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INTRODUCTION Scenarios, as the adage goes, are the language of risk. And liquidity risk is very scenario specific. Scenarios are far more important to liquidity risk measurement and management than for credit risk, rate risk and operations risk. The need for liquidity arises in many very dissimilar banking situations. The range of potential risk scenarios is far more varied. Both the nature and size of a liquidity event vary by scenario. Customer and counterparty options to withdraw indeterminate maturity deposits, draw-under loan commitments and prepay loans will be exercised differently under different conditions. Equally important, tactics that work in some scenarios are often constrained and sometimes unavailable in others. For examples, it may be easy to renew or replace maturing, unsecured liabilities during some types of systemic funding events, but not in a severe bank-specific funding problem. Marketable assets, on the other hand, may be difficult to sell during a capital market flight to quality. Regulators understand the importance of scenario-specific liquidity risk. The Bank for International Settlement (BIS), for example, emphasizes that: “A bank should analyze liquidity utilizing a variety of ‘what-if’ scenarios”. Consider the following three hypothetical situations: • A major and unexpected withdrawal of funds happens to occur on the same day as a major and unexpected loan funding. Where could the necessary cash be obtained? What potential sources of funds should be considered? • Alternatively, suppose that the bank is launching a new consumer lease product, which is expected to grow very rapidly over the next nine months. Deposits are anticipated to continue to grow at the current sluggish pace, which will barely fund growth in existing loan categories. How should funding be obtained for this new opportunity? Which sources would be available for interim or permanent funding of a new asset type? • Lastly, consider the case of a bank that is just about to publish its quarterly earnings. For the second quarter in a row, earnings are wiped out by extraordinarily large additional provisions to the loan lass reserve. Those provisions are required because of large loan losses.
The third is an example of a more severe need scenario. while others are not desirable for non-acute liquidity needs. this choice is heavily influenced by the preferences and experiences of individual managers. Cash flows from maturing securities and/or loans may also be a source of funds for the second hypothetical bank. Clearly. 2 . Indeed. liquidity sources may be viewed as holdings of short-term salable assets. it may not be able to borrow on an unsecured basis at all. as the capacity to increase liabilities. The first is short term and mild. we will evaluate both.Each of these hypothetical situations describes a potential need for liquidity. and as net cash inflows from all sources. In this chapter. the bank will probably not be able to borrow new. The bank might generate the necessary funds from many sources. DEFINING SCENARIOS Deterministic or probabilistic? Liquidity risk managers tend to feel strongly that only one or the other is appropriate for stress-testing liquidity. for each of these situations the time period in which liquidity is needed. some liquidity sources are more useful when liquidity is needed quickly. However. The bank may obtain additional funds easily from almost any source-including additional purchases of overnight Fed funds. unsecured funds at a reasonable cost. including a marketing program for new. while others are not available unless the need for liquidity is prolonged. Used in combination. The bank in the third situation will have to rely on secured borrowings and/or sales of marketable securities. are materially different. these three groups of liquidity sources meet all of the possible needs described previously. As these hypothetical cases illustrate. the time horizon and the acuteness of the need dictate which of the three previously defined liquidity sources is most suitable. long-term certificates of deposit (CDs). In that case. The second is long term but mild. Together. The identification of deterministic scenarios is discussed in the following paragraphs. As is the case for many other management decisions. non-acute liquidity needs. It is equally important to understand that some liquidity sources are available only for low-severity. as well as the available sources of liquidity to meet that need.
Many banks (and regulators) only look at seven-and 30-day hypothetical liquidity events. This avoids the need to explain why business volume or rate forecasts are inconsistent. The two most typical systemic crises are a capital markets disruption/flight to quality and a severe recession. A bank with significant exposure to emerging markets should model an emerging 3 . Barings) or as long as 13 months (for example. • Many bankers like to synchronize their ordinary course of business liquidity scenario with their budget. • Most importantly.It must be relevant to the strategic nature of your business. for example. A selection of systemic crises fills out the list. Historically. can become severe in one or two days. the scenario and its constituent elements absolutely must be relevant to your bank. create and evaluate a wide variety of scenarios. a funding problem can build up over months.Identifying and Describing Deterministic Scenarios As we all know. the past is not usually a very good predictor of the future. This creates a particularly significant challenge when developing deterministic scenarios. • Sometimes. capital market flights to quality. and a bank-specific funding crisis scenario. liquidity events have led to bank failures in as little as a few days (for example. . A mild bank-specific funding problem and a worst case problem are simply one scenario described at two different stress levels. Bank of New England). Two standards are: a normal course of business/business as usual scenario. For example. Deterministic liquidity risk modelers must. • Stress levels must not be confused. A few tips for creating and evaluating deterministic scenarios include: • The ordinary course of business scenarios should include any seasonal fluctuations in the bank’s liquidity. Other funding problems. • The need to evaluate both long-term and short-term scenarios. therefore. the impact of a severe recession peaks well after it begins.
Haircuts for securities with modest risk rose significantly. but the Federal Reserve stepped in promptly to assure a smooth resolution. Changes in oil prices impact on major exporters and major importers. LTCM. Why did two seemingly modest events trigger worldwide disruptions in equity. banks with significant equity exposure need to model stock market events. such as securitized assets. scenario stress testing submits a 4 . Normally. Sometimes the links are between markets such as commodities and foreign exchange. Currencies are impacted by cross-border exchanges. marketable instruments. as defined by the BIS. Liquidity Events Are Often Global and Have Interrelated Elements For several months in the fall of 1998.markets melt down. The Russian economy at that time was smaller than the economy of the Netherlands. was highly leveraged and did have huge positions in US Treasury securities. were hard to sell at almost any price. the collapse of a private hedge fund and the nearly simultaneous melt down of the Russian ruble caused a worldwide disruption in capital markets. capital markets are globally linked. . altering prices and relative values. More than ever before. can be either a stress test scenario or a sensitivity stress test. A bank that is heavily dependent on volatile sources of funds should create more scenarios and those scenarios should reflect vagaries in counterparty risk tolerance. and so on. Since we know that no financial institution can afford to hold enough liquidity for a highly improbable event. we use scenario stress testing to understand if we are holding enough liquidity to buy enough time to either outlast the event or implement remedial measures. debt and commodities markets? The hedge fund in question. In a nutshell. or a hypothetical scenario.It must be relevant to the stability or stickiness of your liabilities. They go on to define a stress test scenario as a multi-variant test that can be either an historical scenario based on a significant previous event. STRESS TESTING AND SENSITIVITY ANALYSIS A stress test. The exporters invest or disinvest in capital markets instruments.
scenario to large. Equally. For bank-specific risk scenarios. credit spreads for financial institutions. Sensitivity analysis is a simple. when. The objective is to determine whether the institution can survive those movements. Stress testing serves one other purpose. enables us to evaluate if we can liquidate assets and implement other remedial actions soon enough and in large enough amounts to survive. and for how long. market access and time required to unwind specific asset holdings. Armed with at least approximate answers to those questions. Like so many other key elements of liquidity risk management. assumptions regarding the funding requirements for off-balance sheet commitments. modelers often perform sensitivity analysis on the following risk factors: prevailing interest rates. Sensitivity Analysis Risk managers often want to know how much of the forecast risk exposure in a scenario is driven by a single independent or dependent variable. stress testing deals with the unavoidable fact that banks never hold enough liquidity during normal conditions to survive hypothetical worst case problems. Stress testing and sensitivity analysis highlight what can go wrong. opportunities for effective and rapid responses if such a hypothetical funding problem ever occurs. in advance. problems. Forecasting is unavoidably inaccurate. risk managers can identify and implement measures that reduce the impact of hypothetical funding. risk evaluation and contingency planning. and assumptions regarding the rollover of maturing capital markets funding. if not more important. in that context. how badly. adverse movements. intuitive way to accomplish that goal. We stress that testing can help us refine our forecasts by identifying potential assumption errors and potential misunderstandings of correlations between risk factor. modelers often perform sensitivity analysis on the following risk factors: deposit loss assumptions. 5 . Stress testing is an important element for liquidity risk measurement. assumptions regarding the availability of new capital markets borrowings. Stress testing. risk managers can identify. No one can accurately predict future events. For systemic liquidity risk scenarios. We hold liquid assets to buy time at the inception of non-normal conditions.
such as the Loss Distribution Approach (LDA) and the square root VaR model. Conversely. are not useful for lowfrequency/high-severity losses such as contingent liquidity risk. raising the loss threshold raises the error in the measurement because fewer data points are observed. The VaR at the confidence level is calculated as a closed form solution based upon the estimation of the two parameters in the distribution. The tools are familiar metrics for trading risk evaluation. A variety of other quantification tools. in some banks. The central question for stress testing is: What differentiates normal and non-normal or extreme events? We can identify three alternative methods to answer that question: historical Value-at-Risk (VaR) and extreme value analysis. VaR analysis looks at the loss within a selected confidence level. (Don’t forget that since liquidity losses result in a non-normal distribution. extreme events are characterized by both changes: a wide range of risk factors and changes in interrelationships between risk factors. 6 . more data is included but the GPD parameters are biased toward non-extreme data points.) In the real world.) Extreme value analysis attempts to peer into the tail of the distribution to quantify the worst case amount of loss. where estimates of loss frequency tend to be highly unstable. Extreme value analysis relies on the fact that the portion of events in a distribution that fall beyond a selected threshold converge asymptotically to a Generalized Pareto Distribution (GPD). Historical VaR and Extreme Value Analysis Historical VaR seems to be everyone’s favorite stress testing metric. while holding credit risk and. interest rate risk constant. Extreme value analysis is often applied to fat tailed distributions like the distributions for liquidity risk. We have a “Black Swan” problem. and Monte Carlo. Excess tail losses are calculated as a function of the two parameters. (Credit risk and rate risk managers often hold liquidity risk constant. does not meet our requirements. deterministic modeling. If the loss threshold is low. The concepts are simple and easy to apply. Yet even a high loss threshold. The resulting measured quantity of risk is easy to explain. the normal relationship between standard deviations and percentage confidence levels does not apply. Each is explored in the following subsections.Scenario Stress Test Overview Scenario-based liquidity risk measurement and stress testing tends to vary key liquidity parameters. isolating the extreme tail of the distribution.
They note that: “Unlike VaR…. it relies upon the assumption that historical events are at lease approximately reflective of future events. the question is: “Is there a structural change that the bank should model?” The BIS agrees.The Black Swan Problem For liquidity risk managers.[are] used to compute VaR” Some Thoughts About the Use of Hypothetical Assumptions The best stress tests rely on hypothetical data and assumptions.” Historical VaR Summary Despite its popularity.stress tests simulate portfolio performance during abnormal market periods. the events that concern can’t be seen because they aren’t there in the first place. Dr. they provide information about risks falling outside those typically captured by the VaR framework… Those [risks] associated with forward-looking scenarios that are not reflected in the recent history…. Furthermore. The primary advantages of hypothetical 7 . But for most banks. David Hume: “No amount of observations of white swans can allow the inference that all swans are white. Accordingly.. looking into the fat tail is not insightful either. as we just discussed. Like all applications of historical VaR. historical VaR is a poor tool for quantifying liquidity risk. No matter what statistical tools one selects to peer into the tail. historical data simply do not include the sorts of extreme events that comprise contingent liquidity risk. most of the time. the central problem with both VaR and extreme value analysis is that the tail in the distribution of liquidity changes only reveals the most severe changes in the period covering the observations. This is simultaneously beneficial and inaccurate. • Instead. but the observation of a single black swan is sufficient to refute that conclusion. The name comes from an observation made by the eighteenth century Scottish philosopher. Robert Fiedler summed up this issue very succinctly with the following two observations: • The Question is not: “What risk will we get if we push out the quantiles?”The answer to that question is only a matter of scaling and is therefore meaningless. This is an example of what is known as a “Black Swan” problem..
Hence. those “firms whose stress testing and risk management systems recognized potential linkages across markets had more realistic estimates of the way events in the fall of 1998 were likely to affect their firms.” As one regulator points out: “International bank supervisors conducted a study of the performance during the market upheaval of banks’ risk management systems and the Value-at-Risk models used to calculate market risk capital requirements. Deterministic Scenario Modeling at Multiple Stress Levels Useful stress tests for quantifying contingent liquidity risk are deterministic scenarios evaluated at multiple stress levels. or did not occur with sufficient frequency or severity in recent historical data. In previous chapters we have discussed the fact that liquidity risk is a consequential risk. scenario-based stress testing reflects the following truths: • Liquidity problems usually do not arise in a vacuum. The primary disadvantages are that they are inherently subjective and they provide no information about the probability of loss-only the severity. and the results help risk managers identify the most important vulnerabilities. Stress 8 . Robust applications of this approach define current “industry best practice. hypothetical assumptions are a flawed but workable alternative. As one risk professional said: “This type of testing is extremely subjective and rests entirely on the skill and judgment of the risk manager constructing the test. Deterministic stress testing simulates shocks that never occurred.” The study examined information on the stress testing done by large banks in several G-10 countries and found that ex ante stress test results provided a better picture of actual outcomes during the third quarter of 1998. rather than on large movements in a single market risk factor. they can be tailored to meet highly customized stress scenarios.assumptions are: they can draw from historical experience without necessarily duplicating it. However. when those tests were based on actual historical experiences of hypothetical scenarios that incorporated simultaneous movements in a range of rates and prices. and will add considerable value to an organization if done well” In short.” Robust deterministic. Risk managers should consider them to be a “least worst” solution. it is probably one of the most important exercises a risk manager can undertake.
For example.” In the good times. He replied: “It depends on the parameter values. an economist was once asked the meaning of life. we simply have a different application of the Black Swan problem. Morte Carlo analysis can provide liquidity risk managers with both. • As we noted above. • One of the two most important requirements is that robust stress scenarios must reflect the interactions between both independent and dependent variables. bankers tend to forget about previous instances when conditions were less favorable. Therefore. deterministic modeling provides no information about the probability of an event-just its severity. • The second of the two most important requirements is that the most severe stress levels modeled need to be very severe indeed. Where are these obtained? As the story goes. Monte Carlo modeling requires a starting state and parameterization.” If one uses observed parameters.scenarios should be tailored to match expected developments following the triggering event or events. Using Monte Carlo Modeling to Capture Stress Levels Of course. The key parameters are mean reversion and volatility. Monte Carlo modeling is as inappropriate for liquidity risk measurement and stress testing as historical VaR. • As we noted earlier in this chapter. 9 . In its purest form. This historical data for most banks simply doesn’t include the extreme events. Time after time.”) Managers may also get over-confident in their risk management skills. the duration of funding problems can be a matter of days or more than a year. A range of stress scenarios should be evaluated to understand short.(This is half facetiously referred to as “disaster myopis. the very identification of “marketable securities” needs to narrow as stress levels increase in systemic scenarios. liquidity problems are often mild in the beginning and then either end or progress in stages to worst case levels. The stress scenario must have economic and business coherence. intermediate and long duration events. interviews with risk professionals who have actually worked through a major liquidity event include observations to the effect that “our worst case scenario wasn’t as bad as it really got. Stress scenarios should not overemphasize instantaneous shocks. it is very unlikely that observed parameters will reflect conditions during extreme liquidity events. even though such shocks can sometimes be insightful.
Interest rate changes affect liquidity needs in several related ways: • The term structure of the bank’s assets or liabilities may be affected by changes in prevailing interest rates. Rate changes can cause fluctuations in demand for rate-sensitive bank assets and liabilities. deposit customers may not renew maturing CDs. The Impact of Interest Rates on Liquidity Needs Some potentially material changes in liquidity risk are clearly associated with changes in interest rate levels. For example. 10 . which does reduce the bank’s potential liquidity because actual liquidity might be less at a future date if the funds are withdrawn. Instead. when prevailing rates seem low. As illustrated by the deposit example. Where do the numbers come from? More specifically. shifts like those just described reduce the term of liabilities.WHERE DO THE NUMBERS COME FROM? Astute readers may have noticed that our complaint against historical VaR-the lack of data from non-normal conditions-can just as easily be leveled against deterministic stress scenario models. fixed-rate loans when prevailing rates are lower. customers prefer longer term. the change in term preference for loans does not affect immediate liquidity. how does a bank with no history of operating under severe stress estimate balance sheet changes for hypothetical funding problems? Segmenting the Problem Like most difficult problems. Similarly. they may use the proceeds from those CDs to increase holdings of savings and money market deposit accounts (MMDAs). The higher rate loans are also more likely than lower rate loans to generate principal prepayments and therefore create additional cash flows when prevailing rates subsequently decline. Such shifts do not reduce the bank’s immediate liquidity since the funds remain in the bank. this one is much easier to solve when we break the problem into pieces that can be solved separately. while preferring shorter term and floating-rate loans when rates are higher. However. but may affect future liquidity since shorter term loans provide more cash flow from cash-scheduled amortization than longer term loans of the same amount.
When prevailing interest rates are high. When prevailing rates are high. The same factors tend to result in higher loan delinquencies. • The volume of the bank’s assets and liabilities may be indirectly affected as changes in prevailing interest rates track (or cause) changes in business conditions. For example. customers are more likely to disintermediate the banks-to take their funds out of banks and invest those funds directly in capital markets instruments offering actual or potentially higher yields. The associated contraction in business activities creates both direct and indirect incentives for customers to reduce deposits-especially term deposits like CDs. business tend to manage their deposit float more aggressively. business demand for credit tends to be much lower. which may also reduce bank liquidity during those periods. or even a majority of depositors may be that rate sensitive. unfunded loan commitments for business loans may be drawn down in larger amounts during high-rate environments than during low-rate environments. for example. During recessions. the most rate sensitive customers are often those with the highest levels of investable funds. demand for residential mortgage loans is usually strong when rates are low. not all. however. reduce hiring. or in a few cases go out of business. or changes in that exposure. • The volume of new bank assets can be directly affected by changes in interest rates.• Holding of bank assets and liabilities with embedded options can be naturally affected by changes in prevailing interest rates. Of course. loan payment must be larger to meet the same principal amortization schedules. Impact of Credit Risk on Liquidity needs Some potentially material changes in liquidity risk are clearly associated with changes in credit risk levels. The level of a financial institution’s credit risk exposure. as a result. which reduce the cash flow received from loan payments. • The volume of the bank’s liabilities can be directly affected by changes in interest rates. however. affect liquidity in several related ways: 11 . fewer consumers can qualify for the loans. employers tend to lay off workers. At the same time. Similarly. When rates are high.
a funding crisis following such an announcement is exacerbated because the bank’s funding managers are not informed prior to the announcement. Indeed. the relative size of the loan portfolio. are originally underwritten with the intent of refinancing the outstanding balance at maturity. few liquidity management tactics are more important than managing the maturity profile of your liabilities. Two key observations: • First. A variety of credit quality indicators. suddenly dries up in response to market awareness of credit problems. • Second. By for the most typical institution-specific funding crisis is a crisis where the availability of funds. Typically. while a lack of liquidity has often been the immediate cause of bank failures. credit problems are usually the underlying cause. The only variable is time. including loan growth rates. like loans with balloon payments. Liabilities that do not mature before the projected time horizon of one’s liquidity forecast are 100% stable.• • The price that the bank pays for funds. levels of delinquent loans. followed by credit losses. Some assets. and then sometimes followed by bank failure. Quantifying Contractually Fixed Cash Flows This is by far the easiest group of cash flows to project. especially uninsured funds. However. A commonly seen chain of events starts with credit risk exposure. will reflect that bank’s perceived level of credit risk exposure. (Too often. a quarterly provision for the institution’s allowance for loan losses that is significantly larger than normal triggers a funding crisis. For large banks and bank holding companies. the market premium for credit risk exposure is often at least partially based on published credit ratings. market participants know that credit ratings often lag behind events. Such communications should be required by the bank’s liquidity contingency plan. especially jumbo CDs and other borrowed funds. do not assume that the bank will receive 100% of the proceeds from assets that have contractual maturities within your forecast time horizon. levels of non-performing loans. and levels of loan losses. Short-term assets and amortizing assets throw off cash flows. Some 12 . followed in turn by a funding crisis. are all matters of public record and are often used by funds suppliers to judge credit risk. And many financial institutions are unrated.
these cash flows are correlated with market rates. it is more than a little curious that so many banks do not include these flows when they measure contingent liquidity in stress scenarios. This is definitely not true in bank-specific stress scenarios. Most loan prepayment options can be forecast to be exercised “rationally. Cash inflows from new borrowings and new deposits obtained from capital markets counterparties or serious investors are driven by market rates in normal conditions and in systemic stress scenarios. We can estimate the size of some future cash flows reasonably accurately by apply quantitative analysis. • Funding of some off-balance sheet commitments fluctuates with the economic cycle. These cash outflows are loosely correlated with changes in prevailing interest rates. Requirement to fund off-balance sheet commitments can be a major source of cash outflows in stress scenarios. Quantifying Cash Flows Primarily Driven by Market Interest Rates.assets. Accrual accounting obscures the 13 .) • Funding of some off-balance sheet commitments fluctuates with changes in credit risk that are associated with economic conditions. have to be refinanced at maturity because the borrower’s source of repayment has a longer time horizon than the contractual loan term. Liquidity risk managers evaluating systemic stress scenarios with high interest rates can project changes in prepayments using standard rate risk models. CP backup lines and stand-by letters of credit. we can divide all off-balance sheet commitments into three groups.” This means that most will fund when prevailing rates fall below the sum of the current coupon rate plus the refinancing costs. (Accordingly. Examples are bank guarantees. Some loans and investments default. (Cash flows from two of those three groups are driven by rates and economic conditions. These cash outflows are highly correlated with the credit risk of the bank’s counterparty. Examples are working capital lines of credit extended to finance business receivables and inventory. mainly badly underwritten business loans. Reductions in expected cash flows resulting from loan delinquency and default also fluctuate with changing economic conditions.) For liquidity risk analysis purposes. In short. Economic Conditions and Related Changes in Credit Risk.
and whether or not the counterparty has a relationship with the bank. Nor can we avoid the subjectivity and uncertainty in hypothetical assumptions. We can add some rigor to the subjective process of evaluating the credit sensitivity of counterparties: a framework for segmenting funds providers based on three proxies for credit sensitivity: whether the liability is insured or secured. we can identify drivers for each group of changes. However. Insured deposits are less credit sensitive that uninsured deposits. 14 . Quantifying Cash Flows Primarily Driven by Counterparty Confidence By far the most challenging part of building deterministic stress scenarios is quantifying confidence-driven cash flows. However. as the previous paragraphs make clear. The two keys are: 1. The same is true for secured deposits. whether or not the counterparty relies on public information for decisions. Customer-driven Deterministic Stress Scenario Assumption Summary We can’t get around the fact that hypothetical assumptions are required. Drivers include contractual restrictions. By segmenting and grouping the changes we need to predict. and economic conditions and counterparty confidence. we can develop plausible assumptions.relationship between loan losses and interest rates. Equally important. while historical data from our own banks is not useful at all. we can apply the best tools to estimate the changes in each group. We can further segment liabilities based on variables such as deposit insurance and collateral. interest rates. 2. The more plausible our conclusions. Extrapolating Hypothetical Assumptions from Historical Events Arguably the best tool for estimating cash flows for high-stress scenarios is to use historical changes as a starting point. As we have discussed. loan delinquency is at least loosely correlated with changes in prevailing interest rates. Careful analysis of historical data from failed banks can be huge. we know that counterparties who own the funds tend to be less credit sensitive than counterparties who simply manage the funds for third parties.
or raising prices to discourage new loans. The two primary tools are selling securities from the bank’s stand-by liquidity reserve and. you are masking risk.) A Serious Problem A fundamental dilemma applies to management-driven cash flows. And it is much easier to explain the forecast risk levels to senior management when plausible assumptions underlie the analysis.” On the other hand. tactics may also include new borrowings. “If you are covering today’s risk with tomorrow’s promises.It is much easier to appreciate the forecast risk levels when the hypothetical assumptions are grounded in plausible analysis. STRESS TEST PROCEDURES 15 . At worst. In some circumstances. liquidity risk is obscured when stress scenario forecasts include assumptions for future cash flows from management actions such as sales of investment securities and loans. This point is discussed further in the following section. the full extent of the liquidity risk cannot be seen unless the analyst drills down to see the “before management actions” and “after” forecast levels of risk. selling other bank assets. At best. time permitting. it is hidden. (Of course the effectiveness of each of these tools depends upon both the scenario and the stress level. The problem is as basic as it is serious. How else can we determine whether or not the risk level is acceptable? The solution is to carefully separate the customer-driven cash flows and bank management-driven cash flows. Cash Flows Resulting from Bank Management Decisions Bank managers can choose from a fairly wide array of potential tactics to increase liquidity. using prices to spur new deposits and retain current deposits. On the one hand. the entire exercise fails to produce meaningful risk measures if we can not relate a forecast quantity of funds needed to a forecast quantity of funds available to meet that need.
or options to withdraw funds from indeterminate maturity deposit accounts. Add the non-discretionary Treasury cash inflows and outflows. Identify and use procurers for ratings downgrades instead. For each scenario. Make sure that each customer behavior-driven change in your forecast is appropriate and consistent for the scenario and the stress level. This total is the forecast liquidity requirement for each time period in each scenario at each stress level.Using the assumption tools outlined in the prior section. Step 2 Step 3 Step 4 Step 5 Step 6 16 . Calculate the net cash flow coverage ratio for each time bucket in each scenario at each stress level. This is the amount by which the forecast cash inflows exceed (or fall short of ) the forecast outflows. The ratio is typically calculated using the formula shown below. Use the assumption estimation guidelines discussed in the prior section. For each scenario. at each stress level. the call exercise needs to be forecast in a time bucket consistent with the interest rate assumption for that scenario at the stress level. Note that: If you have callable securities. at each stress level. Customer behavior changes also include noncontractual actions such as new loans. identify the contractual cash flows and outflows that can be expected to occur in each future time period for your forecast. Sum the customer-driven cash flows and the non-discretionary Treasury flows. but there are several equally acceptable variations. Note: it is not a good idea to use changes in the bank’s rating to define the stress levels. These may be from the exercise of contractual options such as loan prepayment options. estimate the cash inflows and out flows resulting from customer behavior. The ratings changes are lagging indicators of trouble and almost always follow the mark. we can describe stress testing as a nine-step process. These include contractual maturities of investments and borrowings. Step 1 Define the scenarios and stress levels you wish to test.
it is impossible to answer the central liquidity risk management question: “Is the current level of risk acceptable?” In order to forecast the quantity of stand-by liquidity available. For example. Determine the quantity of stand-by liquidity available. forecasts for ordinary course of business scenarios and for scenarios at minimal stress levels should always show a cushion. A positive margin for error is required to offset potential model risk. the forecast cash flow cushion for each time period. The quantity of liquidity needed must be compared to a quantity of liquidity available. we need to do four things: • determine what sources are available in each scenario at each stress level • determine in what order we plan to access each source. Second. the number of cash flow cushion ratios can quickly get out of hand. The data in this report can be color coded to call attention to cases where the forecast cushion is very close to the minimum (yellow) and cases where it is below the minimum (red). for example. Note: First.Step 7 So. if you use 12 time periods for bank-specific scenarios done at each of three stress levels. a forecast that showed cash inflows totaling 120 and cash outflows totaling 100 would have a cash flow cushion of 12:1 or 120%. in each scenario at each stress level can be compared to either required liquidity risk minimums or recommended guidance minimums. (The quantity of liquidity available is sometimes called the “counter-balancing capacity. This can be described as a cash flow waterfall • forecast how long it will take to convert each source to cash 17 . you will have 36 cash flow cushion ratios just from this single scenario type.”) Note: Unless we can compare some quantity of liquidity need to some quantity of liquidity available. Third. The solution is to report these in summary form.
we definitely do not mean to imply that at the end of five months management locks its doors and gives the keys to the bank liquidators. Make the management connection. Compare the quantity of forecast need to the quantity of forecast funds available. you must then make an assumption for the change in average daily trading volume that is likely to occur in each scenario at each stress level. For example. the quantity of the stand-by liquidity reserve is communicated in either currency units or as a ratio.Step 8 Step 9 determine how much cash we can obtain. of average daily trading volume. Haircuts for “marketable securities” can vary significantly with changes in prevailing interest rates and changes in credit spreads. One part of that plan is a list of • 18 . The final and most important step is to compare how much cash we think we need to how much we think we can get. you can unload a quantity equal to a percentage. It also tells them how much additional cash they have to obtain. depending upon changes in conditions impacting market breadth for each large position. say 20%. A bank may say that it has a stand-by liquidity of 100 euro. In that case. When we say that the bank has a large enough stand-by liquidity reserve to survive for five months. Note: Traditionally. that its reserve is equivalent to 10% of total assets or that its reserve is equivalent to 60% of volatile liabilities. The time required to unwind a large position in your stand-by liquidity reserve can vary significantly. It tells the bank’s managers how long they would have to come up with additional cash in the event of a scenario like the one projected. No bank managers intend to preside over the failure of their bank. you might assume that on any given day. It is essential to view the liquidity reserve survival period as a window of opportunity. Communicating in units of time is far more meaningful to senior managers. None of those measures effectively communicates all of the dimensions of risk. Those last two pieces of information must be back to the bank’s liquidity contingency funding plan.
19 . Scenario stress tests are essential for understanding the full scope of liquidity risk exposures. Risk managers must segment assumptions. managers know that they much either reduce the bank’s liquidity risk exposure or identify more sources of funds that can be obtained in that situation. Stochastic tools are valuable because they can tell us the probability. Yet quantitative tools. Funding needs are best understood when split into separate categories. Liquidity risk measurement and management must always differentiate between potential bank-specific problems and potential systemic problems. The appropriate amount of liquidity and the appropriate sources of additional liquidity depend on the nature of the need. stress testing and contingency planning fit together. management should use scenario based sets of cash flow projections. not just the severity. dynamic liquidity risk management process. As we have observed. for unexpected cash needs. If the actions on that list do not appear sufficient to raise enough cash in the time available. and apply reasonable methods to obtain plausible estimates. of liquidity risk exposures. Stress testing is not an end onto itself. Deterministic stress tests require application of some “least worst” assumptions and methods. Because liquidity risk is scenario specific. like historical VaR and Monte Carlo are particularly ill-suited for liquidity risk stress scenarios. CONCLUSION The need for liquidity results from many dissimilar banking situations. identify what drives the changes. But liquidity is hard to stress test. Stress testing is just one part of an integrated. Assumptions must also be varied so that they are consistent with the nature and severity of the scenario under review. And earlier we discussed integrating stress testing and its limits. The necessary assumptions must be internally consistent.potential remedies that management may undertake in the event of a bank-specific funding problem.
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