricing funding liquidity risk, 298-301
"zero" cost of funds approach, 294
principles and recommendations, 307
Index ■ 407
liquidity transfer pricing (LTP) (Continued) mobile apps, 223
purpose, 288 model risk management, 182
regulatory developments, 289-290 money market deposit accounts, 223
remuneration practices, 293-294 money market investment instruments
sizing and attributing costs, 289 bankers' acceptances, 59-60
liquidity transfer restrictions, 175 certificate of deposit (CD), 59
locational banking statistics by nationality (LBSN), 328 commercial paper, 60
long financing, 275-276 federal agency securities, 59
long-term capital management (LTCM), 12 international eurocurrency deposits, 59
LTP, see liquidity transfer pricing (LTP) short-term municipal obligations, 60
treasury bills, 57
treasury bonds, 59
M treasury notes, 59
management committee, 212 money market mutual funds, 23-24
margin, 12 money position
margin loans, 26-27 management, 106-110
market indicators, 51 manager, 103
market liquidity, 42 Monte Carlo simulation, 177
markets structure, collateral markets mortgage-backed bond, 61
margin loans, 26-27 municipal bonds, 60-61
repurchase agreements, 27 municipal notes, 60-61
securities lending, 27 municipal obligations, short-term, 60
total return swaps, 27
market-wide credit/liquidity stress, 129
N
Markowitz, H., 382, 395
National Council of Real Estate Investment Fiduciaries (NCREIF),
maturity gap, 355
388-389
maturity management tools
Negotiable CD, 256-258
duration
negotiable order of withdrawal (NOW) accounts, 223
immunization, 77-78
net debit cap, 130-131, 132
portfolio immunization, 78
net interest margin, 356
yield curve
net interest margin (NIM), 356
carry trade, 77
net liquidity position, 89
forecasting interest rates and economy, 76
net stable funding ratio (NSFR), 9
riding, 77
netting/net settlement, 132
risk-return trade-offs, 76-77
non-amortising bullet loans, 298
maturity strategies, investments
nondeposit funds
back-end load maturity policy, 75
demand for, 261
Barbell strategy, 75
factors to consider, 262-267
front-end load maturity policy, 74-75
sources, 249
ladder/spaced-maturity policy, 73-74
long-term, 260
rate expectations approach, 75-76
noninterest-bearing transaction (demand) deposits, 223
maturity transformation, 18-19
nontransaction (savings/thrift) deposits, 224
M.E.R.I.T.
Northern Rock, 7
early warning indicators
nostro account, 122, 132
environments, both normal and stressed, 50
NOW accounts, 223
escalation, 50
forward looking bias/view, 49-50
industry practices, 51 O
integrated systems, 50 off-balance-sheet financing, 160-161
measures, 47, 49 off-balance-sheet funding, 22-23
reporting, 50 off-the- run (OFR), 281
spanning various time horizons, 50 on-balance sheet funding liquidity risk management
thresholds, 50-51 matched-maturity marginal cost of funds, 297-298
Metallgesellschafi (MG), 9 maturity transformation, 294

408 ■ Index
 pooled "average" cost of funds approach, 295 2007-2009 crisis, 277-280
poor LTP practices, 294 and long financing, 275-276
pricing funding liquidity risk, 298-301 rates, 280-281
"zero" cost of funds approach, 294 reverse repos and short positions, 276
on-the- run (OTR), 281 in United States
opportunity cost, 91 and auction cycle, 281-284
order-driven system, 38 and level of rates, 284-285
other term funding, 125 reserves
outgoing wire transfers, 122 computation, 103-104
overdraft penalties, 110 computation period, 103
overnight borrowings, 125 maintenance, 104
over-the-counter derivatives, 158-160 required calculation, 104-106
requirements, 104

P sources of, 110

resiliency, 38
passbook savings deposits, 224
retirement savings deposits, 224-225
payment finality, 132 reverse repos
payments, clearing, and settlement services (PCSs), 132
and short positions, 276
settlements, 122
transactions, 144
Payment System Risk (PSR) policy, 121 reverse Yankee issuance, 338
payment throughput, 128 risk assessment, 126
Pioneering Portfolio Management, 382
Ross, S., 386
pledging requirements, 72-73
plumbing, system and funding liquidity risk, 42
policy responses, 165-166 S
portfolio immunization, 78, 372 seasonal component, 95
portfolio shifting, 68 seasonal credit, 256
predatory trading, 12 secondary credit, 256
prepayment risk, 71-72 securitization process, 8, 26
price sensitivity to changes in interest rates, 366 securitized assets, 61-63
pricing deposit security
at cost plus profit margin, 230 borrowing, 145
services, 229 dealing, 158
primary credit, 256 held by banks, 63-64
primary obligor, 59 lending, 27, 144
prime brokerage, 160 linked liquidity, 142
private equity, secondary markets, 394 portfolio, 57
problems with interest-sensitive GAP management, 362-364 unlinked liquidity, 142
selection bias, illiquid assets returns, 389-390
Q sell/buyback transactions, 144
seller's market, see real estate market
quote-driven system, 38
settlement windows, 131
solvency, 2
R system and funding liquidity risk, 41
real estate market, 3 sources and uses, funds approach, 94-96
rebalance, long-run average holding, 396-397 stop-loss rules, 11
Recommendations for Securities Settlement Systems (RSSS), 121 stress testing assumptions, 181
regulatory jurisdiction, 176 stripped security, 62
relationship pricing, 237 structured credit and off-balance-sheet funding, 22-23
repo transactions, 144 structured notes, 61
repurchase agreements (repo), 27, 92, 252-255 Super NOWs, 223
back-to-back trades, 276 survivorship bias, 385-386
bond trading special, 285 sweep accounts, 107
and cash management, 274-275 Swensen, D., 382

Index ■ 409
system and funding liquidity risk transparency, 3
interconnectedness, 43 treasury, 182
and market liquidity, 42 treasury bills, 57
and plumbing, 42 treasury bonds, 59, 60
solvency, 41 treasury notes, 59, 60
systematic funding liquidity risk, 24-25 trend component, 95
Systemically Important Financial Institutions (SIFIs), 132 trend trading, 11
systemic risk, 132 Truth in Savings Act, 234
definition, 18

U
T underwriting, dealer banks, 158
tax exposure, 65-69 unsecured wholesale funding, 180
tax swap, 67 unsmoothing returns
term structure of expected cash flows (TSECF), 138-141 dramatic effect, 389
term structure of expected liquidity (TSLe), 149-150 Geltner-Ross-Zisler unsmoothing process, 386
thrift deposits, 224 illiquid assets returns are not returns, 386-389
time critical payment, 132 properties, 388
time deposits, 224 real estate, 388-389
total return swaps, 27 transfer function, 386
trading US dollar shortage
book positions, 6-7 banks' international positions, 311-313
dealer banks, 158 during crisis, 310
liquidity risk international policy response, 325-327
bid-offer, 2 long and short of banks' global balance sheets
predatory trading, 3 balance sheet expansion since 2000, 316
transaction cross-currency funding positions, 316-320
cost liquidity risk, 39-40 maturity transformation across banks' balance sheets, 320-323
costs, portfolio choice with asset allocation, 395-396 structure of banks' operations, 313-316
(payments/demand) deposits, 222-224 magnitude, risk, 310
liquidity, definition, 18 market conditions, 323
measurement U.S. Treasury bill, 57
adverse price impact, 40-41 U.S. Treasury market, 392
transaction cost liquidity risk, 39-40
transactions liquidity risk
causes
W
adverse selection, 37 wholesale and retail deposits, 7-8
cost of trade processing, 37
differences of opinion, 38 Y
inventory management by dealers, 37 yen/dollar case, 343-344
order-driven system, 38
yield curve
quote-driven system, 38
carry trade, 77
characteristics of market liquidity forecasting interest rates and economy, 76
adverse price impact, 38
riding, 77
bid-ask spread, 38
risk-return trade-offs, 76-77
depth, 38 yield to maturity (YTM), 65, 352
resiliency, 38
slippage, 38
tightness, 38 Z
definition, 18 Zisler, R., 386

410 ■ Index