Professional Documents
Culture Documents
Liquidity and Treasury Risk Measurement and Management: Books Center
Liquidity and Treasury Risk Measurement and Management: Books Center
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“Early Warning Indicators” by Shyam Venkat and Stephen Baird, “The US Dollar Shortage in Global Banking and the International Policy
reprinted from Liquidity Risk Management: A Practitioner‘s Perspective Response,” BIS Working Paper No. 291, by Patrick McGuire and Götz
(2016), by permission of John Wiley & Sons, Inc. All rights reserved. Used von Peter, October 2009, by permission of the Bank for International
under license from John Wiley & Sons, Inc. Settlements. Information retrieved from the Bank for International
Settlements is freely available at their website: www.bis.org.
“The Investment Function in Financial Services Management” and “Liquidity
and Reserves Management: Strategies and Policies,” by Peter S. Rose and “Covered Interest Rate Parity Lost: Understanding the Cross-Currency
Sylvia C. Hudgins, reprinted from Bank Management & Financial Services, Basis,” by Claudio Borio, Robert McCauley, Patrick McGuire, and
Ninth Edition (2013), by permission of the McGraw Hill Companies, Inc. Vladyslav Sushko, BIS Quarterly Review, September 2016, by permission
of the Bank for International Settlements. Information retrieved from the
“Intraday Liquidity Risk Management,” by Shyam Venkat and Stephen
Bank for International Settlements is freely available at their website:
Baird, reprinted from Liquidity Risk Management: A Practitioner’s
www.bis.org.
Perspective (2016), by permission of John Wiley & Sons, Inc. All rights
reserved. Used under license from John Wiley & Sons, Inc. “Risk Management for Changing Interest Rates: Asset-Liability
Management and Duration Techniques,” by Peter S. Rose and Sylvia C.
“Monitoring Liquidity,” by Antonio Castagna and Francesco Fede,
Hudgins, reprinted from Bank Management & Financial Services, Ninth
reprinted from Measuring and Managing Liquidity Risk (2013), by
Edition (2013), by permission of the McGraw Hill Companies, Inc.
permission of John Wiley & Sons, Inc. All rights reserved. Used under
license from John Wiley & Sons, Inc. “Illiquid Assets,” by Andrew Ang, reprinted from Asset Management: A
Systematic Approach to Factor Investing (2014), by permission of Oxford
“Liquidity Stress Testing” by Shyam Venkat and Stephen Baird, reprinted
University Press.
from Liquidity Risk Management: A Practitioner‘s Perspective (2016), by
permission of John Wiley & Sons, Inc. All rights reserved. Used under “Movements in the Effective Federal Funds Rate, Its Target (the
license from John Wiley & Sons, Inc. Intended Federal Funds) Rate, and the Discount (Primary Credit) Rate for
Depository Institutions Seeking Credit from the Federal Reserve Banks,”
“The Failure Mechanics of Dealer Banks,” by Darrell Duffie, reprinted
reprinted with permission from the Federal Reserve Bank of St. Louis
from the Journal of Economic Perspectives, vol. 24, no. 1, Winter 2010,
Monetary Trends, March 2011, p. 3; https://s3.amazonaws.com/files.
by permission from Journal of Economic Perspectives.
research.stlouisfed.org/datatrends/pdfs/mt/20110301/mtpub.pdf.
“Liquidity Risk Reporting and Stress Testing,” by Moorad Choudhry,
Learning Objectives provided by the Global Association of Risk
reprinted from The Principles of Banking (2012), by permission of John
Professionals.
Wiley & Sons, Inc. All rights reserved. Used under license from John
Wiley & Sons, Inc. All trademarks, service marks, registered trademarks, and registered
service marks are the property of their respective owners and are used
“Contingency Funding Planning” by Shyam Venkat and Stephen Baird,
herein for identification purposes only.
reprinted from Liquidity Risk Management: A Practicioner‘s Perspective
(2016), by permission of John Wiley & Sons, Inc. All rights reserved. Used Pearson Education, Inc., 330 Hudson Street, New York, New York 10013
under license from John Wiley & Sons, Inc. A Pearson Education Company
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www.pearsoned.com
“Managing and Pricing Deposit Services” and “Managing Nondeposit
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Liabilities,” by Peter S. Rose and Sylvia C. Hudgins, reprinted from Bank Printed in the United States of America
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00022446-00000004 / A103000319406
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Serrat, reprinted from Fixed Income Securities: Tools for Today‘s Markets, EEB/AM
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Short Positions 34
Further Reading 15
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Derivatives 35
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Structured Credit 36
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Management 55
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Strategies 73
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Duration 77
4.2 Investment Instruments
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iv ■ Contents
for FMUs 12
129
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Marketplace 101
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Contents ■ v
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
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Testing 187
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vi ■ Contents
Accounts 237
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Conclusion 219
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Contents ■ vii
to Consider 262
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viii ■ Contents
Basis 333
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Appendix:
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Contents ■ ix
x ■ Contents
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Contents ■ xi
On behalf of our Board of Trustees, GARP’s staff, and particu- effects of the pandemic on our exam administration, we were
larly its certification and educational program teams, I would able to ensure that none of the changes resulted in additional
like to thank you for your interest in and support of our Financial charges to candidates. In addition to free deferrals, we provided
Risk Manager (FRM®) program. candidates with new materials at no cost when those unavoid-
able deferrals rolled into a new exam period, in which new
The past few years have been especially difficult for the
topics were covered due to curriculum updates.
financial-services industry and those working in it because of
the many disruptions caused by COVID-19. In that regard, our Since its inception in 1997, the FRM program has been the
sincere sympathies go out to anyone who was ill, suffered a loss global industry benchmark for risk-management professionals
due to the pandemic, or whose career aspirations or opportuni- wanting to demonstrate objectively their knowledge of financial
ties were hindered. risk-management concepts and approaches. Having FRM hold-
ers on staff gives companies comfort that their risk-management
The FRM program has experienced many COVID-related chal-
professionals have achieved and demonstrated a globally recog-
lenges, but GARP has always placed candidate safety first.
nized level of expertise.
During the pandemic, we’ve implemented many proactive
measures to ensure your safety, while meeting all COVID-related Over the past few years, we’ve seen a major shift in how individ-
requirements issued by local and national authorities. For exam- uals and companies think about risk. Although credit and market
ple, we cancelled our entire exam administration in May 2020, risks remain major concerns, operational risk and resilience and
and closed testing sites in specific countries and cities due to liquidity have made their way forward to become areas of mate-
local requirements throughout 2020 and 2021. To date in 2022, rial study and analysis. And counterparty risk is now a bit more
we’ve had to defer many FRM candidates as a result of COVID. interesting given the challenges presented by a highly volatile
and uncertain global environment.
Whenever we were required to close a site or move an exam
administration, we affirmatively sought to mitigate the impact The coming together of many different factors has changed and
on candidates by offering free deferrals and seeking to create will continue to affect not only how risk management is prac-
1
additional opportunities to administer our examinations at ticed, but also the skills required to do so professionally and at
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different dates and times, all with an eye toward helping can- a high level. Inflation, geopolitics, stress testing, automation, on,
n,
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didates work their way through the FRM program in a timely technology, machine learning, cyber risks, straight-through ug gh pro-
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way. cessing, the impact of climate risk and its governance e structure,
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xii ■ Preface
As can be readily seen, we’re living in a world where risks are We’re committed to offering a program that reflects the
becoming more complex daily. The FRM program addresses dynamic and sophisticated nature of the risk-management
these and other risks faced by both non-financial firms and those profession.
in the highly interconnected and sophisticated financial-services
We wish you the very best as you study for the FRM exams, and
industry. Because its coverage is not static, but vibrant and
in your career as a risk-management professional.
forward looking, the FRM has become the global standard for
financial risk professionals and the organizations for which they
work. Yours truly,
The FRM curriculum is regularly reviewed by an oversight com-
mittee of highly qualified and experienced risk-management
professionals from around the globe. These professionals
include senior bank and consulting practitioners, government
regulators, asset managers, insurance risk professionals, and
academics. Their mission is to ensure the FRM program remains
Richard Apostolik
current and its content addresses not only standard credit and
market risk issues, but also emerging issues and trends, ensuring President & CEO
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Preface ■ xiii
Chairperson
Nick Strange, FCA
Senior Technical Advisor, Operational Risk & Resilience,
Prudential Regulation Authority, Bank of England
Members
Richard Apostolik Keith Isaac, FRM
President and CEO, GARP VP, Capital Markets Risk Management, TD Bank Group
Co-Director and Site Director, NSF IUCRC CRAFT Partner, Oliver Wyman
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John Hull
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Senior Advisor
Maple Financial Professor of Derivatives and Risk Management,
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● 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 Goldfields, positive feedback trading.
and Metallgesellschaft.
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Excerpt is Chapter 24 of Risk Management and Financial Institutions, 5th Edition, by John C. Hull.
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It is important to distinguish solvency from liquidity. Solvency The price at which a particular asset can be sold depends on
refers to a company having more assets than liabilities, so that
1. The mid-market price of the asset, or an estimate of its
the value of its equity is positive. Liquidity refers to the ability of
value
a company to make cash payments as they become due. Finan-
cial institutions that are solvent can—and sometimes do—fail 2. How much of the asset is to be sold
because of liquidity problems. Consider a bank whose assets 3. How quickly it is to be sold
are mostly illiquid mortgages. Suppose the assets are financed 4. The economic environment
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% When there is a market maker who quotes a bid and offer
of depositors suddenly deciding to withdraw their funds. In this price for a financial asset, the financial institution can sell
chapter we will examine how Northern Rock, a British bank spe- the asset at the bid and buy at the offer. However, it is usu-
cializing in mortgage lending, failed largely because of liquidity ally stated (or understood) that a particular quote is good for
problems of this type. trades up to a certain size. Above that size, the market maker
is likely to increase the bid–offer spread. This is because the
It is clearly important for financial institutions to manage liquid- market maker knows that, as the size of a trade increases,
ity carefully. Liquidity needs are uncertain. A financial institution the difficulty of hedging the exposure created by the trade
should assess a worst-case liquidity scenario and make sure that also increases.
it can survive that scenario by either converting assets into cash
or raising cash in some other way. The new Basel III require- When there is no market maker for a financial instrument,
ments are designed to ensure that banks do this. there is still an implicit bid–offer spread. If a financial institution
approaches another financial institution (or an interdealer bro-
Liquidity is also an important consideration in trading. A liq- ker) to do a trade, the price depends on which side of the trade
uid position in an asset is one that can be unwound at short it wants to take. The bid–offer spread for an asset can vary from
notice. As the market for an asset becomes less liquid, traders 0.05% of the asset’s mid-market price to as much as 5%, or even
are more likely to take losses because they face bigger bid– 10%, of its mid-market price.
offer spreads.
The general nature of the relationship between bid quotes, offer
For an option or other derivative, it is important for there to be quotes, and trade size is indicated in Figure 1.1. The bid price
a liquid market for the underlying asset so that the trader has tends to decrease and the offer price tends to increase with the
no difficulty in doing the daily trades necessary to maintain size of a trade. For an instrument where there is a market maker,
delta neutrality. the bids and offers are the same up to the market maker’s size
This chapter discusses different aspects of liquidity risk. It con- limit and then start to diverge.
siders liquidity trading risk and liquidity funding risk. It also looks Figure 1.1 describes the market for large deals between
at what are termed “liquidity black holes.” These are situations sophisticated financial institutions. It is interesting to note that
where a shock to financial markets causes liquidity to almost bid–offer spreads in the retail market sometimes show the
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completely dry up. opposite pattern to that in Figure 1.1. Consider, for example, e,
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100,000 shares in IBM, liquidity risk is not a concern. Several The price that can be realized for an asset often
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million IBM shares trade on the New York Stock Exchange on how quickly it is to be liquidated and the
e economic
eco
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2 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
is expected that Company X will have to sell a large position in lesson from all this is that the market can sometimes get car- arr-
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a particular stock, they short the stock in anticipation of a price ried away trading complex products that are not transparent,
nspaarent
rent
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decline. This makes it more difficult than it would otherwise be but, when it comes to its senses, liquidity for the products
p ducts soon
prod
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for Company X to exit from its position at competitive prices. disappears. When the products do trade again, prices
rices are likely
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To avoid predatory trading, financial institutions emphasize to to be low and bid–offer spreads are likely to o be
be high.
hig In July
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employees the importance of keeping their positions and their 2008 Merrill Lynch agreed to sell $30.6 billionon of ABS CDO
billio
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future trading plans confidential. Predatory trading was an tranches (previously rated AAA) to Lone
one Star Funds for
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issue for the trader known as the London Whale in 2012 and for 22 cents on the dollar.
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tional bid–offer spread for the shares is 1/90 or 0.01111. The book by calculating the measures in equations (1.1) and
.1) annd (1(1.2)
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900 * 0.01111/2 + 752.5 * 0.006645/2 = 7.5 measures in equations (1.1) and (1.2) are the
therefore
erefo likely to
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liquidation.
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4 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
a s xi
gested combining them into a liquidity-adjusted VaR measure. 2 2
i=1
One definition of liquidity-adjusted VaR is regular VaR plus the
cost of unwinding positions in a normal market. From equation A trader might reasonably wish to minimize VaR after trading
(1.1) this gives costs have been considered. This corresponds to minimizing
n sa something similar to the liquidity-adjusted VaR measure in equa-
i i
Liquidity@Adjusted VaR = VaR + a (1.3) tion (1.3). The trader’s objective is to choose the qi so that
i=1 2
n n p(qi)
Alternatively it can be defined as regular VaR plus the cost of l s2x2i + a qi
unwinding positions in a stressed market. From equation (1.2) A ia
=1 i=1 2
this gives1 is minimized subject to
(mi + lsi)ai
n
n
Liquidity@Adjusted VaR = VaR + a
i=1 2 a qi = V
i=1
14.1, 5.1, and 1.9 million units, respectively. As the VaR confidence
o dence
5
level is reduced, the amounts traded per day show less vari-
sss var
ri--
ri
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i=1 45.0, 29.1, 15.6, 7.0, and 3.3 million units, respectively.
pectivvely. When
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actions,” journal of Risk 3 (Winter 2001): 5–39. units should be traded each day.
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cial institutions need to ask themselves: “How much of a Liquidating Trading Book Positions Liquidity funding risk is
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mismatch is too much?” related to liquidity trading risk, considered in Section 1.1,
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3. A poor financial performance, leading to a lack of confi- because one way a financial institution can meet its funding
ndin ng
g
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dence. This can result in a loss of deposits and difficulties in requirements is by liquidating part of its trading book.ok. It
It is there-
tth
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See Y. Amihud, “Illiquidity and Stock Returns: Cross-Section and Time- the book to raise cash. The financial institution
n wants
on wan to make
Series Effects”Journal of Financial Markets 5 (2002): 31–56. sure that it will be able to survive stressed market
mar
mark conditions
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6 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
where there is a general shortage of liquidity. The financial insti- company afloat, but it still experienced significant problems and
tution’s analysis should therefore be based on stressed market was taken over by Bank of America in January 2008.) As Business
conditions, not normal market conditions. This is the reason why Snapshot 1.1 shows, Northern Rock, a similar British mortgage
the measures discussed in the previous section concerned with lender, did not fare so well.
bid–offer spreads in stressed markets are important.
Wholesale and Retail Deposits Wholesale deposits are a more
Ability to Borrow When markets are unstressed, a creditworthy volatile source of funding than retail deposits and can disappear
bank usually has no problem in borrowing money, but in stressed quickly in stressed market conditions. Even retail deposits are
market conditions there is a heightened aversion to risk. This not as stable as they used to be because it is very easy to com- m-
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leads to higher interest rates, shorter maturities for loans, and in pare interest rates offered by different financial institutions
io s and
tion
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some cases a refusal to provide funds at all. Financial institutions make transfers via the Internet. Unfortunately, liquiditydity problems
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should monitor the assets that can be pledged as collateral for tend to be market-wide rather than something that hatt affects
affect one
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loans at short notice. A financial institution can (at a cost) miti- or two financial institutions. When one financialial institution
in
nstitu
stitu wants
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gate its funding risks somewhat by arranging lines of credit. For to increase its retail or wholesale deposit base e for liquidity rea-
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example, Countrywide, an originator of mortgages in the United sons by offering more attractive rates of interest,
intteres others usually
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States, had a syndicated loan facility of $11.5 billion, which it was want to do the same thing and the increased
eased funding is likely to
cre
able to use during the credit crisis of 2007. (This helped keep the be difficult to achieve.
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4
Central banks are concerned about the failure of investment banks by hedging is provided by a German company, Metallgesell-
tallg
gesell
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because of systemic risk. Investment banks have derivatives contracts schaft, that entered into profitable fixed-price oilil and
an
ndd gas
ga
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with other investment banks and with commercial banks. There is a contracts with its customers (see Business Snapshot
napsh
apsh hot 1.3).
1 The
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failure by an investment bank will have a ripple effect throughout the lesson from the Ashanti and Metallgesellschaftafft episodes
ep is not
financial sector leading to a failure by commercial banks. that companies should not use forward and d futures
nd fut contracts
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8 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
In some countries there are reserve requirements that require Following the liquidity crisis of 2007, bank regulators issued a
banks to keep a certain percentage of deposits as cash in the revised set of principles on how banks should manage liquidity.5
bank’s vault or on deposit with the central bank. The reserve These are as follows:
requirement applies only to transaction deposits (in essence, 1. A bank is responsible for the sound management of liquidity
those made to a checking account). For large banks in the risk. A bank should establish a robust liquidity risk manage-
United States, the reserve requirement is currently about 10%. ment framework that ensures it maintains sufficient liquidity,
Some countries, such as Canada and the United Kingdom, have including a cushion of unencumbered, high-quality liquid
no compulsory reserve requirements. Others have higher com- assets, to withstand a range of stress events, including those
pulsory reserve requirements than the United States. involving the loss or impairment of both unsecured and
In addition to ensuring that banks keep a minimum amount of secured funding sources. Supervisors should assess the ade-
liquidity, reserve requirements affect the money supply. When quacy of both a bank’s liquidity risk management framework
the reserve requirement is 10%, a $100 deposit leads to $90 of and its liquidity position and should take prompt action if a
lending, which leads to a further $90 of deposits in the banking bank is deficient in either area in order to protect depositors
system, which leads to further $81 of lending, and so on. As this and to limit potential damage to the financial system.
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process continues, the total money supply (Ml) that is created 2. A bank should clearly articulate a liquidity risk tolerance
eran
ra ce that
tha
th
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is 90 + 81 + 72.9 + c or $900. If the reserve requirement is is appropriate for its business strategy and its role in
in the
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20%, a $100 deposit leads to $80 of lending, which leads to $64 financial system.
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on a timely basis under both normal and stressed conditions liquidity risk management processes or liquidity position.
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ferentiating between encumbered and unencumbered tion regarding the supervision and oversight htt of liquidity
liquid risk
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assets. A bank should monitor the legal entity and physical management. Communication should occur ccur regularly
rregu during
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location where collateral is held and how it may be mobi- normal times, with the nature and frequencyncy of
en
ency o the informa-
lized in a timely manner. tion sharing increasing as appropriatee during
durin times of stress.
duri
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10 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
6
See A. D. Persaud, ed., Liquidity Black Holes: Understanding, Quantify-
5
ing and Managing Financial Liquidity Risk (London: Risk Books, 1999). cally affected.
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7
See, for example, J. Clunie, Predatory Trading and Crowded Exits: New 4. Creating options synthetically. Hedging a short hortt position
p
posit in
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possition in the
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is in theory also possible for them to occur when there are price increases.
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This is a simplification of reality to help understand the dynamics of
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markets. Some traders follow complicated strategies that cannot be the same sort of trading as it would d do if it were hedging
ld
classified as positive feedback or negative feedback. a short option position. This leads
ds to positive feedback
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portfolio insurance rules should have generated at least ket participants are doing the same thing. To quote from a
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$12 billion of equity or index futures sales as a result of this report on the crash, “Liquidity sufficient to absorb the limited mited
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decline. In fact, portfolio insurers had time to sell only selling demands of investors became an illusion of liquidity diity
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$4 billion and they approached the following week with huge by massive selling, as everyone showed up on the same ame side
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amounts of selling already dictated by their models. It is esti- of the market at once. Ironically, it was this illusion n of
o liquidity
lliqui
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mated that on Monday, October 19, sell programs by three which led certain similarly motivated investors, such h as port-
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portfolio insurers accounted for almost 10% of the sales on folio insurers, to adopt strategies which call for liquidity
lliquid far in
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the New York Stock Exchange, and that portfolio insurance excess of what the market could supply.”
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12 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
sales being necessary and a further reduction in asset prices. risky positions at the same time. This can lead to further losses
sses
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5
may be curtailed.
different purposes. From the middle of 2007 onward, the situa-
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tion changed and the deleveraging process shown in Figure 1.3 The classic example of what has been described bed above
escrib a is the
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started. Credit spreads increased, it became much less easy to subprime crisis that started in 2007. Other
err examples
he
her exa are the 1987
borrow money, and asset prices decreased. stock market crash, the 1994 bond marketrket crash, the 1997–1998
arket
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Should other financial institutions such as life insurance compa- lar time can be measured as the dollar bid–offer spread or ass
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nies and pension funds be regulated in the same way as banks? the proportional bid–offer spread. The latter is the difference ence
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It is tempting to answer “yes” so that one financial institution between the bid and offer price divided by the average gee of
of the
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is not given an advantage over others. But the answer should bid and offer price. The cost of unwinding a position on in the asset
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be “no.” These financial institutions have longer time horizons is half of the bid–offer spread. Financial institutions
ons should
shou
s moni-
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than banks. They should not be penalized for investing in illiq- tor the cost of unwinding the whole trading bookk in both b normal
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uid assets. Also, they should not be required to adjust their market conditions and stressed market conditions.
dittions
ions
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14 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Bangia, A., F. Diebold, T. Schuermann, and J. Stroughair. 95% confidence level for the costs?
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“Liquidity on the Outside.” Risk 12 (June 1999): 68–73. 1.6 Explain the difference between the liquidityy coverage
covvera
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and Supervisory Challenges,” February 2008. 1.7 Why is it risky to rely on wholesale deposits
dep
ep
po
osits for
f funding?
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Bank for International Settlements. “Principles for Sound Liquid- 1.8 What was the nature of the funding
ding
g risk problems of
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ity Risk Management and Supervision,” September 2008. Ashanti Goldfields and Metallgesellschaft?
ges
esellsc
sellsc
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16 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● Differentiate between sources of liquidity risk and ● Distinguish methods to measure and manage funding
describe specific challenges faced by different types of liquidity risk and transactions liquidity risk.
financial institutions in managing liquidity risk.
● Calculate the expected transactions cost and the spread
● Summarize the asset-liability management process at a risk factor for a transaction and calculate the liquidity
fractional reserve bank, including the process of liquidity adjustment to VaR for a position to be liquidated over a
transformation. 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.
Excerpt is Chapter 12 of Financial Risk Management: Models, History, and Institutions, by Allan M. Malz.
20
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17
Systemic risk refers to the risk of a general impairment liability to bear losses. To convince providers of capital to o place
p
65 ks
of the financial system. In situations of severe financial equity with a firm, they must be promised a high expected xpectted
06 oo
82 B
stress, the ability of the financial system to allocate return. At the other end of the spectrum, short-term term debt
deb instru-
-9 ali
58 ak
credit, support markets in financial assets, and even ments generally have lower required returns and contributecontr
c less
11 ah
administer payments and settle financial transactions to the cost of capital, as long as the borrower’s er’’s credit
er’s cre risk is per-
41 M
18 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
cash, and roll off into cash within a short time. Short-term yields
66
98 er
about the timing and volume of cash flows. But market ket partici-
p
partic
1- nt
20
are lower because short-term debt partially satisfies the need for
66 Ce
The major exception to this general observation are short-term tainty about future asset prices, and risk preferences.
eference Keynes
refe
-9 ali
58 ak
interest rates on currencies in imminent danger of devaluation. denoted this motive as “speculative” because
ecau
ecaus se of
use o his focus on
11 ah
Because a discrete depreciation causes an instantaneous capital one of the key phenomena in financiall crises,
ises namely, asset-
crrises,
41 M
loss to market participants long the currency, short-term yields price spirals in which market participants
ants want
w to hold cash
20
99
a loss, so the firms cannot in general repay the loans in full prior
60
taking risky positions in assets with their own capital. But net
5
66
to maturity.
98 er
1- nt
20
of its assets, but this would reduce its net interest margin.
marggin. The
T
82 B
1
In his typically memorable phrasing, these motives were the answer to
58 ak
the question, “Why should anyone outside a lunatic asylum wish to use ing functions, namely selecting worthy projectscts that
hat are
th a likely to
11 ah
41 M
money as a store of wealth?” (Keynes [1937], p. 216). repay loans fully and timely, and monitoring borrowers’
b
borro financial
2
In the older economics literature, this urge is called hoarding. condition and timely payment of principal and interest. And to
20
99
20 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
At the extreme, all or a large number of depositors may ask precipitously following the Lehman bankruptcy,
an
ank
nkrupt
krupt as it could no
for the return of their money simultaneously, an event called a longer be placed.
20
99
is secured rather than unsecured debt. The two major types es are:
ypes are
06 oo
issuance rose dramatically, to near 90 percent, as financial firms 1. Asset-backed commercial paper conduits purchase
pur
urch
chase vari-
v
-9 ali
58 ak
had few other alternatives. The European debt crisis had a simi- ous types of assets, including securities as well
we as whole
11 ah
41 M
lar, but more muted, impact in the spring of 2010. The funding loans and leases, and finance the assetss by
b issuing
iss ABCP.
difficulty was reflected also in the Libor-OIS spread. They typically enjoy explicit credit and
d liquidity
liqu support
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99
22 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
form of accounting, the “amortized cost method,” thatt further ffu ther
5
drawal and fluctuating asset value. The rule permits mitss MMMFs
M
MMM to
65 ks
06 oo
Depository institutions and MMMFs are at an extreme position, long as the short-term debt is expected d to
ed o be redeemed
r at par
11 ah
41 M
because they must repay depositors instantly on demand. But within a short time, it is not necessary to
o revalue
rev it in response
other types of financial intermediaries face similar problems. to fluctuations in interest rates and credit
credi spreads. Because the
20
99
shown in the decline in assets under management by hedge Apart from providers of financing, other participants in these
hese
1- nt
20
66 Ce
funds during the subprime crisis; the decline in assets was a transactions, such as hedge funds involved in merger arbitrage,
arb
arbi
bitr
trage
65 ks
3
Similar mechanisms have been used by commercial banks; for example
41 M
in eighteenth-century Scotland, to limit the impact of bank runs by price, since the acquirer often takes on additional
onal debt to
tio
depositors in the absence of public-sector deposit insurance. finance the acquisition. Merger arbitrage exploits
explo the remaining
20
99
24 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Lynch All U.S. Convertibles Index (VXA0), weekly through 1997 and daily d through July
58 ak
unt.
credit, risk-free rates, and the embedded option into account.
41 M
the secured money market to obtain the funds it lends to mar- ar-
r
5
create bonds “with the highest credit rating,” which could then
66
98 er
for a margin loan to the broker, and the collateral is moved oveedd to
65 ks
06 oo
Firms can borrow or lend collateral against cash or other securi- to short the borrowed security or to facilitate e a client’s
clie short
ties. A haircut ensures that the full value of the collateral is not position. In extreme market conditions, such ch as
a the subprime
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26 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
In the United States, initial haircuts on equity purchases are set As in repo transactions, the “perfection” of the lien on the col-
at 50 percent by the Federal Reserve Board’s Regulation T (“Reg lateral is enhanced by structuring the transaction as a sale, so
T”), but, as we will see, derivatives can be used to increase the that the lender holding the collateral can rehypothecate it or, in
amount implicitly borrowed. Many transactions occur outside the event that the loan is not repaid, sell it with minimal delay
U.S. jurisdiction in order to obtain lower haircuts. and transactions costs.
Reg T governs initial margin for common stock and other listed There are a few typical patterns of securities lending:
securities. After a position is established, the margin will be
• In a stock lending transaction, the source of the securities is
adjusted as the value of the security fluctuates. As the market
a large institutional investor in equities or a hedge fund. The
value of a long position declines, the broker loses the protection
investor makes the equities available for lending by hold-
the collateral provides against the customer defaulting on the
ing them at the custodian or prime broker in “street name,”
margin loan, so he will issue a margin call to the customer. Most
so that they can be rehypothecated to a trader who wishes
customers have portfolios of long and short positions in cash
to sell the securities short. The owner receives a rebate
securities, so cross-margining agreements are put in place to
in exchange. A securities lending transaction is generally
govern the net margin assessed.
“born” on the broker’s balance sheet; that is, the securities
are already in a margin account when a customer indicates a
Repurchase Agreements
desire to go short.
Repurchase agreements or repos are matched pairs of the • A typical fixed-income securities lending transaction aims to
spot sale and forward repurchase of a security. Both the spot earn a spread between less- and more-risky bonds. The trans-
and forward price are agreed now, and the difference between action would again typically start with an institutional inves-
them implies an interest rate. The collateralization of the loan tor in, say, U.S. Treasury or agency bonds that can be used
is achieved by selling the security temporarily to the lender. as collateral for a short-term loan at a rate lower than other
The collateralization is adjusted for the riskiness of the security money-market rates, and a low haircut. The investor receives
through the haircut. cash collateral in exchange for the loan of the Treasury
Repos are also a fairly old form of finance, but have grown sig- bonds. The cash can then be used to invest in other, higher-
nificantly in recent decades. More significantly, the range of col- yielding securities.
lateral underlying repos has widened. At one time, repo lending Much securities lending is carried out via agency securities
could be secured only by securities with no or de minimis credit lending programs, whereby a third party, usually a large broker-
risk. A few decades ago, repo began to encompass high-yield dealer, or a custodial bank with many institutional clients (e.g.,
bonds and whole loans, and more recently, structured credit State Street), intermediates between the lender and borrower of
products. It has been a linchpin of the ability of large banks and securities.
brokerages to finance inventories of structured credit products,
facilitated also by extending high investment-grade ratings to Total Return Swaps
the senior tranches of structured credit products such as ABS
and CDOs. The ability to short equities depends on the ability to
borrow and lend stock. An important instrument of many
The mechanics of repo lending are similar to margin loans. Like short stock trades are total return swaps (TRS), in which one
margin lending, repo creates a straightforward liability on the party pays a fixed fee and receives the total return on a
economic balance sheet. However, under certain circumstances, specified equity position on the other. TRS are OTC deriva-
1
60
such as back-to-back security lending and borrowing for cus- tives in which one counterparty, usually a bank, broker-dealer
ker-
er deale
5
66
98 er
tomers, transactions can be combined so as to permit the gross or prime broker, takes on an economic position similar ar to
imila
1- nt
20
66 Ce
economic exposure to remain off-balance-sheet. that of a stock lender, enabling the other counterparty,party often
nterrp
65 ks
06 oo
In a securities lending transaction, one party lends a security to broker then needs either to lay off the
he e risk
rissk via a congruent
11 ah
41 M
another in exchange for a fee, generally called a rebate. The opposite TRS, or to hedge by establishing
isshing
ishhing a short position in
security lender, rather than the borrower, continues to receive the cash market.
20
99
increase leverage and returns. These markets grew tremendously in volume in the years
5
66
98 er
• Margin lending, the simplest form of a market for collateral, amounts. Reported balance sheet volumess understate
unddersta the
11 ah
41 M
is primarily used by investors wishing to take leveraged long volume of repo lending and the amount off leverage
lle
lever
ever intro-
positions in securities, most often equities. duced into the financial system by excluding
ding transactions in
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99
28 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
the financing, the net value may be quite small compare to the
5
66
price falls.
margin lending may be extended on a portfolio basis. This may
65 ks
06 oo
be as simple as reducing the margin for offsetting long and Prior to the subprime crisis, many institutionall investors
vesto and
inve
inv
82 B
short trades in the same security. Margin may also be reduced mutual funds maintained large securities lending
lendi ng programs,
endiing p in
-9 ali
58 ak
for less direct portfolio effects. Some brokers use risk models which they lent high-quality securities and received
recei
r cash col-
11 ah
41 M
such as VaR to help determine the appropriate margin for an lateral, which they invested in higher-yielding
eldin bonds. These
yie
elding
account. “sec-lending” programs invested heavily
eavily in structured credit
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99
(lower panel). Agency MBS are also highly creditworthy, but not
5
eral will not fall quite as low as for the very best collateral. Both
B
of the issuers of agency bonds, the government-sponsored The owner of high-quality collateral who usess it to finance a
11
41
enterprices (GSEs), exacerbated the size and volatility of these position in lower-quality bonds can maintain
ain a highly leveraged
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30 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
So far in this chapter, we have seen how pervasive leverage The equity denominator of the leverage measure depends on
is in the financial system, and some of the new forms it takes. what type of entity we are looking at and the purpose of the
Next, we look at the mechanics of leverage, particularly via the analysis. For an intermediary such as a bank or broker-dealer,
economic, as opposed to the accounting, balance sheet of the the equity might be the book or market value of the firm. These se
1
60
firm. We present the standard definition of leverage as the ratio firms also issue hybrid capital, securities such as subordinated
din
in ted
ed
5
66
98 er
of the firm’s assets to its equity. The schematic balance sheet of preference shares that combine characteristics of debt ebt and
a
1- nt
20
66 Ce
Assets Liabilities
58 ak
11 ah
Equity (E)
41 M
E
99
An alternative definition often used in fundamental credit analy- Continuing the previous example, suppose the firm’s return
sis relates the debt, not to the assets of the firm, but to its cash on assets is ra = 0.10, while its cost of debt is rd = 0.05. If the
flows. The cash flow measure typically used is earnings before hurdle rate or return on equity is 15 percent, the firm will choose
interest, taxes, depreciation, and amortization (EBITDA). This leverage of 2. If the hurdle rate, however, is 25 percent, then the
measure of cash flow captures the net revenues of the firm, firm will choose a leverage ratio of 4:
while excluding costs that are particularly heavily influenced by 4 # 0.10 - 3 # 0.05 = 0.25
accounting techniques. It also excludes interest, which is deter-
Many leveraged fixed-income trades involve spreads. If a fixed-
mined less by the firm’s business activities than by its choice of
income security has a coupon rate higher than the borrowing
capital structure. Leverage is then defined as the ratio of debt
rate on a loan collateralized by the security, for example via a
to EBITDA.
repo transaction, the rate of return to a leveraged purchase is
limited only by the haircut. To see this, denote the coupon rate
Example 2.1 Leverage and the Leverage Effect by c, the haircut by h, and the repo rate by r, and assume c 7 r
(all in percent). The coupon and repo rates have a time dimen-
Suppose the firm’s return on assets is fixed at ra = 0.10, while its sion; the haircut does not. For every $100 of par value, the inves-
cost of debt is rd = 0.05, and initially has this balance sheet: tor puts up capital of h, earns a coupon of c, and pays (1 - h)r in
1
Assets Liabilities repo interest. The leverage is equal to . The leveraged return,
h
Equity E = 1 measured as a decimal fraction of the investor’s equity capital, is
Value of the firm A = 2
Debt D = 1
c - (1 - h)r 1-h
=c + (c - r)
Its leverage is then 2 and its return on equity is h h
2 # 0.10 - 0.05 = 0.15 As h decreases, the levered return rises. The increase in returns
1 - h
Adding a turn of leverage, that is, borrowing an additional unit as the debt-to-equity ratio rises is proportional to the
h
of funds and investing it in an additional unit of assets, changes spread c - r. Conversely, the increase in returns as the spread
the balance sheet to 1 - h
c - r rises is proportional to the debt-to-equity ratio .
h
Assets Liabilities
The tension between required returns and leverage played an
Equity E = 1 important role in creating the conditions of the subprime crisis,
Value of the firm A = 3
Debt D = 2 in an environment in which prospective asset returns were falling
more rapidly than funding costs; the decline in credit spreads in the
and increases the equity return to 0.20.
years just prior to the subprime crisis is one example. Higher lever-
In reality, of course, asset returns are not fixed, but risky. What age is needed to achieve a given required rate of return on capital
1
if asset returns end up a disappointing 0 percent? The equity as the spread c - r contracts, and mechanisms were found to
5 60
achieve it. For example, the net spreads earned by the off-balance-
alance
lancce-
66
leverage of 3, a loss of 10 percent. sheet vehicles described earlier in this chapter, ABCP conduits
du
uitss and
65 ks
SIVs, were extremely tight, often under 10 bps. But withth sufficient
h suf
ufficie
06 oo
leverage based on the return they need to achieve. For a given The use of leverage applies not only to financial
ncial intermediaries,
cial iinter
11 ah
41 M
cost of debt, and a given asset return, there is a unique leverage but also to households able to borrow to finance
an
nce a asset pur-
ratio that will permit the equity owners to “break even,” in the chases. Most households that own homes,, for e example, have
20
99
32 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
age. It also illustrates why leverage is often used as a measure of Margin Loans and Leverage
5
66
98 er
pendent source of risk. These last two ideas can be misleading. Margin lending has a straightforward impact on leverage.
evvera
eve rage.
age. The
65 ks
is that financial accounting standards have been developed with haircut of h percent, 1 - h is lent against a given
givven
en market
m value
82
a view to solving a completely different set of problems, for of margin collateral, and h percent of the
he position’s
ositio market value
po
-9
1
the explicit liabilities of the firm. tion with a haircut of h percent is .
41
h
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99
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
finance long positions, but cannot reduce leverage in the short ort
rt
Short Positions
5
66
98 er
position itself.
1- nt
20
66 Ce
Short positions lengthen the balance sheet, since both the value
65 ks
age, which looks at the gross amount of assets, that is, longs Although, like any other risk asset, short positions
itionss generate
gen
11 ah
41 M
plus the absolute value of short positions. leverage, they reduce risk if there are long positions
possition with which
osition
20
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34 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
As we discussed, there are two basic types of derivatives, short $100 against the euro
66
98 er
1- nt
20
the other. Their use has a very different impact on leverage: option on S&P 500 equity index futures, with
th an
n underlying
und
06 oo
82 B
Futures, forwards, and swaps are linear and symmetric in index value of $100
-9 ali
58 ak
the underlying asset price and can be hedged statically. • A short equity position expressed via
ia a three-month
tth
three equity
11 ah
41 M
Therefore, the amount of the underlying that the derivatives total return swap (TRS), in which Lever
er Brothers
eve Bro pays the total
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99
the pool.
58 ak
Assets Liabilities
11 ah
41 M
36 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Asset Volatility and Leverage Transactions liquidity includes the ability to buy or sell an asset
without moving its price. An order to buy an asset increases
Investing in assets with a higher return volatility is economically demand and causes its price to increase. The effect is usually
quite similar to leverage. Ignoring the potential reputational small, but can be large when the order causes a large transitory
risk, losses beyond the investor’s equity in a trade don’t matter imbalance between the demand and supply of the asset at the
to him. An asset with more volatile returns provides a higher initial price. A market participant can thereby be locked into a
probability of higher leveraged returns to the investor, but also losing position by lack of market liquidity.
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 Causes of Transactions Liquidity Risk
convexity to the return profile. Examples of the impact of the
convexity inherent in leveraged returns include: Transaction liquidity risk is ultimately due to the cost of search-
ing for a counterparty, to the market institutions that assist in
1. An investor in assets financed with margin loans can system-
search, and to the cost of inducing someone else to hold a posi-
atically favor more-volatile over less-volatile assets within a
tion. We can classify these market microstructure fundamentals
class with the same haircut. This behavior is also an example
as follows:
of adverse selection.
Cost of trade processing. Facilitating transactions, like any
2. Equity holders may favor greater risk-taking by a firm than
economic activity, has fixed and variable costs of processing,
do its creditors because of risk-shifting incentives. Public
clearing, and settling trades, apart from the cost of finding a
risk policy that leads creditors of financial intermediaries to
counterparty and providing immediacy. These costs are tied
believe that they will be made whole in the event of a sys-
partly to the state of technology and partly to the organiza-
tematic risk event (“too-big-to-fail”) reduces credit risk pre-
tion of markets. While processing may be a significant part
miums and makes leverage more economically appealing to
of transaction costs, it is unlikely to contribute materially to
equity holders, compounding the effect.
liquidity risk. An exception is natural or man-made disasters
Leverage ratios do not capture the effect of volatility on convex- that affect the trading infrastructure.
ity, which amplifies leverage economics and can make it more
Inventory management by dealers. The role of dealers is to
attractive. At the same time, volatility estimates do not capture
provide trade immediacy to other market participants, includ-
the funding risk of a portfolio. Both are needed for genuine
ing other dealers. In order to provide this service, dealers
insight into the risk of a portfolio.
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
2.4 TRANSACTIONS LIQUIDITY RISK which they must be compensated by price concessions. The
dealers’ inventory risk is fundamentally a volatility exposure
Next, we turn to market or transactions liquidity risk. We begin
and is analogous to short-term option risk.
by describing what is meant when we say an asset, as opposed
1
60
to a market or a market participant, is “liquid.” An asset is liquid Adverse selection. Some traders may be better informed orm
rm d
5
66
98 er
if it resembles money, in that it can be exchanged without delay than others, that is, better situated to forecast the he equi-
eq
qui-
1- nt
20
66 Ce
for other goods and assets, and in that its value is certain.5 Most librium price. Dealers and market participantss cannot
ca
annnot dis-
d
65 ks
06 oo
5
This is true even if there is inflation. At any moment, the holder of
41 M
money knows exactly how many nominal units he has, even if he can’t be (“liquidity” or “noise” traders) from
m those
t who recognize that
quite sure what the real value of his money balances is. the prevailing price is wrong (“information”
form
forma traders). A dealer
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99
• In a quote-driven system, certain intermediaries, who may be These characteristics, and particularly the latter two, are hard
dealers, market makers, or specialists, are obliged to publicly to measure, making empirical work on market liquidity difficult.
post two-way prices or quotes and to buy or sell the asset at Data useful for the study of market microstructure, especially
those prices within known transaction size limits. These inter- at high-frequency, are generally sparse. Bid-ask spreads are
mediaries must be prepared to hold long or short inventories available for at least some markets, while transactions volume
of the asset and typically trade heavily among themselves data is more readily available for exchange-traded than for
and with the “buy side” in order to redistribute inventories of OTC securities.
securities and reduce them overall. Quote-driven systems are
typically found in OTC markets.
• Order-driven systems come closest to the perfectly competi-
2.5 LIQUIDITY RISK MEASUREMENT
tive auction model. In this type of market clearing, market
participants transmit orders to an aggregation facility, for
Measuring Funding Liquidity Risk
example, a broker, specialist, or electronic trading system. In Asset-Liability Management
some cases, a call auction is held in which the price is gradu-
Remaining liquid in the sense of reducing funding liquidity risk
ally adjusted until the volumes of bids and offers forthcoming
is part of the traditional asset-liability management function in
at that price are equated. More typically, a continuous auction
banks. This process includes measures such as
is conducted in which the best bids and offers are matched,
where possible, throughout the trading session. Order-driven • Tracking and forecasting available cash and sources of fund-
systems are typically found on organized exchanges. ing on the one hand, and cash needs on the other
• Keeping certain ratios of ready cash and readily marketable
Characteristics of Market Liquidity securities to meet unusual demands by depositors and other
short-term lenders for the return of their money
A standard set of characteristics of market liquidity, focusing
primarily on asset liquidity, helps to understand the causes of
illiquidity:
Example 2.7 Goldman Sachs Global Core Excess
1
60
market adversely.
58 ak
Resiliency is the length of time for which a lumpy order rities that may be sold or pledged to provide
ovvide same-day
ovide
moves the market away from the equilibrium price. liquidity . . . to allow us to meet immediate
ediat obligations
ediate
20
99
38 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Other high-credit quality assets, such as U.S. agency bonds, banks’ liquidity risk since the onset of the subprime crisis.
risis. Partly,
crisis Part
66
98 er
1- nt
20
that is, bonds issued by Fannie Mae and Freddie Mac, were it is due to the measurement challenges alluded to o above.
abo
bove.
ove.
66 Ce
less reliable stores of value during the subprime crisis. The use-
65 ks
06 oo
fulness of bonds other than Treasuries and agencies to serve as Transaction Cost Liquidity Risk
B
onnal hypothesis
costs. The starting point is a distributional hy regarding
11
6
the future bid-ask spread.
41
a two-day holding period on a fraction of the position, which may accelerate redemptions.
5
T
66
98 er
T - 2
1- nt
20
The next step is to arrive at an estimate of the one-day position referred to as “toxic assets,” primarily structured
tured credit
tured
ed cre products
41 M
VaR. Suppose the entire position X were being held for T days. and mortgage loans. However, prices for these ese pproducts were
20
99
40 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Systemic risk can be thought of as resulting from external costs During the financial crisis, both illiquidity and insolvency played
in the production of financial services, analogous to pollution or a role in causing the collapse of financial institutions. Schemati-
traffic jams. Market participants, in this approach, incur risks that cally, the sequence of events in the collapse of an intermediary
are partially shifted to the market as a whole. These collectively can be described this way:
borne risks are generated by correlation between the impact of • Reports of losses at the intermediary, or even losses to other
market events on different market participants. When general institutions, raise questions about the firm’s solvency. Actual
market conditions deteriorate, many borrowers are affected in losses at the intermediary are not necessary to set the pro-
the same way at the same time. One way this happens is when cess in motion.
the value of collateral declines, or lenders become more con- • All firms, financial intermediaries as well as nonfinancial firms,
cerned about the transactions liquidity risk of certain types of become more reluctant to lend to the intermediary. The
collateral. Another way many borrowers can be affected at once reluctance is reflected not only in higher credit spreads, but
is when the market becomes more reluctant to finance certain more importantly, in an inability of the affected firm to obtain
types of trades or lend to certain types of institutions. Finally, the previous volume of loan proceeds.
asset price declines may contribute to the simultaneous deterio-
• The intermediary is forced to raise cash by liquidating assets.
ration of different market participants’ financial positions.
In a distressed market, the firm is likely to realize losses by
Liquidity is ephemeral for many securities. It tends to become doing so.
impaired at precisely the moments when market participants
• Lenders are aware that the intermediary’s problems are now
most need it. Liquidity is a result of network effects and mutually
being compounded by realized mark-to-market losses, fur-
reinforcing expectations that are hard to capture quantitatively.
ther reducing their willingness to extend credit.
A well-functioning market can depend on whether the market
• The process now accelerates, becoming a run. Lenders to the
will “all hold hands,” or not, and on whether enough market
intermediary act out of the belief that it is insolvent and that
makers will make two-way prices they would be willing to honor
they will be repaid in full only if they are repaid early. The
in actual transactions.
1
60
for the full amount it owes. Within a very few days, ys, the
he inter-
th int
1- nt
20
66 Ce
Funding Liquidity and Solvency mediary will be unable to meet the demand for or cash.
cca
ash.
65 ks
06 oo
Liquidity is the ability to meet immediate demand for cash. Sol- It is the drain of cash, not defaults, that destroy
oy the
tro t firm.
f But it
82 B
-9 ali
vency is having a positive amount of equity capital, that is, assets is questionable whether a pure liquidity event,
even
eventt, unaccompanied
nt, un
58 ak
11 ah
exceeding liabilities. Liquidity and solvency are closely related, by even the shadow of a doubt aboutt its ssolve
solvency, can occur for
41 M
since both pertain to the ability to repay debts. But a firm can one firm in isolation.
20
99
the debt.
5
contemporary regulatory parlance, include securities exchanges, A number of funding liquidity risks are inherent in this process.
roces
oces
ess.
ss.
66 Ce
clearinghouses, securities depositories and settlement systems, A clearing bank might decline credit to one of its customers,
stome
tom
65 ks
mers,
ers,
06 oo
and payment systems. A disruption of any of these can impact provoking or amplifying a rollover risk event for the
e customer.
he cu
ustom
82 B
-9 ali
many market participants simultaneously, and illiquidity or insol- The lenders of cash might decline to leave cashsh with
witth a clear-
c
58 ak
11 ah
vency of one counterparty can have downstream effects on oth- ing bank, or might withdraw from the repo market
markket generally.
rket g
41 M
ers through these systems. Tri-party repo is not only large, but concentrated;
rated three dealers
20
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42 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
and concern. system to systemic risk include Bernanke (1990) and d Copeland,
Coppelan
1- nt
20
66 Ce
Further Reading th
heirr role in financial
The development of collateral markets and their
82 B
-9 ali
to financial intermediation by banks and other institutions. Much and Metrick (2010). The role of rehypothecation
othec in financial
20
99
1
560
66
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1- nt
20
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65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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44 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● 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.
1
60
5
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
Excerpt is Chapter 6 of Liquidity Risk Management: A Practitioner’s Perspective, by Shyam Venkat and Stephen
teph Baird.
tephe
20
99
45
act as one of the core guiding principles for EWI selection and
nd
66
98 er
requirements.
1- nt
20
monitoring at a bank.
66 Ce
65 ks
Beyond
06 oo
82 B
-9 ali
obligations is ultimately a cost-benefit decision. The protection Sept 2008, Early Warning Indicators.
41 M
20
99
46 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
treasury, the independent risk management function, and Principle 5 from the BCBS’ Sound Principles articulatesates the
5
66
98 er
1- nt
20
other relevant stakeholders. Once the institution has assessed hallmarks of EWIs. The principle states that “to obtain
obtaain a for-
66 Ce
its liquidity risks, including their sources and drivers, the firm ward looking view of liquidity risk exposures,, a bank
bank should
s
65 ks
06 oo
can then develop a framework for measuring and monitoring use metrics that assess (a) the structure off the
t balance
bala sheet,
82 B
-9 ali
these risks, consisting of stress tests, EWIs, and a limit and as well as metrics that (b) project cash flows
wss and future
lows
58 ak
11 ah
• A bank should have EWIs that • A bank should design a set of • Intraday liquidity monitoring indi- • Institution management should
signal whether embedded trig- indicators to identify the emer- cators include: monitor for potential liquid-
gers in certain products (i.e., call- gence of increased risk or vul- • Daily maximum liquidity ity stress events by using
able public debt, OTC derivatives nerabilities in its liquidity risk requirement early-warning indicators and
transactions) are about to be position or potential funding • Available intraday liquidity event triggers. The institution
breached, or whether contingent needs. • Total payments should tailor these indicators to
risks are likely to materialize. • Early warning indicators can be • Time-specific and other critical its specific liquidity risk profile.
• Early recognition of a potential qualitative or quantitative in obligations • Early recognition of potential
event allows a bank to enhance nature and may include but are • Value of customer payments events allows the institution to
a bank’s readiness. EWI’s may not limited to made on behalf of financial position itself into progressive
include: • Rapid asset growth, especially institutions customers states of readiness as the event
• A reluctance of traditional when funded with potentially • Intraday credit lines extended evolves, while providing a frame-
fund providers to continue volatile liabilities to financial institution work to report or communicate
funding at historic levels • Growing concentrations in customers within the institution and to
• Pending regulatory action assets or liabilities • Timing of intraday payments outside parties.
(both formal and informal) or • Increases in currency • Intraday throughput • Early-warning signals may
CAMELS component or com- mismatches include, but are not limited to:
posite rating downgrade(s) • Decrease of weighted average • Negative publicity concerning
• Widening of spreads on senior maturity of liabilities. an asset class owned by the
and subordinated debts, credit • Repeated incidents of posi- institution
default swaps, and stock price tions approaching or breach- • Increased potential for dete-
declines ing internal or regulatory limits rioration in the institution’s
• Difficulty in accessing long- • Negative trends or heightened financial condition
term debt markets risk associated with a particu- • Widening debt or credit
• Reluctance of trust managers, lar product line default swap spreads
money managers, public enti- • Increased concerns over the
ties, and credit-sensitive funds funding of off-balance-sheet
providers to place funds items
• Rising funding costs in an
otherwise-stable market
• Counterparty resistance to
off-balance-sheet products or
increased margin requirements
99 • The elimination of committed
20 credit lines by counterparties
41 M
OC
OCC:
OCC
2 1 a Liq
Liquidity booklet of the OCC’s Comptroller’s Handbook (2012)
15C:hLiak
3 8
BCBS: - B a Committee on Banking Supervision, “Principles for Sound Liquidity Risk Management and Supervision” (2008)
BS:9 Basel
48 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
82 li B
4
BCBS: Basel Committee
o
06 oCom on Banking Supervision, “Monitoring Indicators for Intraday Liquidity” (2012)
5
65 ks
Interagencyy Polic
Policy Sta
Statement on Funding and Liquidity Risk Management (2010)
66 cyyCeSt
1- nt
98 er
20
66
56
01
1. Risks Identification 2. Risk 3. Risk 4. Contingency
Assessment Capture
Tier 1 Risks
Liquidity Risks
Credit Liquidity Stress Test Contingent Liquidity
Inventory Processes Buffer
Modeling
Derivatives and
Reputation Collateral Exposure
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
1
Developing EWIs that are both sharp and forward looking allows within the bank or may be influenced by external al elements
elle
e lemen
65 ks
actions; it also helps to ensure that managers have a better For example, an idiosyncratic deposit run mayy result
resu from either
82
6
BCBS, “Principles of Sound Liquidity Management and Supervision,” EWIs should be positioned to capture emerg
emerging
emerg internally-
11
Sept 2008.
20
99
a potentially large cash outflow may require the asset-liability constant investigation of its movements, desensitizing management
5 60
EWIs will have a tangible and favorable impact on LRM governance calibration time series needs to be sufficiently long
ng in
n order
orde to
-9 ali
58 ak
only when they are linked to a clearly defined escalation plan. The be significant but should also capture recent events
nts to ensure
even
event
11 ah
41 M
governance overseeing the escalation of EWI triggered actions that it represents the current operating environment.
onnmen If possible,
must be formalized and documented as part of the liquidity risk the time series should include a period of stress,
stress such as during
20
management framework and be included in the institution’s CFP. 2007-08, to more accurately assess the performance
perfo of the metric
99
50 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Over the last few years, banking institutions have increased the 6M 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 Bank O/N Rate - Fed Effective 7 10 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 61.x for MM Funds
Illustrative EWI List
trends
-9 ali
52 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Repo Haircut
41 M
CONCLUSION and aligned with other core aspects of the LRM framework,
such as:
Over the years after the 2007-08 financial crisis, banking insti- • Risk inventory
tutions have significantly increased their reliance on EWIs to
• Liquidity stress testing assumptions
avert any potential liquidity crisis. Nonetheless, supervisors as
• Cash flow—actuals and projections
well as risk managers within the banks are constantly looking
to expand and refine their EWIs so that the list stays relevant • Business plans—Short-term/tactical and long-term/strategic
both to the internal changes that the bank may be under- • Contingency funding plan
going and to the dynamic, ever-changing macro-economic
1
landscape.
66
98 er
defense)
1- nt
20
66 Ce
Regulatory focus is expected to remain elevated, and super- EWIs will likely aid in managing the risk and averting the crisis is only if
crisiis
65 ks
06 oo
visors are likely to scrutinize idiosyncratic EWIs as these are the reporting mechanism is highly efficient. Thus, liquidity
idityy risk man-
82 B
more tailored to the bank’s specific vulnerabilities. Liquidity agers should ensure the quality and timeliness of thehe data
data that
th feeds
-9 ali
58 ak
risk managers at the bank must ensure that EWIs are gov- into the EWIs. A relevant and reliable EWI list will not
n only on alert the
o
11 ah
41 M
erned as a part of the holistic risk management function within leadership during or ahead of a crisis, but alsoo will
w likely
lik comple-
the organization. It is critical to ensure that EWIs are updated ment the overall risk management capabilities ies of
o the institution.
20
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54 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● 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.
1
605
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
Excerpt is Chapter 10 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
20
99
55
Assets Liabilities
Cash Deposits
Investments Nondeposit
1
Borrowings
605
66
98 er
1- nt
20
Sell Add to
66 Ce
investments investments
65 ks
demand is demand is
82 B
-9 ali
high low
58 ak
11 ah
41 M
Loans
Exhibit 4.1 Investments: The crossroads account on a depository institution’s balance sheet.
20
99
56 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
4.2 INVESTMENT INSTRUMENTS some investments will be sold to accommodate the heavy loan
demand. Finally, when deposits are not growing fast enough,
AVAILABLE TO FINANCIAL FIRMS some investment securities will be used as collateral to borrow
nondeposit funds. No other account on the balance sheet
The number of financial instruments available for financial
occupies such a critical intersection as do investments.
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
4.3 POPULAR MONEY MARKET
and economic conditions. To examine the different investment INVESTMENT INSTRUMENTS
vehicles available, it is useful to divide them into two broad
groups: (1) money market instruments, which reach maturity Treasury Bills
within one year and are noted for their low risk and ready
One of the most popular of all short-term investments is the
marketability and (2) capital market instruments, which have
U.S. Treasury bill—a debt obligation of the United States
remaining maturities beyond one year and are generally noted
goverment that, by law, must mature within one year from date
for their higher expected rate of return and capital gains
of issue. T-bills are issued in weekly and monthly auctions and
potential. See Table 4.2 for a summary of the advantages and
are particularly attractive to financial firms because of their high
disadvantages of the principal types of investment securities
degree of safety. Bills are supported by the taxing power of the
available.
federal government, their market prices are relatively stable,
1
60
Some authorities refer to investments as the crossroads and they are readily marketable. Moreover, T-bills can serve se e as
ser
5
66
98 er
account. Investments held by depository institutions literally collateral for attracting funds from other institutions. s. Bills ls are
Billlls
1- nt
20
66 Ce
stand between cash, loans, and deposits. When cash is low, issued and traded at a discount from their par (face) face
acee)) value.
vvalue Thus,
65 ks
06 oo
some investments will be sold in order to raise more cash. the investor’s return consists purely of price appreciation
ppre eciat
eciati as the
82 B
On the other hand, if cash is too high, some of the excess bill approaches maturity. The rate of return n (yield)
rn eld) on
(yiield) o T-bills is
-9 ali
58 ak
cash will be placed in investment securities. If loan demand is figured by the bank discount method, which whicch uses
use each bill’s
us
11 ah
41 M
weak, investments will rise in order to provide more earning par value at maturity as the basis for calculating
allculat
culat its return (as
assets and maintain profitability. But, if loan demand is strong, discussed in Chapter 18).
20
99
Short-Term Federal International Short-Term
Treasury Notes Agency Certificates Eurocurrency Bankers’ Commercial 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 $100,000 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 longer-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
99 disadvantages: private securities Some issues have limited resale Inflexible terms unstable in price than Treasury
20 Taxable gains and income potential Taxable gains and income securities
Limited supply of longest-term Taxable capital gains May carry substantial default
41 M
11 ah
58 ak issues risk Taxable gains and income
-9 ali
58 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
82 B
06 oo
65 ks
66 Ce
1- nt
98 er
20
66
56
01
Short-Term Treasury Notes and Bonds Freddie Mac notes) appears now to be facing serious risk (with
Fannie and Freddie recently taken into receivership by the
At the time they are issued, Treasury notes and Treasury bonds U.S. government).
have relatively long original maturities: 1 to 10 years for notes
and over 10 years for bonds. However, when these securities
come within one year of maturity, they are considered money Certificates of Deposit
market instruments. While T-notes and bonds are more sensi-
A certificate of deposit (CD) is simply an interest-bearing
tive to interest rate risk and less marketable than T-bills, their
receipt for the deposit of funds in a depository institution.
expected returns are usually higher than for bills with greater
Thus, the primary role of CDs is to provide depository institu-
potential for capital gains. T-notes and bonds are coupon instru-
tions with an additional source of funds. Banks often buy CDs
ments, which means they promise investors a fixed rate of return,
issued by other depository institutions, believing them to be an
though the expected return may fall below or climb above the
attractive, lower-risk investment. CDs carry a fixed term and a
promised coupon rate due to fluctuations in market price.
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
Factoid jumbos or negotiable CDs) with denominations over $100,000
Which federal agency in the United States has more securi- (though only the first $250,000 is federally insured). CDs have
ties outstanding in the financial marketplace for investors to negotiated interest rates that, while normally fixed, may fluctu-
buy than any other agency? ate with market conditions. Security dealers provide a secondary
market for $100,000-plus CDs maturing within six months.
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 International Eurocurrency Deposits
Mortgage Corporation (Freddie Mac).
Eurocurrency deposits are time deposits of fixed maturity issued
in million-dollar units by the world’s largest banks headquar-
All negotiable Treasury Department securities are issued by tered in financial centers around the globe, though the heart
electronic book entry. This system, known as Treasury Direct, of the Eurocurrency market is in London. Most of these inter-
provides investment security owners of U.S. Treasury securi- national deposits are of short maturity—30, 60, or 90 days—to
ties with a statement showing the bills, notes, and bonds they correspond with the funding requirements of international trade.
hold. Any interest and principal payments earned are depos- They are not insured, and due to their perceived higher credit
ited directly into the owners’ checking or savings account. risk, they often carry slightly higher market yields than domes-
This approach means not only greater convenience but also tic time deposits issued by comparable-size U.S. banks. (For
increased protection against theft. a detailed discussion of the role and creation of Eurocurrency
deposits, see Chapter 13.)
taxable and, in most cases, subject to state and local taxa- Because acceptances have a resale market
market,
arke they may be
tion as well. Some agency debt (especially Fannie Mae and traded from one investor to another
er before
her be reaching maturity.
20
99
Factoid
66
98 er
income tax rates. However, as we will see later, the tax savings Which U.S. Treasury security is the most popular (measured
easur
asu ed
65 ks
06 oo
associated with municipals has been sharply limited for U.S. by volume outstanding)—Treasury bills, notes, or bond
bonds?
ds?
82 B
60 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
ment securities?
60
4.2. What key roles do investments play in the manage- ilar home mortgages appearing on its balance sheet,, rem removes
moves
1- nt
20
66 Ce
ment a depository institution? them from that balance sheet into an account controlled
ntro
trrolle by a
led b
65 ks
market instruments available to institutions today? collateral. As the mortgage loan pool generates
erate
rate principal and
ess prin
-9 ali
58 ak
What are their most important characteristics? interest payments, these payments are “pass
“passed
“pas sed tthrough” to
ssed
11 ah
The Federal National Mortgage Association (Fannie Mae), char- 1. Guarantees from government agencies (in the case of
tered by but legally separate from the U.S. government, also home-mortgage-related securities) or from private institu-
helps create pass-throughs by purchasing packages of mortgage tions (such as banks or insurance companies pledging to
loans from lending institutions. While GNMA aids in the creation back credit card loans).
of mortgage-loan-backed securities for government-insured 2. The higher average yields generally available on securitized
home loans, FNMA securitizes both conventional (noninsured) assets than on most government securities.
and government-insured home mortgages. Investors who acquire
3. The lack of good-quality assets of other kinds in some mar-
pass-throughs issued against pools of government-insured home
kets around the globe.
mortgages which may be protected against default on those
securities if the Federal Housing and Veterans Administrations 4. The superior liquidity and marketability of securities backed
ensure that the pooled loans will be repaid even if the home- by loans compared to the liquidity and marketability of
owner abandons his or her home. Moreover, GNMA and FNMA loans themselves.
may add their own guarantees of timely repayment of principal However, despite the widespread popularity of asset-backed
and interest. instruments the credit crisis of 2007–2009 revealed substan-
In 1983 another government-sponsored agency, the Federal tial weaknesses among these investments, including sharp
Home Loan Mortgage Corporation (Freddie Mac), now legally deterioration in their market values as the underlying assets
separate from the U.S. government, developed the collateral- (loans) experienced a significant rise in default rates. Trad-
ized mortgage obligation (CMO)—a pass-through security ing volume among securitized assets plummeted, though at
divided into multiple classes (tranches), each with a different least some signs of recovery among stronger international
promised (coupon) rate and level of risk exposure. CMOs arise banks appeared following the depths of a global recession in
either from securitizing of mortgage loans themselves or from 2007–2009.
securitizing pass-through securities.
stay on the issuer’s balance sheet. The financial institution issu- lar, stripped securities offer interest-rate hedging possibilities to
5 60
ing these bonds will separate the mortgage loans held on its help protect an investment portfolio against loss from interest- rest-
est-
66
98 er
1- nt
20
66 Ce
balance sheet from its other assets and pledge those loans as rate changes. The securities whose interest and principal all pay-
pay
paay-
y-
65 ks
collateral to support the MBBs. A trustee acting on behalf of the ments are most likely to be stripped today include U.S. .S. Treasury
T
Treas
06 oo
82 B
mortgage bondholders keeps track of the dedicated loans and notes and bonds and mortgage-backed securities. es. Both
s. Bo
B oth P PO and
-9 al
checks periodically to be sure the market value of the loans is IO bond strips are really zero coupon bonds with no n periodic
pe
58 ak
11 ah
greater than what is owed on the bonds. interest payments; they therefore carry zero o reinvestment
reiinves
inve risk.
41 M
20
99
62 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
account
65 ks
06 oo
to customers.
5
66
98 er
1- nt
20
After loans, what is the greatest source of revenue for most chosen include:
58 ak
11 ah
64 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Expected Rate of Return In this case, the note’s HPY would be 11.51 percent.1
that equalizes the market price of the loan or security with its
20
66 Ce
1
Using a financial calculator such as the Tl BA Plus™, N = 2, i = ?,
A II P
Plu
41 M
(or 1,000 * 0.08 = $80) and is slated to mature in five years. PV = - 900, Pmt = 80, FV = 950. Solving for the tth interest rate (HPY)
If the T-note’s current price is $900, we have gives i = 11.51%.
20
99
Crisis in the Investments Market: What the repurchase agreements—became as costly as the failure to
9/11 Terrorist Attacks Did to the Delivery deliver what was promised.
of Securities to Investors Fortunately, two critical government agencies reacted
quickly. The Federal Reserve poured liquid funds into the
The market for investment securities is one of the larg- banking system so that emergency money was available. The
est in the world. Trillions of dollars change hands daily and U.S. Treasury, even though it didn’t need to borrow addi-
both payments and delivery generally occur on time. Now tional funds at the time, announced the reopening of a key
consider what happened following the terrorist attacks on security issue—the 10-year T-note that was currently “on the
September 11, 2001. Within hours the system for delivering run.” The Treasury’s same day (“snap”) auction expanded the
U.S. Treasury securities—the most popular financial invest- supply of these particular notes by 50 percent, which helped
ment in the world—began to unravel, Many sellers were to make borrowing these securities a superior alternative to
unable to meet their promises to deliver and some buyers failing to settle.
couldn’t execute payments on the scheduled date. These
settlement fails soared from an average of less than $2 bil- An excellent article prepared by two staff officers at the Fed-
lion a day before the attacks to as much as $190 billion a day eral Reserve Bank of New York (Fleming and Garbade [6])
immediately following the attacks. offers some proposals for the future should a tragedy of com-
parable magnitude happen again, These proposals include
The settlement fails occurred initially because some com- setting up an expanded government facility that would be
munications systems linking dealers and their customers able to lend securities experiencing excess demand. Indeed,
were destroyed or damaged when the World Trade Center in the wake of 9/11 the Federal Reserve expanded its pro-
collapsed. Moreover, several key institutions experienced gram, set up originally in 1969, to lend Treasury securities
destruction of their records. A severe shortage of certain from its huge open market account to dealers facing settle-
Treasury securities developed, and the usual remedy for such ment problems. A more recent analysis of this problem in
shortages—borrowing securities through special collateral Treasury securities appears in Garbade et al. [11].
income tax could compare each of these potential yields using municipal bond or other tax-exempt security. The TEY indicates
this formula: what before-tax rate of return on a taxable investment pro-
vides an investor with the same after-tax return as a tax-exempt
Before@tax
* (1 - Firm’s marginal income tax rate) investment would. The TEY can usually be found using the fol-
gross yield
lowing relationship:
= After@tax gross yield (4.3)
This comparison yields the following expected after-tax gross After@tax return on a tax@exempt investment
TEY = (4.4)
returns for a taxed financial firm in the top 35 percent federal (1 - Investing firm’s marginal tax rate)
income tax bracket:
In the numerical example above the Aaa-rated corporate bond
Aaa@rated corporate bonds: 7.00 percent * (1 - 0.35) and the prime-rated loans would have to have a before-tax yield
= 4.55 percent of 8.46 percent to match the Aaa-municipal bond’s after-tax
Prime@rated loans: 6 percent * (1 - 0.35) = 3.90 percent yield of 5.50 percent.
ations enter into this decision, such as the need to attract other
legislation during the 1980s, banks held close to a quarter
qua
art
rter
t
65 ks
Note that Equation (4.3) permits an investments officer to corporate tax rates, and (3) fewer qualifiedd tax-exempt
tax-
calculate what is called the tax-equivalent yield (TEY) from a securities.
20
99
66 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Before 1986 the federal tax code allowed significant tax deduc- Tax advantage
tions for interest expenses incurred when banks borrowed funds of
=
to buy municipal securities. However, after 1986, banks could no qualified
longer deduct all of the interest paid on borrowed funds used to bond
purchase tax-exempt bonds. Today banks buying bank-qualified The bank’s Percentage of Interest
bonds—those issued by smaller local governments (govern- marginal interest expense expense of
ments issuing no more than $10 million of public securities per E income * that is still * acquiring the U
year)—are allowed to deduct 80 percent of any interest paid tax rate tax deductible municipals
to fund these purchases. This tax advantage is not available for (in percent) (if any) (in percent)
nonbank-qualified bonds. (4.6)
Prior to the 1986 Tax Reform Act the highest corporate tax Suppose a bank purchases a bank-qualified bond from a small
bracket was 46 percent. Today the top bracket is 35 percent for city, county, or school district and the bond carries a nominal
corporations earning more than $10 million in annual taxable (published) gross rate of return of 7 percent. Assume also that
income or 34 percent otherwise. Lower tax brackets reduce the the bank had to borrow the funds needed to make this purchase
tax savings associated with the tax-exemption feature.2 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
Fewer state and local bonds qualify for tax exemption today.
government that qualifies for special tax treatment under the
If 10 percent or more of the proceeds of a municipal bond
1986 Tax Reform Act, the bond’s net annual after-tax return
issue is used to benefit a private individual or business, it is
(after all funding costs and taxes) must be:
considered a private activity issue and fully taxable. In addi-
tion, Congress placed ceilings on the amount of industrial Net after@tax return
development bonds (IDBs) local governments could issue to on a qualified = (7.0 - 6.50) + (0.35 * 0.80 * 6.50)
provide new facilities or tax breaks in order to attract new municipal security
industry. These laws reduced the supply of tax-exempt securi- = 0.50 percent + 1.82 percent
ties for investors to purchase and contributed to the lower = 2.32 percent (4.7)
proportion of municipals found in the securities portfolios of The investments officer would want to compare this calculated
many taxed financial institutions. net after-tax return to the net returns after taxes available from
To evaluate the attractiveness of municipals, financial firms other securities and loans, both taxable and tax-exempt. If the
calculate the net after tax returns and/or the tax-equivalent municipal bond described previously had come from a larger
yields to enable comparisons with other investment alterna- state or local government not eligible for special treatment
tives. The net after-tax return of bank-qualified municipals is under the Tax Reform Act, none of the interest expense would
calculated as follows: have been tax deductible and the net tax advantage to the bank
purchasing the nonqualified bonds would be nil.
Net after@tax Nominal return Interest expense incurred
return on on municipals - in acquring the The Tax Swapping Tool
= D T
municipals after taxes municipals The size of a lender’s revenue from loans plays a key role in how its
(in percent) (in percent) (in percent)
investments are handled. In years when loan revenues are high, it
Tax advantage may be beneficial to engage in tax swapping. In a tax swap, the
+ of a (4.5) lending institution sells lower-yielding securities at a loss in order
qualified bond to reduce its current taxable income, while simultaneously purchas- ass
1
Under current federal law, U.S. banks must calculate their income
06 oo
taxes in two different ways—using a normal tax rate schedule (maximum ones. Usually larger lending institutions are in
n the
e top income-
82 B
35 percent tax rate) and using an alternative minimum tax rate of tax bracket and have the most to gain from m security
ecurit portfolio
se
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58 ak
20 percent, and then must pay the greater of the two different amounts. trades that minimize tax exposure. The e manager
mannage tries to esti-
anage
11 ah
bank’s alternative minimum tax (AMT), making municipal income subject mate the institution’s projected net taxable
able income
xa i under alter-
to at least some taxation. native portfolio choices.
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99
This involves, among other things, estimating how much tax- For example, the investments officer of First National Bank may
exempt income the taxed lending institution can use. No be considering the following shift in its municipal bond portfolio:
financial firm can use unlimited amounts of tax-exempt income.
For depository institutions, at least, some taxable income will be
Find a buyer for $10 million S Current market
necessary to offset the allowable annual deduction for possible in 10-year New York City price = $9.5 million
loan losses (ALL). However, once these conditions are met, the bonds bearing a 7 percent
Value recorded on the
basic decision between purchasing tax-exempt securities or pur- coupon rate that the bank
bank’s balance
chasing taxable securities and loans comes down to the relative currently holds.
sheet = $10 million
after-tax returns of the two.
Annual interest
income = $0.7 million
The Portfolio Shifting Tool Then acquire $10 million in S Current market
Lending institutions also do a great deal of portfolio shift- 10-year Los Angeles County price = $10 million
bonds bearing a 9 percent
ing in their holdings of investment securities, with both taxes Annual interest
1
and higher returns in mind. Financial firms, for example, often income = $ 0.9 million
io
o
5
amounts of loan income, thereby reducing their tax liability. Clearly, this bank takes an immediate $500,000 loss befor efore
beforee
65 ks
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They may also shift their portfolios simply to substitute new, taxes ($10 million - $9.5 million) on selling the 7 percent
perceent
82 B
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higher-yielding securities for old security holdings whose yields New York City bonds. But if First National is in thehe 3 per-
35 pe
58 ak
may be below current market levels. The result may be to take cent tax bracket, its immediate loss after taxes
xes bbecomes only
becom
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41 M
substantial short-run losses in return for the prospect of higher $500,000 * (1 - 0.35), or $325,000. Moreover, ver, it has swapped
long-run profits. this loss for an additional $200,000 annually
lly in tax-exempt
ally
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68 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Table 4.4 Default Risk Ratings on Marketable Investment 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
poor prospects
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D
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Most depository institutions are limited to investment-grade securities—that is, they must purchase securities
ities rated AAA to
h
11 Ma
BBB (by recognized rating agencies), Unrated securities may also be acquired, but the regulated institutionn must
mus be able to
demonstrate they are of investment-grade quality.
4
20
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A1 Ba2
A2 Ba3 Business Risk
A3 B1 Financial institutions of all sizes face significant risk that the
B2 economy of the market area they serve may turn down, with
falling sales and rising unemployment. These adverse devel-
B3
opments, often called business risk, can be reflected quickly
in the loan portfolio, where delinquent loans may rise as
These rating modifiers reflect concern about recent trends in the
borrowers struggle to generate enough cash flow to pay the
municipal market, especially increased credit risk and volatility.
lender. Because business risk is always present, many financial
1
60
There has been a fluctuating but general uptrend in munici- institutions rely heavily on their security portfolios to offsetet
5
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pal defaults over the past several years. For example, in 1991 the impact of this form of risk on their loan portfolios. This
1- nt
20
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a record 258 municipal bond defaults occurred, involving usually means that many investment securities purchased hased
hase d will
wil
65 ks
local governments seem to face, potentially at least, even loans. For example, a bank located in Dallas orr Kansasansas City
Ka
-9 ali
58 ak
greater risk of loss because of factors like high unemployment, may purchase a substantial quantity of municipal pal bonds
nicip bo from
11 ah
41 M
depressed government revenues, declining support from the cities and other local governments outside e the
t Midwest
M (e.g.,
federal government for welfare programs, health services, and Los Angeles or New York debt securities). s). Bank
Ba examiners
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70 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
3
lnvestments officers dealing with callable bonds generally calculate
1- nt
20
their yield to call (YTC) as well as their yield to maturity (YTM). If a call-
defaults of d efault of
efaults
defaults
65 ks
indicating its nominal interest rate exceeds current market rates, it is Market value existing loans in ex
xisting loans in
existing
82 B
generally priced as though it will be retired on its call date. The reason (price) of a = the pool in Period 1 +g+ pool in Period n * m
the poo
the
-9 ali
is that callable bonds with bigger nominal rates are the most likely to
11 ah
be called in. On the other hand, a bond typically is priced to its yield to security
41 M
compare these potential benefits to the potential losses from the rest must be backed up by holdings of Treasury and federal era
5
66
98 er
falling interest payments in the form of lower reinvestment rates agency securities valued at par. Some municipal bonds (pro-pro-
1- nt
20
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and lost future income from loans that are prepaid. In general, vided they are at least A-rated) can also be used to secure
ecuree the
curre
65 ks
06 oo
asset-backed securities will fall in value when interest rates federal government’s deposits in depository institutions,s, but
tions
ns, bu
B
decline if the expected loss of interest income from prepaid these securities must be valued at a discount from
om par
p (often
(o 80
82
loans and reduced reinvestment earnings exceeds the expected to 90 percent of their face value) in order to give
e governmental
gov
-9
58
benefits that arise from recovering cash more quickly from pre- depositors an added cushion of safety. State and local govern-
11
41
72 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
state, though most allow a combination of federal and municipal That is, what maturities of securities should the investing institu-
securities to meet government pledging requirements. Some- tion hold? Should it purchase mainly short-term bills and notes,
times the government owning the deposit requires that the or only long-term bonds, or perhaps some combination of the
pledged securities be placed with a trustee not affiliated with two? Several maturity distribution strategies have been devel-
the institution receiving the deposit. We note from looking at oped over the years, each with its own unique set of advantages
Table 4.3 that just over half of bank-held investment securities and disadvantages. (See Exhibit 4.2 and Exhibit 4.3.)
are pledged to back up government-owned deposits.
Pledging requirements also exist for selected other liabilities. The Ladder, or Spaced-Maturity, Policy
For example, when a bank borrows from the discount window One popular approach to the maturity problem, particularly
of the Federal Reserve bank in its district, it must pledge either among smaller institutions, is to choose some maximum accept-
federal securities or other collateral acceptable to the Fed. If a able maturity and then invest in an equal proportion of securities
financial institution uses repurchase agreements (RPs) to raise in each of several maturity intervals until the maximum accept-
money, it must pledge some of its securities (usually Treasury able maturity is reached.
and federal agency issues) as collateral in order to receive funds
For example, suppose management decided that it did not want
at the lowest RP rate.
to purchase any bonds or notes with maturities longer than five ve
1
60
STRATEGIES
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Once the investments officer chooses the type of securities he This strategy certainly does not maximize ize investment
mize in
nves income,
11 ah
41 M
or she believes a financial firm should hold, there remains the but it has the advantage of reducing incomecom fluctuations and
come
question of how to distribute those security holdings over time. requires little expertise to carry out. Moreover,
Mor this ladder
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99
STRATEGY: Divide 30
investment portfolio
ADVANTAGES:
Strengthens the 70
financial firm’s 60
liquidity position
and avoids large 50
capital losses if 40
market interest 70%
30
rates rise.
20
30%
10
0
1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
Maturity in years and months
STRATEGY: All 50
security investments
Percent of the value
are short-term.
of all securities held
40
ADVANTAGES: 100% of portfolio
Maximizes 30
income potential
from security
investments if 20
market interest 30% 30%
rates fall. 10 20%
10% 10%
0
1 yr. 2 yr. 3 yr. 4 yr. 5 yr. 6 yr. 7 yr. 8 yr. 9 yr. 10 yr.
Maturity in years and months
Exhibit 4.2 Alternative maturity strategies for managing investment portfolios.
Factoid
60
securities are always rolling over into cash, the firm can take
5
66
98 er
advantage of any promising opportunities that may appear. Which type of financial institution holds more Treasury
1- nt
20
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The Front-End Load Maturity Policy Answer: The Federal Reserve System with several al hundred
ral h
hu
undre
undre
82 B
74 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
STRATEGY: 50
Security holdings
Half or a substantial Half or a substantial
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 maturity strategies for managing investment portfolios.
100 percent of his or her institution’s funds not needed for loans The Rate Expectations Approach
or cash reserves in securities three years or less from maturity.
The most aggressive of all maturity strategies, often used by the
This approach stresses using the investment portfolio primarily
largest financial firms, is one that continually shifts maturities of
as a source of liquidity rather than as a source of income.
securities in line with current forecasts of interest rates and the
economy. This total performance, or rate expectation, approach
The Back-End Load Maturity Policy
calls for shifting investments toward the short end of the maturity
An opposite approach would stress the investment portfolio as spectrum when interest rates are expected to rise and toward
a source of income. An investing institution following the back- the long end when falling interest rates are expected. Such an
end load approach might decide to invest only in bonds in the approach offers the potential for large capital gains, but also
5- to 10-year maturity range. This institution would probably raises the specter of substantial losses. It requires in-depth knowl-
rely heavily on borrowing in the money market to help meet its edge of market forces, presents greater risk if expectations turn
liquidity requirements. out to be wrong, and carries greater transactions costs because it
may require frequent security trading and switching.
The Barbell Strategy Banks, for example, often trade some of their unpledged
1
60
A combination of the front-end and back-end load approaches, security holdings whenever there is the prospect of significant
gnif
ni cant
5
66
98 er
frequently employed by smaller financial firms, is the barbell gains in expected returns or the opportunity to reduce uce asset
a
1- nt
20
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strategy, in which an investing institution places most of its risk without significant loss in expected yield. Theyey are
hey ar particu-
pa
65 ks
06 oo
funds in a short-term portfolio of highly liquid securities at one larly aggressive when loan revenues are down n and
d the sale of
82 B
extreme and in a long-term portfolio of bonds at the other securities whose market value has risen willll boost
oost net
bo n income
-9 ali
58 ak
extreme, with minimal investment holdings in intermediate and shareholder returns. However, because
cause e losses
loss on security
11 ah
41 M
maturities. The short-term portfolio provides liquidity, while the trades reduce before-tax income, portfolioolio managers
tfo m do not like
long-term portfolio is designed to generate income. to take such losses unless they can demo
demonstrate to the board
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76 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
how and why the curve appears the way it does at any particular
5
66
98 er
any time. Moreover, the yield curve counts only clock time, not eresst is
applies if a security pays interest once each year, if interest is pai
paid more
65 ks
critical information for the investments officer is usually not how Percentage change ange
nge in interest
Change int rate
-9 ali
= - Duration * J R
58 ak
long any particular security will be around but, rather, when it in price 1 + (1/m)(Initial
(1/m
1/m rate)
11 ah
41 M
will generate cash and how much cash will be generated each where m is the number of times during a yearr that the security pays interest.
month, quarter, or year the security is held. miannu
For example, most bonds pay interest semiannually, in which case m = 2.
20
99
gains or losses are counterbalanced by falling or rising rein- investments officer is often charged with the responsibilityy
5
66
98 er
vestment yields when duration matches the investing institu- for backstopping loans—providing more income when loan
1- nt
20
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tion’s planned holding period. demand is weak and more cash when loan demand iss high. h
hig
gh.
65 ks
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78 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
KEY TERMS
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, 68 duration, 77
municipal bonds, 60 interest rate risk, 69 portfolio immunization, 78
1
60
5
66
98 er
1- nt
20
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65 ks
06 oo
82 B
-9
58
11
41
20
99
return of 9.75 percent. Forever Savings Bank has the same 7-year Treasury notes = 3.56 percent
560
b. What is the difference in the net after-tax return for Draw a yield curve for these securities. What at sh
shape
hape does
-9 ali
58 ak
this qualified security (Problem 5) versus the nonquali- the curve have? What significance might htt this yield curve
iss yiel
11 ah
41 M
80 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
1
60
5
66
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1- nt
20
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65 ks
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11 ah
41 M
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Internet Exercises
1. As the investments officer for Bank of America, you have 2. A number of websites are available to help in evaluating
been informed by a member of that bank’s board of direc- the merits and demerits of different types of securities
tors that the investment policies you have followed over that banks are allowed to hold in their investment portfo-
the past year have been substandard relative to your com- lios. See www.sifma.org and www.investinginbonds.com.
petitors, including Citigroup, Wells Fargo, and JP Morgan Find one additional website on your own and compare and
Chase. You protest and observe that all financial institutions contrast the usefulness of these three websites.
have faced a tough market and, in your opinion, your bank 3. If you want a summary of regulations applying to bank and
has done exceptionally well. Challenged, your CEO asks thrift security portfolios, you would turn to the regulators’
you to prepare a brief memo with comparative investment websites. The Federal Reserve’s Trading and Capital-
facts, defending your bank’s relative investment perfor- Markets Activity Manual found at www.federalreserve
mance against the other BHCs mentioned. Use the FDIC’s .gov/boarddocs/supmanual/trading.pdf has a section on
Statistics on Depository Institutions at www2.fdic.gov/sdi to “Capital Market Activities.” Read and briefly outline the
develop a reply. What conclusion did you reach after exam- first two pages on “Limitations and Restrictions on Securi-
ining your bank’s relative investment performance over the ties Holdings” that is found in section 3000.1—Investment
last complete calendar year? Securities and End-User Activities.
YOUR BANK’S INVESTMENT FUNCTION: AN assets, see Item 1—the components of the securities portfo-
EXAMINATION OF THE SECURITIES PORTFOLIO lio are listed as Items 4–7 and 13–14. Enter the percentage
Chapter 4 explores how the investments officer manages a information for these items as an addition to the spread-
financial firm’s securities portfolio and describes the portfolio’s sheet for comparisons with the peer group as illustrated
purpose and composition. A significant portion of the chapter using BB&T’s 2010 and 2009 year-end data.
outlines and describes the different types of money market and
capital market instruments found in the securities portfolio. B. Compare columns of row 77. How has the relative size of
Part One of this assignment examines the types of securities your bank’s securities portfolio-to-total assets ratio changed
in your bank’s portfolio and asks you to make some inferences across periods? Does your BHC have more or less liquidity
about factors that played a role in the selection of securities for than the group of comparable institutions?
that portfolio. The possible factors are discussed midchapter.
Part Two of this assignment examines the maturity structure of C. Use the Chart function in Excel and the data by columns in
your bank’s securities portfolio. This topic is covered in the later rows 78 through 83 to create four pie charts illustrating the
part of the chapter. Chapter 4’s assignment is designed to focus profile of securities held by your BHC and its peer group.
on the issues of importance to investments officers in large com-
With these pie charts provide titles, labels, and percent-
mercial banks or similar competing institutions.
ages. If you save these as separate sheets, they do not clut-
ter the spreadsheets that you use most frequently, yet they
Part One: The Composition of Your Bank’s
are available to insert in Word documents. To give you an
Securities Portfolio—Trend and Comparative
1
example, the charts for BB&T and its peer group for 2010
60
Analysis
5
A. Data Collection: For this part, you will access data at the
66 Ce
this part of the assignment for Report Selection use the pull-
41 M
82 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 ve
and BHCs. You will follow the process used to collect data
1
60
and view this in dollars. For maturity and repricing data for
58 ak
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.
25,000,000
20,000,000
15,000,000
10,000,000 1
60
5,000,000
5
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1- nt
20
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65 ks
0
06 oo
82 B
84 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Selected References
See below for a discussion of securitization, security stripping, Federal Reserve Bank of New York, November 2002,
and other investment instruments: pp. 35–58.
1. Dupont, Dominique, and Brian Sack. “The Treasury Securi- 7. Sundaresan, Suresh M. Fixed Income Markets and Their
ties Market: Overview and Recent Developments.” Federal Derivatives. Cincinnati, OH: Southwestern Publishing, 1997.
Reserve Bulletin 85, no. 12 (1999), pp. 785–806.
To explore the recent emergence of inflation-indexed invest-
2. Smith, Stephen D. “Analyzing Risk and Return for Mortgage- ment securities, see especially:
Backed Securities,” Economic Review, Federal Reserve Bank
8. Sack, Brian, and Robert Elsasser. “Treasury Inflation-
of Richmond, January/February 1991, pp. 2–10.
Indexed Debt: A Review of the U.S. Experience.” Economic
The following articles review yield to maturity, yield curves, and Policy Review, Federal Reserve Bank of New York, May
other yield measures: 2004, pp. 47–63.
3. Gurkaynak, Refet S., Brian Sack, and Jonathan H. Wright. 9. D’Amico, Stefania, Don H. Kim, and Min Wei. “Tips from
“The TIPs Yield Curve and Inflation Compensation.” TIPS: The Informational Content of Treasury Inflation-
Finance and Economics Discussion Series 2008–05, Federal Protected Security Prices,” Finance and Economics Discus-
Reserve Board, Washington, D.C., 2008. sion Series, Federal Reserve Board, Washington, D.C., no.
2010–19, 2010.
4. Poole, William. “Understanding the Term Structure of Inter-
est Rates.” Review, Federal Reserve Bank of St. Louis, Sep- For an in-depth analysis of the impact of default risk in interna-
tember/October 2005, pp. 589–595. tional securities markets see especially:
5. Rose, Peter S.; and Milton H. Marquis. Money and Capi- 10. Hatchondo, Juan Carlos, and Leonardo Martinez. “The Poli-
tal Markets: Financial Institutions and Markets, 11th ed. tics of Sovereign Defaults,” Economic Quarterly, Federal
New York: McGraw-Hill/Irwin, 2010. (See especially Chapter 6, Reserve Bank of Richmond, vol. 96, no. 3 (Third Quarter
“Measuring and Calculating Interest Rates and Financial Asset 2010), pp. 291–317.
Prices.”)
To find a more recent discussion of settlement fails in the Trea-
For a discussion of investment strategies involving securities sury security market consult, for example:
purchased by depository institutions and other investment-
11. Garbade, Kenneth D, Frank M. Keane, Lorie Logan, Amanda
oriented institutions, see:
Stokes, and Jennifer Wolgemuth. “The Introduction of the
6. Fleming, Michael J.; and Kenneth Garbade. “When the TMPG Fails Charge for U.S. Treasury Securities,” Economic
Back Office Moved to the Front Burner: Settlement Fails in Policy Review, Federal Reserve Bank of New York, vol. 16,
the Treasury Market after 9/11.” Economic Policy Review, no. 2 (October 2010), pp. 45–71.
1
60
5
66
98 er
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20
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65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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Liquidity and
Reserves
5
Management:
Strategies
and Policies
■ 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.
indicators).
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20
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65 ks
06 oo
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-9 ali
58 ak
11 ah
41 M
Excerpt is Chapter 11 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
20
99
87
of its safer, more liquid assets. Other lending institutions may ply of liquidity comes from customers repaying their loans and
560
become increasingly reluctant to lend the troubled firm any new from sales of assets, especially marketable securities, from the
66
98 er
1- nt
20
funds without additional security or the promise of a higher rate investment portfolio. Liquidity also flows in from revenues
es (fee
ue (fe
fee
ee
66 Ce
65 ks
of interest, which may reduce the earnings of the beleaguered income) generated by selling nondeposit services and d from
nd om bor-
fro b
06 oo
financial firm and threaten it with failure. rowings in the money market.
82 B
-9 ali
58 ak
11 ah
41 M
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88 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
When the demand for liquidity exceeds its supply (i.e., Lt 6 0), Most liquidity problems arise from outside the financial firm as a
management must prepare for a liquidity deficit, deciding result of the activities of customers. In effect, customers’ liquid-
when and where to raise additional funds. On the other hand, ity problems gravitate toward their liquidity suppliers. If a busi-
if at any point in time the supply of liquidity exceeds all liquid- ness is short liquid reserves, for example, it will ask for a loan
ity demands (i.e., Lt 7 0), management must prepare for a or draw down its account balances, either of which may require
liquidity surplus, deciding when and where to profitably invest the firm’s financial institution to come up with additional funds.
surplus liquid funds until they are needed to cover future cash A dramatic example of this phenomenon occurred in the wake
needs. of the worldwide stock market crash in October 1987. Investors
who had borrowed heavily to buy stock on margin were forced
Liquidity has a critical time dimension. Some liquidity needs
to come up with additional funds to secure their stock loans.
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
Factoid
to withdraw these deposits rather than simply rolling them
over into new deposits. Sources of funds that can be accessed Did you know that a serious liquidity crisis inside the United
immediately must be used to meet these near-term liquidity States in 1907, which followed several other liquidity crises in
pressures. the 19th century, led to the creation of the U.S. central bank,
the Federal Reserve System, to prevent liquidity problems
Longer-term liquidity demands arise from seasonal, cyclical, and
in the future?
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 They went to their lending institutions in huge numbers, turn-
liquidity needs managers can draw upon a wider array of funds ing a liquidity crisis in the capital market into a liquidity crisis for
sources than is true for immediate liquidity needs, such as sell- lenders.
ing off accumulated liquid assets, aggressively advertising the
The essence of liquidity management problems for financial
institution’s current menu of services, or negotiating long-term
institutions may be described in two succinct statements:
1
not all demands for liquidity need to be met by selling assets or 1. Rarely are demands for liquidity equal to the supply
pply of
66
98 er
1- nt
20
borrowing new money. For example, just the right amount of liquidity at any particular moment in time. Thee financial
fina
financia
66 Ce
65 ks
new deposits may flow in or loan repayments from borrowing firm must continually deal with either a liquidity
uiditty deficit
quidit de or a
06 oo
customers may occur close to the date new funds are needed. liquidity surplus.
82 B
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11 ah
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For example, depository institutions borrow large amounts of tact with the largest funds-supplying customers and thehe holders
h
holde
65 ks
06 oo
short-term cash from individuals and businesses and from other of large unused credit lines to determine if and whenen withdraw-
he withd
w
82 B
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lending institutions and then turn around and make long-term als will be made and to make sure adequate funds nds will
unds w be b avail-
58 ak
11 ah
credit available to their borrowing customers. Thus, depository able when demand for funds occurs.
41 M
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90 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
5.4 STRATEGIES FOR LIQUIDITY “Storing Liquidity in Assets—The Principal Options” for brief
descriptions of these liquid assets.) Although a financial firm can
MANAGERS strengthen its liquidity position by holding more liquid assets, it will
not necessarily be a liquid institution if it does so, because each
Over the years, experienced liquidity managers have developed
institution’s liquidity position is also influenced by the demands for
several strategies for dealing with liquidity problems: (1) provid-
liquidity made against it. Remember: A financial firm is liquid only
ing liquidity from assets (asset liquidity management), (2) relying
if it has access, at reasonable cost, to liquid funds in exactly the
on borrowed liquidity to meet cash demands (liability manage-
amounts required at precisely the time they are needed.
ment), and (3) balanced (asset and liability) liquidity management.
Among the most popular liquid assets are Treasury bills, federal must take care that assets with the least profit ofitt potential
po
poten
oten are sold
82 B
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funds loans, certificates of deposit, municipal bonds, federal first in order to minimize the opportunityy cost st of future
f earnings
58 ak
11 ah
agency securities, and Eurocurrency loans. (See the box entitled forgone. Selling assets to raise liquidityty also
als
al so tends
lso te to weaken
41 M
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the appearance of the balance sheet because the assets sold funds through borrowings in the money market. This bor-
are often low-risk securities that give the impression the finan- rowed liquidity strategy—called purchased liquidity or
cial firm is financially strong. Finally, liquid assets generally carry liability management—in its purest form calls for borrowing
the lowest rates of return of all assets. Investing in liquid assets immediately spendable funds to cover all anticipated demands
means forgoing higher returns on other assets that might be for liquidity. Today many different types of financial institutions
acquired. use this liquidity management strategy.
interest and maturity, though continuing-contract RPs 6. Borrowing reserves from the discount window of the e
66 Ce
remain in force until either the borrower or the lender central bank (such as the Federal Reserve or the Bank
Bank
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92 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
mize returns.
98 er
arrangements for lines of credit from potential suppliers of Fourth, liquidity needs must be analyzed on a continuinginuing basis
ontiinu
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06 oo
funds. Unexpected cash needs are typically met from near- to avoid both excess and deficit liquidity positions.
itionns. Excess
itions Ex
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term borrowings. Longer-term liquidity needs can be planned liquidity not reinvested the day it occurs results
esultts in lost
result l income,
-9 ali
58 ak
for and the funds to meet these needs can be parked in short- while liquidity deficits must be dealt with
ith quickly
quickl to avoid dire
q
11 ah
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term and medium-term assets that will provide cash as those emergencies where the hurried borrowingwiing
winng of
o funds or sale of
liquidity needs arise. assets results in excessive losses.
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business sales)
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projected prime
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estimated
growth in the minus the
-9 ali
money commercial
11 ah
inflation
41 M
94 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
deviations from a bank’s total expected deposits and loans from column 4 in Table 5.1. Columns 3 and 4 in Table 5.2 calculate ulate
5 60
66
(measured by the sum of trend and seasonal components), the change in total deposits and total loans from one week week to tthe
98 er
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depending upon the strength or weakness of the economy next. Column 5 shows differences between change loans
oans and
e in lo
65 ks
in the current year. change in deposits each week. When deposits fall all a loans rise,
and lo
06 oo
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whose trend growth rate in deposits over the past decade has
11 ah
41 M
averaged 10 percent a year. Loan growth has been slightly less As Table 5.2 reveals, our bank has a projected
ected liquidity deficit over
oje
rapid, averaging 8 percent a year for the past 10 years. Our the next three weeks—$150 million next week, $200 million the
ext w
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Table 5.2 Forecasting Liquidity Deficits and Surpluses with the Sources and Uses of Funds Approach (figures in
millions of dollars)
third week, and $100 million in the fourth week—because its loans Management can now begin planning which sources of liq-
1
60
are growing while its deposit levels are declining. Due to a fore- uid funds to draw upon, first evaluating the bank’s stock of
5
66
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cast of rising deposits and falling loans in the fifth week, a liquidity liquid assets to see which assets are likely to be available
ble
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surplus of $550 million is expected, followed by a $200 million and then determining if adequate sources of borrowed wedd funds
f
65 ks
06 oo
liquidity deficit in week 6. What liquidity management decisions are likely to be available. For example, the bank probably
prob
bably
82 B
must be made over the six-week period shown in Table 5.2? The has already set up lines of credit for borrowingg from
om its prin-
fro
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58 ak
liquidity manager must prepare to raise new funds in weeks 2, 3, cipal correspondent institution and wants to o be
e sure
sur these
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4, and 6 from the cheapest and most reliable funds sources and to credit lines are adequate to meet the projected
eccted amount of
profitably invest the expected funds surplus in week 5. borrowing needed.
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96 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Second, the liquidity manager must set aside liquid funds Total liquidity = 0.95 * (Hot money funds
according to some desired operating rule for each of these requirement = -Required legal reserves held
funds sources. For example, the manager may decide to set up Deposit and behind hot money deposits)
a 95 percent liquid reserve behind all hot money funds (less any nondeposit +0.30 * (Vulnerable deposits and
required legal reserves held behind hot money deposits). This liability liquidity nondeposit funds - Required legal (5.6)
liquidity reserve might consist of holdings of immediately spend- requirement reserves) + 0.15 * (Stable deposits
able deposits in correspondent institutions plus investments in and loan and nondeposit funds - Required legal
Treasury bills and repurchase agreements where the committed liquidity reserves) + 1.00 * (Potential loans
funds can be recovered in a matter of minutes or hours. requirement outstanding - Actual loans outstanding)
A common rule of thumb for vulnerable deposit and non- Admittedly, the deposit and loan liquidity requirements that
deposit liabilities is to hold a fixed percentage of their total make up the above equation are subjective estimates that
amount—say, 30 percent—in liquid reserves. For stable (core) rely heavily on management’s judgment, experience, and
funds sources, a liquidity manager may decide to place a small attitude toward risk.
proportion—perhaps 15 percent or less—of their total in liquid
A numerical example of this liquidity management method
reserves. Thus, the liquidity reserve behind deposit and nonde-
is shown in Table 5.3. First National Bank has broken down
posit liabilities would be:
its deposit and nondeposit liabilities into hot money, vulner-
Liability = 0.95 * (Hot money deposits and nondeposit able funds, and stable (core) funds, amounting to $25 million,
liquidity reserve funds-Legal reserves held) + 0.30 $24 million, and $100 million, respectively. The bank’s loans
* (Vulnerable deposit and nondeposit funds total $135 million currently, but recently have been as high as
1
60
- Legal reserves held) + 0.15 $140 million, and loans are projected to grow at a 10 percpercent
er ent
5
66
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* (Stable deposits and nondeposit funds annual rate. Thus, within the coming year, total loans might
ns migght rreach
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- Legal reserves held) (5.5) as high as $154 million, or $140 million + (0.10 * $140$140 m
$1 million),
65 ks
06 oo
which would be $19 million higher than they are n now. AApplying
82 B
In the case of loans, a lending institution must be ready at all the percentages of deposits that management mentt wish
wishes to hold
-9 ali
58 ak
times to make good loans—that is, to meet the legitimate credit in liquid reserves, we find this financial firm needs more than
m need
11 ah
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needs of those customers who satisfy the lender’s loan quality $60 million in total liquidity, consisting of both liquid assets and
o bo
standards. The financial firm in this example must have sufficient borrowing capacity.
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Liquidity Shortages in the Wake of the borrowed reserves from other institutions on September 10
September 11, 2001, Terrorist Attacks were unable to return the borrowed funds on the 11th. More-
over, many financial firms near Ground Zero were unable
The terrorist attacks of 9/11 in New York City assaulted the to communicate with their customers to explain what was
financial system as well as the twin towers of the World Trade happening. Nor could they update their records or make
Center. Financial firms with facilities for making payments deliveries of securities they had promised to their clients.
located in or near the World Trade Center experienced tem-
porary, intense shortages of funds due to their inability to Within hours, however, the system began to recover and
collect and record payments they were owed and to dispense was approaching near-normal operating levels by Septem-
payments they were obligated to make. The problems finan- ber 14. Why did recovery from such a serious liquidity crisis
cial institutions near Ground Zero in Lower Manhattan faced come about so quickly? The Federal Reserve—the proverbial
soon spread to outlying firms in domino fashion. Firms whose “lender of last resort”—stepped in aggressively. At 10:00 A.M.
electronic communications systems were destroyed or dam- on September 11, the Fed announced that loans from its
aged couldn’t make timely payment of their obligations to discount window would be available. At the same time, the
other institutions that, in turn, could not make good on their Fed temporarily suspended penalties against banks running
overdrafts and cranked up its open market operations to
1
One of the first signs of trouble was a sharp reduction in the more than $45 billion on September 12, while the Fed’ss ope open-
o en-
65 ks
movement of funds through Fed Wire—the Federal Reserve’s market trading desk accelerated its trading activity from a
06 oo
electronic funds transfer network—as firms hit hardest by relatively normal $3.5 billion a day to about $38 billion
illio
ion that
n tha
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same day. The Fed’s quick reaction along with the d determina-
dete
58 ak
tions because they could not be sure they themselves would tion of many financial managers to restore communications
ommmunic
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receive the incoming funds they expected. Several banks that links to their customers soon quelled this liquidity
idity crisis.
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98 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Of course, neither the worst nor the best possible outcome is (5.7)
(5.
(5.7
56
66
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likely for both deposit and loan growth. The most likely out- Estimated
1- nt
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based on the probabilities they assign to different possible Outcome B cit iin
deficit n
82
ernment deposits, the fewer securities are available to sell Table 5.4 indicates several recent trends among liquidity
dity indicators
in
ndica
ndicat
06 oo
82 B
when liquidity needs arise.1 for U.S.-insured banks. Many of these indicators displayed
splayed a decline
ispla
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58 ak
1
See Chapter 4 for a discussion of the nature and use of pledged
first loaned out money at a torrid pace, eroding
ng their liquid (“near-
securities. money”) assets. Then the great business recession
essio of 2007–2009
ession
20
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100 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Selected Liquidity Indicators 1985 1989 1993 1996 2001 2003 2007 2010*
Cash Position Indicator: Cash and 12.5% 10.6% 6.3% 7.3% 6.0% 4.6% 4.3% 7.7%
deposits due from depository
institutions , 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) , 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 , 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,
The Ultimate Standard for Assessing
1
Marketplace
20
About half the liquidity indicators discussed in this section focus the financial marketplace. No financial-serviceervice provider can tell for
se
on liquid assets or what is often called stored liquidity. Roughly sure if it has sufficient liquidity until it has passed
p the market’s test.
20
99
Experiencing the Ultimate Liquidity Crisis had to rely on “hot money” (i.e., negotiable CDs and nonde-
posit borrowings in the money market) rather than more stable
Few events in the management of a financial firm are as scary deposits for its funding. When money market investors heard
as a “bank run” in which flocks of customers either come in that Continental was experiencing trouble in its loan portfolio
to withdraw their money or transfer large amounts of funds the “hot money” suddenly left and the bank was forced to bor-
by wire to other, presumably “safer” institutions. And it’s not row from government agencies in order to survive.
just depositors who may take their money and run; borrow-
ers too may switch to other lenders when they are scared A similar combination of events greeted the British bank
their current lender may be losing its creditworthiness. Dur- Northern Rock PLC in 2007. Rumors the bank was on the
ing the Great Depression of the 1930s thousands of failures verge of serious trouble (in part stemming from its large
occurred, sometimes doing in not only those depository insti- mortgage loan portfolio) led to depositors lining up at the
tutions that were in real trouble, but also sound institutions bank’s branches, demanding their money, while others
which had the misfortune of being in the wrong place at the sought recovery of their funds through the bank’s website.
wrong time. The “run” is the ultimate liquidity crisis for man- Within hours losses approached $2 billion. As explained by
agement and stockholders of a financial firm. Milne and Wood [5], the Bank of England quickly stepped in
as a “lender of last resort” and several large banks expressed
Bank runs recorded in history go all the way back to the Roman interest in a possible takeover.
Empire. In modern times the failure of Continental Illinois
1
60
National Bank of Chicago in 1984 was one of the biggest, los- In short, liquidity crises—especially lack of available funds, ris-
5
66
98 er
ing $10 billion in deposits over a 60-day period. Ultimately the ing funding costs, and bad loans that reduce cash flow—can an
1- nt
20
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Federal Deposit Insurance Corporation (FDIC) put together a be lethal in sinking even the largest of financial institutions.
ns.
65 ks
rescue program that, for all intents and purposes, “national- Liquidity managers need to pay special attention to the
06 oo
ized” this huge money-center bank. Continental’s chief errors changing cost and composition of their institution’ss funding
fun
nding
82 B
-9 ali
were allowing excessively rapid growth in its business loans, and also to what is happening to quality and composition
mpo ositio in
58 ak
many of which turned out to be bad, and growing so fast it the asset portfolio.
11 ah
41 M
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102 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Management of a financial institution’s liquidity position can be week period stretching from a Tuesday through gh a Monday
Mon two
65 ks
06 oo
a harrowing job, requiring quick decisions that may have long- weeks later. This interval of time is known asas the
th
hee reserve
r
re com-
82 B
-9 ali
run consequences for profitability. Nowhere is this more evident putation period. The daily average amount ountt of vault cash each
mount
58 ak
11 ah
than in the job of money position manager. depository institution holds is also figured
ed over
gure ov the same
o
41 M
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99
Reserve Requirements
How much money must be held in legal
reserves? The answer depends on the
volume and mix of each institution’s
deposits and also on the particular time
period, because the amount of deposits
subject to legal reserve requirements
changes each year. For example, in the
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 2010 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 10 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 10 percent instead
of 3 percent is then adjusted by 80 percent of the calculated
annual deposit growth rate. This annual legal reserve adjust-
2 ment is designed to offset the impact of inflation, which over
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
1
each representing one quarter of the calendar year. These smaller U.S. tanc
centage of legal reserves, reflecting their great importanceancce
e as
65 ks
06 oo
depository institutions, then, must settle their reserve position at the funds managers for themselves and for hundreds off smaller
smmaller
aller
82 B
required level weekly based on a legal reserve requirement determined financial institutions. However, whether large orr small,
sma all, the
th total
-9 ali
once each quarter of the year. In contrast, the largest U.S. depositories
58 ak
must meet (settle) their legal reserve requirement over successive two-
41 M
week periods (biweekly). by the same method. Each reservable liabilityy item is multiplied
20
99
104 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
by the stipulated reserve requirement percentage to derive each A sample calculation of a U.S. bank’s total required legal
depository’s total legal reserve requirement. Thus: reserves is shown in Table 5.5.
Once a depository institution determines its required reserve
Total required = Reserve requirement on transaction deposits
amount it compares that figure to its actual daily average hold-
legal reserves * Daily average amount of net transaction
deposits over the computation period ings of legal reserves—vault cash and any deposits held directly
+ Reserve requirement on nontransaction or indirectly at the central bank. If total legal reserves held are
reservable liabilities * Daily average greater than required reserves, the depository institution has
amount of nontransaction reservable liabilities excess reserves. Normally management of the financial firm will
over the computation period.3 move quickly to invest any excess reserves to earn additional
(5.8)
income. However, during the global credit crisis of 2007–2009
3 excess reserves held by U.S. depository institutions repeatedly
Net transaction deposits include the sum total of all deposits on which a
depositor is permitted to make withdrawals by check, telephone, or other approached a trillion dollars, reflecting record extensions of
transferable instrument minus any cash items in the process of collection and credit to private banks by the U.S. central bank. Initially these
deposits held with other depository institutions. Nonpersonal (business) time credit extensions by the Federal Reserve appeared to have little
deposits and Eurocurrency liabilities also may, from time to time, be subject
to legal reserve requirements. Nonpersonal time deposits include savings impact on lending to rescue the economy. Eventually, however,
deposits, CDs, and other time accounts held by a customer who is not a with the Fed pushing toward lower interest rates economic con- n
1
rency liabilities are mainly the sum of net borrowings from foreign offices.
66
98 er
Note that only transaction deposits currently carry legal reserve require-
66 Ce
ments that act as a “tax” on financial institutions offering this type of exceeds the amount of legal reserves actually held d on
eld o a daily
65 k
06 oo
deposit. Financial institutions subject to this requirement try to minimize average basis, the depository institution has a reserve
eserv deficit.
re
82 B
the “tax burden” by selling customers nonreservable time deposits and Law and regulation normally require the institution
nstittutio to cover this
instit
-9 ali
portion of the tax burden imposed by reserve requirements. a penalty of up to 2 percent a year above
bo ve the
ove th Fed’s Discount
20
99
institutions at a Federal Reserve bank. However, the new law called for a
5
delay in paying interest on reserve balances until 2011 because the Fed
1- nt
20
paying out interest would reduce the earnings the U.S. Treasury receives
65 ks
each year from the Federal Reserve banks. Recently the Fed asked Con- Treasury into a tax and loan Federal Reserve bankbank for
fo
06 oo
gress if the effective date for the beginning of interest payments could
account held at the bank. a
agaainst the
checks drawn against
82 B
be moved up, arguing that it would help stabilize the volume of legal
-9 ali
reserves and the Federal funds rate—the Fed’s principal tool to carry out
11 ah
monetary policy. In October 2008 the Fed initiated interest payments on eral Reserve bank for checks • Withdrawal
awalal of large
l
41 M
bank reserves, reducing pressure on banks to invest any excess reserves previously sent for collection deposit acco
accounts, often
they might hold and holding more funds at the Fed. Excess reserve bal-
(deferred availability items). immediately
edia by wire.
20
106 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
(3 * $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 * $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 Exhibit 5.2 Movements in the Effective Federal
increased another $10 million, for a closing balance on Friday Funds Rate, Its Target (the Intended Federal Funds)
of $480 million. Once again, because Friday’s balance carried Rate, and the Discount (Primary Credit) Rate for
over for Saturday and Sunday, the money desk manager faced a Depository Institutions Seeking Credit from the Federal
cumulative reserve deficit of $410 million on Monday morning, Reserve Banks.
with only that day plus Tuesday and Wednesday to offset the Source: Reprinted with permission from the Federal Reserve Bank of
deficit before the reserve maintenance period ended. St. Louis Monetary Trends, March 2011, p. 3; https://s3.amazonaws.com/
files.research.stlouisfed.org/datatrends/pdfs/mt/20110301/mtpub.pdf.
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 most volatile day in terms of trying to anticipate which way and
avoid this penalty, the bank money manager swung into high by how much the funds rate will move is during bank settlement
gear, borrowing $250 million in Federal funds on Monday and day (usually a Wednesday), when many depository institutions
$100 million on Tuesday. Over two days this injected $350 mil- may find themselves short of required reserves with the door
lion in new reserves. With an additional borrowing of $70 million (i.e., the reserve maintenance period) about to slam shut on
in the Federal funds market on Wednesday, the last day of the them at day’s end!
reserve maintenance period (known as “bank settlement day”),
the bank in our example ended the period with a zero cumula- Other Options besides Fed Funds
tive reserve deficit.
While the Federal funds market is usually the most popular route
for solving immediate shortages of reserves, the money position
Use of the Federal Funds Market manager usually has a fairly wide range of options to draw upon
In the foregoing example, the money position manager had a from both the asset (stored liquidity) and liability (purchased
large reserve deficit to cover in a hurry. This manager elected to liquidity) sides of the balance sheet. These include selling liquid
borrow heavily in the Federal funds market—usually one of the securities the institution may already hold, drawing upon any
cheapest places to borrow reserves, but also frequently volatile. excess correspondent balances placed with other depository
institutions, entering into repurchase agreements for temporary
The effective interest rate on Federal funds changes minute by
borrowing, selling new time deposits to the largest customers,
minute so money position managers must stay abreast of both
and borrowing in the Eurocurrency market. The money position on
1
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Federal Reserve sets a target range for the Fed funds rate and
Bank Size and Borrowing and Lending
ing
g Reserves
Res
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its target. As Exhibit 5.2 indicates, the effective daily funds rate
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hovers close to the Fed’s target (intended) Fed funds rate range, Recent research on money position management
ana
agem suggests that
41 M
generally within a few basis points of that target range. The smaller depository institutions tend to
o have
hav frequent reserve
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on the other hand, are often covered with sales of longer- that are in danger of overdrafting their accounts to quickly
ckly
kly
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arrange for their funding needs before the door closesses orr
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institutions have access to all funds markets. For example, The liquidity manager must carefully weigh each of these
hese factors
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smaller depositories cannot, as a practical matter, draw in order to make a rational choice among alternative
ve sources
ernativ
rnativ
ive so of
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110 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
5.8 CENTRAL BANK RESERVE demand, and satisfy other emergency cash needs. Capable
liquidity managers are indispensable in the modern world.
REQUIREMENTS AROUND
THE GLOBE
SUMMARY
We should note that not all central banks impose legal reserve
requirements on the depository institutions they regulate. Managing the liquidity position for a financial institution can be
For example, the Bank of England has not established official one of the most challenging jobs in the financial sector. In this
reserve requirements for its banks and there is a trend among chapter we reviewed several fundamental principles of liquidity
central banks around the globe to eliminate, suspend, or at least management and looked at several of the liquidity manager’s
make less use of the reserve requirement tool, in part because best tools. Key points in the chapter include:
it is so difficult to control. A notable exception is the European • Liquidity needs are generally met either by selling assets (i.e.,
Central Bank (ECB), whose reserve requirements are often a converting stored liquidity into cash) or by borrowing in the
binding constraint on European banks, with the latter frequently money market (i.e., using purchased liquidity) or by a combi-
accessing the additional liquidity they need to meet these cash nation of these two approaches.
requirements by participating in the ECB’s weekly auction of
1
liquid funds.
5
Finally, it is important to recognize that even if central banks needs are likely to be. One of these estimation n methods
m
met hod is
ethod
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imposed no reserve requirements at all, the managers of deposi- the sources and uses of funds method in which ich total
hich ttota sources
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tory institutions would still have a demand for cash reserves. All and uses of funds are projected over a desired
desi ed planning
essire pl
p hori-
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depository institutions at one time or another need immediately zon and liquidity deficits and surpluses
es are
arre calculated
cal from
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available funds to handle customer withdrawals, meet new loan the difference between funds sourcesces and funds uses.
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KEY TERMS
liquidity, 88 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, 100 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
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112 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 $10 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 $10 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 $10 $5 $1,200
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.
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Assets:
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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 $200 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 1,100,000 853,000
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 $100 Deposits $4,000 of $44 million as of the close of business this Tuesday. The
Securities 1,000 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
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114 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
worksheet for this association’s money position over the Nonpersonal time deposits:
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next two weeks. Insert your planned adjustments in discount Less than 18 months 3%
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18 months or more 0%
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What is this bank’s daily average required level of legal Internet Exercises
reserves? How much must the bank hold on a daily average
basis with the Federal Reserve bank in its district? 1. Evaluate the cash assets, including legal reserves, held by
the Bank of America and Citigroup. How has their liquid-
13. Frost Street National Bank currently holds $750 million in
ity position changed recently? One website that provides
transaction deposits subject to reserve requirements but
this information for all the depository institutions in a bank
has managed to enter into sweep account arrangements
holding company (BHC) is www2.fdic.gov/sdi/. You are par-
with its transaction deposit customers affecting $150 mil-
ticularly interested in the items identified as “Cash and Due
lion of their deposits. Given the current legal reserve
from Depository Institutions.”
requirements applying to transaction deposits (as men-
tioned in this chapter), by how much would Frost Street’s 2. With reference to the BHCs mentioned in exercise 1, what
total legal reserves decrease as a result of these new sweep was their ratio of cash and due from depository institutions
account arrangements, which stipulate that transaction to total assets at last year’s year-end? Do you notice any
deposit balances covered by the sweep agreements will be significant trends in their liquidity position that you think
moved overnight into savings deposits? have also affected the banking industry as a whole? Exam-
ine the ratios for all FDIC-insured banks. This can also be
14. Bridgewater Savings Association maintains a clearing
accomplished at www2.fdic.gov/sdi/.
account at the Federal Reserve Bank and agrees to keep
a minimum balance of $30 million in its clearing account. 3. In describing reserve management, we referenced some
Over the two-week reserve maintenance period ending numbers that change eveiy year based on U.S. bank
today Sweetbriar managed to keep an average clear- deposit growth. The reservable liabilities exemption
ing account balance of $33 million. If the Federal funds determines which banks are exempt from legal reserve
interest rate has averaged 1.75 percent over this particu- requirements, and the low reserve tranche is used in calcu-
lar maintenance period, what maximum amount would lating reserve requirements. Go to www.federalreserve
Bridgewater have available in the form of Federal Reserve .gov/bankinforeg/reglisting.htm and explore information
credit to help offset any fees the Federal Reserve bank concerning Regulation D. Find and report the low reserve
might charge this association for using Federal Reserve tranche adjustment and the reservable liabilities exemption
services? adjustment that are being used this year.
tor approach, and (4) signals from the marketplace. In this bank’s information and the peer group information across ss
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assignment we will calculate and interpret several of the ratios years. In this part of the assignment, for Report Selection
ction
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associated with the liquidity indicators approach. By compar- you will access a number of different reports. We suggest
sug
gggest
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doing so, you will familiarize yourself with some new terms and
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data exploration that are best described as a financial analyst’s is denoted by**. All data are available inn SDI
S by b the name
“treasure hunt.” given next to the**. As you collect the e information,
info enter
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116 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 10 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.
01
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Selected References
The following studies discuss the instruments often used to For the latest developments in liquidity and reserve manage-
manage the liquidity positions of financial institutions and their ment see, for example:
customers:
6. Anderson, Richard G., and Charles S. Gascon. “The
1. Bartolini, Leonardo, Svenja Gudell, Spence Hilton, and Commercial Paper Market, the Fed, and the 2007–2009
Krista Schwarz. “Intraday Trading in the Overnight Federal Financial Crisis,” Review, Federal Reserve Bank of
Funds Market.” Current Issues in Economics and Finance, St. Louis, vol. 91, no. 6 (November/December 2009),
Federal Reserve Bank of New York, vol. 11, no. 11 (Novem- pp. 589–612.
ber 2005), pp. 1–7.
7. Judson, Ruth, and Elizabeth Klee. “Whither the Liquidity
2. Hilton, Spence, “Trends in Federal Funds Rate Volatility.” Effect: The Impact of Federal Reserve Open Market Opera-
Current Issues in Economics and Finance, Federal Reserve tions in Recent Years,” Finance and Economics Discussion
Bank of New York, vol. 11, no. 7 (July 2005), pp. 1–7. Series, Federal Reserve Board, Washington, D.C., 2009–25,
Z. 11.
For a review of the rules for meeting Federal Reserve deposit
reserve requirements, see the following: 8. Keister, Todd, and James J. McAndrews. “Why Are Banks
Holding So Many Excess Reserves?” Current Issues in Eco-
3. Hein, Scott E., and Jonathan D. Stewart. “Reserve Require-
nomics and Finance, Federal Reserve Bank of New York,
ments: A Modern Perspective.” Economic Review, Federal
vol. 15, no. 8 (December 2009), pp. 1–10.
Reserve Bank of Atlanta, Fourth Quarter 2002, pp. 41–52.
9. Lopez, Jose A. “What Is Liquidity Risk?” FRBSF Eco-
For an examination of market discipline as a force in the liquidity
nomic Letter, Federal Reserve Bank of San Francisco,
management of financial firms, see especially:
no. 2008–33, October 24, 2008, pp. 1–3.
4. Stackhouse, Julie L., and Mark D. Vaughan. “Navigating the
10. Mora, Nada. “Can Banks Provide Liquidity in a Financial
Brave New World of Bank Liquidity.” The Regional Econo-
Crisis?” Economic Review, Federal Reserve Bank of Kansas
mist, Federal Reserve Bank of St. Louis, July 2003, pp. 12–13.
City, vol. 95, no. 3 (Third Quarter 2010), pp. 31–68.
For an explanation of how regulatory agencies in Great Britain han-
dled the first significant bank run in modern times, see especially:
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118 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● Identify and explain the uses and sources of intraday ● Differentiate between methods for tracking intraday flows
liquidity. and monitoring risk levels.
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Excerpt is Chapter 4 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen
tephe Baird.
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119
Table 6.1 Relationship of U.S. Banks’ Average Peak Intraday Overdrafts to M1 Money Supply
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Peak Intraday Overdraft ($billions) 62.9 106.2 67.4 99.4 140.0 29.4 16.6
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Data Source: Federal Reserve Board of Governors website (www.federalreserve.gov), money supply data.
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120 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
3
CPSS. “Core Principles for Systemically Important Payme
Payment
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ayment S
Sy
Systems.”
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1 p
pdf.
January 2001. http://www.bis.org/cpmi/publ/d43.pdf.
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the Group of Ten Countries. February 1989. http://www.bis.org/cpmi/ CPSS. “Recommendations for Securities Settlement
tleme
emeent S
Sy
Systems.”
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publ/d02.pdf. /publ/
publ//d46.
November 2001. http://www.bis.org/cpmi/publ/d46.pdf.
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CPSS. “Principles for Financial Market Infrastructures.” April 2012. BCBS. “Monitoring Tools for Intraday Liquidity
uidity
idity Management.”
http://www.bis.org/cpmi/publ/d101a.pdf. s248.
April 2013. http://www.bis.org/publ/bcbs248.pdf.
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With all of this occurring, the funds management group of a assets, such as securities purchases for the investment
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large bank’s treasury has a difficult task in managing intraday portfolio, client loans, and fixed asset purchases, is another
other
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liquidity. A bank’s cash position is impacted by literally thou- common use of intraday liquidity.
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sands of transactions per hour, both client- and bank-related Fortunately for the bank treasurer, there are multiple le sources
ource of
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activity, much of it not known in advance by the treasury group. intraday funding available. Each source varies inn its contribution
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Additionally, most banks do not have all of their cash position- to overall funding from day-to-day, but each h is critical
crritica to the
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ing data in one system. They can monitor their central bank overall funding landscape. Table 6.3 lists the
e common
ccomm sources
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122 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
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
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Table 6.3 Sources of Intraday Credit
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
99 overnight deposit)
20
Other
41O the
M Term Funding Other term deposits, Yes, clients may be direct No, other Bank lines of Client supply of term funding tends
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124 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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01
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
Cash balances. The most obvious source of intraday liquidity
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 funds flow. Incoming flows from payments and 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
Intraday credit: Central banks serve as a large source of 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 assets. 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.
Overnight borrowings. Fed funds, London Interbank Offered
Rate (LIBOR), and Eurodollar deposits are examples of over-
6.3 RISK MANAGEMENT,
night borrowings that can provide quick, intraday liquidity MEASUREMENT AND MONITORING
for a bank. These types of borrowings are not repaid on the TOOLS FOR FINANCIAL 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
1
60
borrow overnight, the bank treasury must weigh the potential managing intraday liquidity risk at large banks.
5
66
98 er
1- nt
the risk of not being able to complete the current day’s busi-
65 ks
Other term funding. Similar to overnight borrowing, a ture that defines the roles and responsibilities
sibiilities of various bank
41 M
bank can tap into other funding sources (e.g., Federal employees and committees in overseeingeing risk-related activities.
20
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Active risk management. In many institutions, intraday Risk measurement and monitoring. There are two perspec-
liquidity risk is accepted as a cost of doing business and is tives from which leading institutions monitor their intraday
not as actively managed with the same level of rigor as other liquidity risk: (1) the amount of intraday credit the institution
types of enterprise risk or even other liquidity risks. The is extending to clients, and (2) the amount of intraday credit
leading banks with large volumes of PCS activities recognize the institution utilizes. For the first perspective, systemically
the criticality of understanding and working to reduce their important financial institutions (SIFIs) with large transaction
intraday liquidity risks. These institutions classify settlement banking and/or capital markets businesses have made sig-
and systemic risks as components of their risk taxonomy, nificant investments in recent years to upgrade their ability
and critically, incorporate them into the firm’s risk appetite to compile and monitor their clients’ real-time cash positions.
framework. This has historically been a significant challenge due to the
wide array of client activities that can impact cash accounts
Integration with risk governance. Oversight of intraday
and the batch-orientation of DDA and other feeder systems.
liquidity risk management is integrated into the bank’s overall
Banks with these capabilities are well positioned to pass on
risk oversight structure. This ensures that:
the intraday over-draft charges they receive from central
• The intraday liquidity risk management framework follows banks onto clients, if the industry moves in that direction.
the industry’s three lines of defense model, with particular
emphasis on expertise in the second line of defense to The second measurement perspective should provide a holistic
coordinate across the institution. and comprehensive view of all intraday credit used by an institu-
tion. This is more challenging for several reasons:
• Roles and responsibilities for all aspects of intraday liquid-
ity risk management in all lines of defense are clearly • Availability of data for its cash accounts. While many FMUs
defined. can provide useful statistics on intraday credit usage, not
all of them can provide real-time account position data,
• Treasury is the first line of defense, actively managing
especially in a way that can be captured and stored. Data
the intraday and end-of-day funding positions of the
on intraday credit usage from correspondent banks is also
bank as well as the risk management programs related
spotty.
to funding activities.
• Corporate Risk Management is the second line of • Data aggregation. Consolidating data into a single reposi-
defense, responsible for overseeing funding-related tory that enables comprehensive analysis and monitoring
policy and procedures: advising in the development poses significant institutional challenges. Few banks have
of risk management programs, monitoring the ongo- made the investments required in technology infrastructure
ing risk-taking activities across all of a bank’s funding to provide full, real-time position monitoring across all of
desks, aggregating reporting across the bank, and their PCS activities, in all markets, and in all of their lines of
providing an independent view of the effectiveness of business and subsidiaries.
the bank’s overall intraday liquidity risk management
programs.
Measurement of Intraday Liquidity
• Internal Audit is the third line of defense, responsible
for independently assessing the bank’s adherence to its This subsection describes commonly used measures that are
intraday risk policies and procedures. useful for understanding and tracking bank intraday liquidity
• Key decisions are made and reviewed by the appropriate risk. Many of these items were highlighted in the BCBS’
level of management. “Monitoring Tools for Intraday Liquidity Management.”6 The
1
• Oversight committees have the appropriate representa- first set of measures is helpful for understanding the profile of
5 60
lines of business).
65 ks
126 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
• Total payments sent and received for non-financial institution Total Intraday Credit Lines to Clients
clients and Counterparties
• Total payments sent and received for financial institution A bank risk manager looking after the bank’s own intraday
clients liquidity risk needs to understand the potential and actual
• Total payments sent and received for bank activity amounts of intraday credit the bank is extending to clients and
counterparties. In some cases, these intraday credit lines could
• Net position in the settlement account at any time of day in
be committed and disclosed to the client, but most are uncom-
aggregate
mitted and undisclosed. In addition to the credit lines, the bank
• Net position in the settlement account at any time of day, should have data regarding average and peak usage, and the
filtered by payment type ability to model activity at the client and portfolio levels.
• Trend in payments volumes over time, for correlation analysis
Total Bank Intraday Credit Lines Available
Other Cash Transactions and Usage
A bank should also track its intraday and end-of-day settlement As demonstrated through the requirements for preparing
positions at all financial market utilities in which it participates. resolution plans, regulators increasingly expect financial institu-
The bank should try to maximize the amount of transaction- tions to understand and manage the amount of systemic risk
level detail captured and stored for further analysis. Securities they pose to the overall financial system (in addition to the risk
settlements networks (SSN), particularly those utilizing a central posed to taxpayers and industry-funded insurance plans). A key
counterparty (CCP) model, often manage their intraday and component of that analysis is the amount of intraday credit that
overnight risk exposures through collateralization (discussed a bank relies on in business-as-usual conditions and the maxi-
in more detail in the next section). A bank participating in an mum amount of intraday borrowing it can draw down. This data
SSN should strive to capture snapshots of its account and col- captures the amount of committed and uncommitted intraday
lateral positions throughout the trading day. For example, the credit (and usage thereof) the bank has at its disposal, ideally
Federal Reserve uses one minute intervals for tracking collateral across all of its cash and settlement accounts.
positions.
1
Settlement Positions
66
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Risk Levels
1- nt
20
66 Ce
data on its settlement positions with all its FMUs. These criti- This is a measure of the bank’s usage of ann intraday
inttraday
raday credit
-9 ali
58 ak
cal, deadline specific payments, often with large transaction extension. While many cash accounts can facilitate
facilit
fa real-time
11 ah
41 M
amounts, are critical to managing intraday liquidity and systemic reporting, this calculation does not require
uire real-time
qu r monitoring
risk. A bank should monitor patterns in settlement positions and of an account (provided the bank hasas the ability to recreate all
20
99
client level enables risk managers to pinpoint clients that run fre- The process of stress testing of intraday liquidity risk manage-ge-
66
98 er
1- nt
20
quent overdrafts and determine if these clients need to change ment can yield multiple benefits for a bank. As is typical in
66 Ce
65 ks
their practices or if the bank needs to increase its charges for stress testing exercises, the benefits are not just the empirical
emp
empi
pirical
irica
06 oo
this credit extension. Monitoring these measures over time can results but, more importantly, the interactions and d discussions,
disc
d scussi
cuss
82 B
-9 ali
provide indicators of the success of any initiatives undertaken brainstorming, and other critical thinking that senioror manage-
senio ma
m
58 ak
11 ah
to modify client behavior in order to reduce reliance on intraday ment engages in when working through the e scenarios.
sceenario Bringing
41 M
credit. Finally, bank risk managers can use this data to inform together the right set of people with subjectctt matter
ma
mat expertise in
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128 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
While this approach allows FMUs to more easily apply credit risk
60
tional failures.
65 ks
7
BCBS. “Monitoring Tools for Intraday Liquidity Management.” April of tiering are: (1) the failure of a directt member
meembe affecting the
41 M
• A payment system may reduce a member’s net debit cap several tools to monitor and manage these intraday exposures ess
5
66
98 er
(which is essentially an intraday credit line), or require a par- and to assist their participants with their own intraday liquidity
uidity
idityy
1- nt
20
66 Ce
ticipant to pre-fund its account and not permit it to run intra- risk management.
65 ks
06 oo
day overdrafts.
B
eral, or post a letter of credit or performance bond from a Many FMUs utilize a net debit cap to limit their
heir risk
r exposure
e
-9
58
third party institution to backstop its credit risk. to a single participant. A net debit cap constrains
rains the size of a
trains
11
41
20
99
130 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Settlement Windows F
Some FMUs have established settlement deadlines in a way Financial Market Utility
that reduces intraday liquidity risk. Instead of having one An organization whose purpose is to process and settle
consolidated settlement position, typically at end of day, some payments and securities transactions; these entities are also
1
the day. This can be achieved by having individual settlement Transfer Networks (VTNs). This includes:
1- nt
20
66 Ce
times for specific asset classes or currencies. • Wholesale payments systems, such as wire transfer
ansfe
ansf
fer networks,
ne
65 k
06 oo
Contingent Liquidity
-9 ali
FMUs maintain backup credit lines from both commercial banks settling large numbers of transactions
ons such
s as automated
41 M
and central banks to be able to provide liquidity in a crisis clearinghouses and credit card networks
works
20
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ket at another correspondent bank to support payments and/or payment required to close on a financial transaction (e.g., a
5
66
98 er
132 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● 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.
1
605
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
Excerpt is Chapter 6 of Measuring and Managing Liquidity Risk, by Antonio Castagna and Francesco Fede.
e.
20
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133
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.
ō5LVNIUHH)L[HG5DWH%RQGV ō3D\RXWRIDRQHWRXFKRSWLRQ
&RXSRQV ZKHQEDUULHULVKLW fixed rate mortgages or loans. These cash flows
)L[HG ō&DSLWDO$PRUWLVDWLRQRI ō:LWKGUDZDOVE\WKH%DQN are produced by payments of periodic interests
5LVNIUHH)L[HG5DWH IURPFUHGLWOLQHVUHFHLYHG
0RUWJDJH (e.g., every six months) and periodic repayment
of the capital instalments if the asset is amortiz-
ō5HFRYHU\RI139RQFOLHQWłV
ing. It should be noted that not only bonds or
&UHGLW GHIDXOW loans held in the assets of the bank generate
5HODWHG ō0LVVLQJFDVKĠRZDIWHUFOLHQWłV
these kinds of cash flows, but also bonds issued
Amount
GHIDXOW
ō5LVNIUHH)ORDWLQJ5DWH%RQG ō3D\RXWRQDQ$PHULFDQ and loans received by the bank held in its liabili-
,QGH[HG &RXSRQV RSWLRQłVH[HUFLVH ties. Moreover, when considering assets, that
&RQWLQJHQW
Stochastic
ō3D\RXWRID(XURSHDQ2SWLRQłV
1
ō:LWKGUDZDOVIURPGHSRVLWV
1- nt
20
ō:LWKGUDZDOVRIFUHGLWOLQHVWR
66 Ce
%XVLQHVV ō5HQHZDORI([SLULQJ&RQWUDFWV ō1HZDVVHWV Deterministic amount cash flowss can also occur
11 ah
41 M
134 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
whose counterparty to the bank is default risk free. not directly entail a profit or a loss in financial terms, rather it is
560
66
98 er
bank, so that the time when the cash flows occur is stochastic Comparing these options with standard d options
opt
op usually traded
in this case. Missing cash flows with respect to the contract in financial markets, the major difference
rence is that the latter are
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99
On the other hand, a liquidity option is exercised because of In the end, although liquidity options can be triggered by fac-
the cash flows produced after exercise, even if it is sometimes tors other than financial convenience, the effect on the bank can
not convenient to exercise it from a financial perspective. For be considered twofold:
example, consider the liquidity option that a bank sells to a cus-
1. A liquidity impact on the balance sheet, given by the
tomer when the bank opens a committed credit line: the obligor
amount withdrawn or repaid.
has the right to withdraw whatever amount up to the notional of
the line whenever she wants under specified market conditions, 2. A (positive or negative) financial, impact, given by the dif-
typically a floating rate (say, 3-month Libor) plus a spread, that ference between the contract’s interest rates and credit
for the moment we consider determined only by the obligor’s spread and the market level of the same variables at the
default risk. The option to withdraw can be exercised when it time the liquidity option is exercised, applied on the with-
also makes sense under a financial perspective; for example, drawn or repaid amount.
if the spread widened due to worsening of the obligor’s credit
Sometimes the second impact is quite small, as, for example,
standing: in this case funds can be received under the contract’s
when a client closes a savings account: the bank’s financial loss
conditions (which are kept fixed until expiry) and hence there
is given in this case by the missing margin between the con-
is a clear saving of costs in terms of fewer paid interests on the
tract deposit rate and the rate it earns on the reinvestment of
line’s usage rather than opening a new line. On the other hand,
received amounts (usually considered risk-free assets), or by the
the line can be used even if the credit spread shrinks, so that
cost to replace the deposit with a new one that yields a higher
it would be cheaper for the obligor to get new funds in the
rate. The liquidity impact, on the other hand, can be quite sub-
market with a new loan, but for reasons other than financial con-
stantial if the deposit has a big notional.
venience it chooses to withdraw the needed amounts from the
credit line. While the financial effects of liquidity options can be directly,
although partially, hedged by a mixture of standard and statisti-
Another example of a liquidity option is given by sight and sav-
cal techniques, the liquidity impact can only be managed by
ing deposits: the bank’s clients can typically withdraw all or part
the tools that we analyse in the following. These tools, loosely
of the deposited amount with no or short notice. The withdrawal
speaking, involve either cash reserves or a constrained allocation
might be due to the possibility to invest in assets with higher
of the assets in liquid assets or easy access to credit lines (i.e.,
yields more than compensating for higher risks, or it might be
a long position in liquidity options for the bank). All of these
1
this case there may exist some financial rationale behind exercis-
ing contracts to deal with clients, so that models to price long g
1- nt
20
66 Ce
on a statistical basis.
or losses when exercised, so that they can also be seen een under
se u
-9 ali
58 ak
Exercising a liquidity option can also work the other way round: some respects as financial options, models must jointly
jjoint consider
11 ah
41 M
the bank’s client has the right to repay the funds before the liquidity and financial aspects.
20
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136 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
such but deemed to have little impact Figure 7.2 CDS Itraxx Financial rolling series from September
ember
emb
b 2004
2 to
-9 a
58 ak
quite simple to understand if one looks Source: Market quotes from major brokers.
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99
and it is a rarer risk for a bank since business activity usu- Assume we are at the reference time t0: we define by CF(t0, tj)
ally hinges on assets with longer durations than liabilities. the cumulative amount of all cash flows starting from date ta up
These (opportunity) costs also refer to the cost dimension of to time tb:
liquidity risk. b
CF(t0, ta, tb) = a (cfe+(t0, ti) + cfe-(t0, ti)) (7.3)
i=a
7.4 QUANTITATIVE LIQUIDITY Expected cash flows and cumulated cash flows allow us to con-
RISK MEASURES struct the basic tools for liquidity monitoring and management:
the term structure of expected cash flows.
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
7.4.1 The Term Structure of Expected
ensure that it stays solvent. Cash flows, however, classified accord- Cash Flows and the Term Structure
ing to the taxonomy above are produced by two classes of of Expected Cumulated Cash Flows
1
60
factors.
5
Definition 7.4.1 (Causes of liquidity). All factors referring to defined as the collection, ordered by date, of positive and
an
ndd
65 ks
existing and forecast future contracts originated by the ordinary expected cash flows, up to expiry referring to the contract
act with
ontrac
ntrac wi
w
06 oo
82 B
business activity of a financial institution can be considered as the longest maturity, say tb:
-9 ali
TSECCF(t0, tb) = {cfe+(t0, t0), cfe-(t0, t0), cfe+(t0, t1), ccfe-((tt0, t1), c ,
11 ah
(7.4)
The other class of factors is given by Definition 7.4.2.
20
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138 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
TSECCF(t0, tb) = {CF(t0, t0, t1), CF(t0, t0, t2), c , CF(t0, t0, tb)} 710 20
(7.5) 100 100
The TSECCF is useful because banks are interested not only in
monitoring the net balance of cash flows on a given date, but and loans; they are financed with deposits, bonds and equity.
also how the past dynamic evolution of net cash flows affects its Assume that the assets bear no default risk and no liquidity
total cash position on that date. If on a given date the balance options are embedded within deposits. The first step to build
of inflows and outflows is net negative, this position can be net- the TSECF is to order the assets and the liabilities according to
ted out with a positive cash position originated by past inflows. their maturity, disregarding which kind of contract they are. This
Obviously the reverse can also be true and the bank can use a is shown in Table 7.1.
net positive inflow on a given date to cover a short cash posi-
When assets expire positive cash flows are received by the bank,
tion deriving from past outflows, although in this case it should
whereas when liabilities expire negative cash flows must be paid
be noted that short cash positions must be financed in any case,
by the bank. The amount of the cash flows is simply the notional
typically with new liabilities (see below), so that positive inflows
of each contract in the assets and liabilities and, under the
are used to pay back these debts.
assumptions we are working with, these amounts are determin-
Conceptually, building the TSECF and TSECCF is quite simple istic both under a time and amount perspective. Collecting them
and can be shown with an example. 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
80
Positive cash-flows
60 Negative cash-flows
Assets Liabilities
Cumulated cash-flows
40
Bonds
30 Bonds
40 20
0
1 2 3 4 5 6 7 8 9 10 >10
–20
1
Deposits
60
40
5
Loans
66
98 er
1- nt
–40
20
70
66 Ce
65 ks
06 oo
Equity –60
82 B
20
-9 ali
58 ak
–80
11 ah
41 M
Figure 7.3 Balance sheet of a bank with types of Figure 7.4 Term structure of expected
xpect
xp
pect cash flows for
assets and liabilities and their quantities. class
the simplified balance sheet reclassified in Table 7.1.
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99
The TSECF, and hence the TSECCF, do not include the flows
2 0 4.95 - 10 - 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
1
is positive at all times. This means that positive cash flows are
66
98 er
- 70 - 3.15 - 3.20
1- nt
7 0 1.95
20
66 Ce
8 0 1.69 0 0 -1.51 by usual business activity. Although this is the ideal situation
ation it
situat
ituat
06 oo
82 B
10 30 1.69 0 0 31.87
41 M
140 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
distribution of flows. As a result the TSECCF contains only Balance sheet shrinkage is operated by selling assets, starting
expected values as well: if it is positive on average most of from more liquid ones such as Treasury bonds, corporate bonds
the time, the distribution of cumulated cash flows at a given and stocks: they are traded in the market actively and can be
time can also actually envisage negative outcomes with an sold within a relatively short period. Reduction may also include
assigned probability. the sale of less liquid assets, such as loans or even buildings
owned by the bank, within a more extended time horizon.
1
and the liabilities could produce periods of negative cumu- Repo transactions can also be considered separatelyy from
m the
98 er
1- nt
20
66 Ce
lated cash flows. These periods may be accepted if they other cases and labelled as “balance sheet neutral”.
al”.
65 ks
The bank may prefer to consider only liquidityy that at can be gener-
tha
82 B
introduce below.
ated without relying on external factors, suchuch as clients or other
a clie
-9 ali
58 ak
When the TSECCF shows negative values, on an expected basis, institutional counterparties. It is easy to recognize
cogniz that LGC
o reco
11 ah
41 M
this means that the bank may become insolvent and eventually related to balance sheet expansion is dependent
de
epen on these exter-
go bankrupt. This is why the treasurer’s main task is to ensure that nal factors, whereas balance sheet reduction,
educt
duc or “balance sheet
20
99
• Security-unlinked liquidity including Remark 7.4.1. The quantities entering in the TSLGC and hence
the TSCLGC are expected values, since they all depend on
– unsecured borrowing from new clients through new
stochastic variables such as the price of assets and the haircut
deposits;
applied to repo transactions. Moreover, the stochasticity of the
– withdrawals of credit lines received from other financial
amount of unsecured funding that it is possible to raise in the
institutions;
market could and should be considered.
– unsecured bond issuance;
The sources of liquidity contributing to the TSLGC belong either
It is immediate clear that security-linked liquidity is little more to the banking or the trading book. In the banking book the
than BSL liquidity, or the liquidity obtained by balance sheet sources of liquidity are all the bonds available for sale1 (AFS) and
reduction. other assets that can be sold and/or repoed relatively easily:
To sum up, we can identify three types of sources of liquidity they are referred to collectively as eligible assets. In all cases
that can be included in the classifications above: these assets are unencumbered; that is, they are not already
pledged to other forms of secured funding such as the ones we
1. Selling of assets, AS.
present just below. To determine at a given date ti the liquidity
2. Secured funding using assets as collateral and via repo that can be generated by these sources, one needs:
transactions, RP.
• AFS bonds: the expected future value of each bond, consid-
3. Unsecured funding via withdrawals of committed credit ering the volatility of interest rates and credit spreads, and
lines available from other financial institutions and via of the probability of default. Moreover, the possibility that
deposit transactions in the interbank market, USF. the bonds may become more illiquid, thus increasing bid–ask
The first two sources generate security-linked BSL by reduc- spreads and lowering the selling price, has to be considered
ing the balance sheet or keeping it constant. The third source in the analysis.
generates security-unlinked non-BSL by expanding the balance • For other assets the selling period and the expected selling
sheet. It is worth stressing that the unsecured funding of point price have to be properly taken into account.
1
60
repoed; that is, the bank can sell them via a repo transaction
ction
tion
66 Ce
existing liabilities or the issuance of new debt to finance busi- and buy them back at expiry of the contract. The repopoo can
can be
65 ks
06 oo
1
58 ak
operations involved in LGC refer to shorter term exceptional The term “available for sale” in our context is not relat
related
ed to the same
11 ah
unsecured funding, in most cases unrelated to a bank’s bond that can be sold because they are unencumbered,, as ex explained in the
issuance and other forms of fundraising. following.
20
99
142 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
tions, usually up to one-year expiry, are part of the banking book BSL is the result of setting assets or carrying out repo transac-
tra ac ac--
5
66
98 er
for accounting reasons. Also here, the possibility to resort to this tions, since both operations have different consequences
ence
ences
ess in
1- nt
20
66 Ce
2
58 ak
3
more general economic environment. For example, it used to be quite At the end of the loan or repo, cash flowss ge
generated
enerat by the bond are
41 M
easy to pledge ABSs as collateral before 2007, but after the subprime usually given back to the borrower by the counte
ounte
counterparty, although the
crisis in the US banks were no longer willing to accept them as collateral. erent solutions.
contract may sometimes provide for different
20
99
4
66 Ce
This was generally true until an annex was incorporated in the e stan
sta
standard
andard
dard
the obligation that it is to be returned to the counteparty has
65 ks
GMRA (the master agreement signed by banks for all repo-like -like
ke ttransa
trans
transac-
to be honoured by the bank. The payments by the asset dur-
06 oo
ing the repo agreement belong to the counterparty, so that the following point) are treated very similarly to a repo o agr reeme
eeme so
agreement,
-9 ali
58 ak
the contract and not on each payment date as in the repo case. In this
41 M
the cash flow paid by the bank at the start and the cash flow case the effects on the different term structures aree sim
similar to those we
received at the end as contract, but only once. The TSAA of /sellb
/sellba
have shown for repo (and reverse repo for buy/sellback) transactions.
20
99
144 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Table 7.4 Types of Contracts Involving Assets and Effects on the TSECF/TSECCF, TSAA and TSLGC
Changes to
0 Buy 99.85 15
0.01 Settlement - 985,000 - 985,000 1,000,000 99.85 15
0.25 1,000,000 99.85 15
0.5 Coupon 50,000 -935,000 1,000,000 99.85 15
0.75 1,000,000 99.90 15
1 Coupon 50,000 -885,000 1,000,000 99.90 15
1.25 1,000,000 99.90 15
1.5 Coupon 50,000 -835,000 1,000,000 99.95 15
1.75 1,000,000 99.95 15
2 Coupon + 1,050,000 215,000 — 100.00 15
Reimbursement
In Table 7.5 we show what happens to the term structures. Assume now the bank decides to sell a quantity of the
The bond pays a semiannual coupon of 10% p.a. and it expires bond equal to a notional of 500,000 after 9 months (or
in 2 years. 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 TSECF records an outflow equal to the notional amount of
the amount times the price, including the accrued interests
the bond times the price (we assume the bank buys the bond
(500,000 * (99.90>100 + 10% * 0.25) = 512,000 as well.
upon a coupon payment, so that the dirty price and the clean
The TSECF and the TSECCF are modified so as to show the
price are the same) occurring on the settlement date, 3 days after
reduced amounts of interest and capital received on the sched-
the reference time 0 (or 0.01 years). The TSAA records an increase
uled dates. The TSAA records a cut in the available amount
of the quantity available to the bank of the bond until its expiry,
for 500,000 until expiry of the bond, when it drops to zero.
when it is reset to zero. The TSLGC is unaffected. The last two
Table 7.6 shows the results.
columns show the price and the haircut. They are expected values
and for the moment we consider them as given, although they Let us now analyse the effects of repo and reverse repo trans-
can be the output of some model or just assumptions of the bank. actions on term structures. Assume the bank repoes the bond
0 Buy 99.85 15
0.01 Settlement - 985,000 - 985,000 1,000,000 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
60
5
-910,000
66
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Coupon + - 360,000
41 M
146 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
0 Buy 99.85 15
0.01 Settlement - 985,000 -985,000 1,000,000 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 1,000,000 — 99.90 15
1 Coupon 50,000 -904,101 1,000,000 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 — 100.00 15
Reimbursement
after 3 months (0.25 years) for a notional amount equal to which should be considered fully as a contract cash flow, thus enter-
500,000 and a period of 6 months. Given the price and the ing the TSECF; the bond is returned to the counterparty and conse-
haircut of the bond, and keeping accrued interest in mind, the quently the TSAA is set back to 1,000,000 as shown in Table 7.7.
amount of cash received by the bank is:
When the bank operates buy/sellback (or sell/buyback) operations,
(500,000 * (99.85% + 10% * 0.25) * (1 - 15%) = 424,469 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
In Table 7.7 the TSCLGC indicates an increase of liquidity,
at the forward price. At the start of the contract the bank pays:
whereas the TSAA indicates that the available quantity of the
bond dropped to 500,000. 400,000 * (99.85% + 10% * 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 * (1 + 9% * 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
400,000 * (99.90% + 10% * 0.25) = 409,600
reverse repo on this bond for a notional of 500,000. The price it
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 * (99.90% + 10% * 0.25) * (1 - 15%) = -424,681
in Table 7.8.
This amount enters the TSECF and alters the TSECCF as a con-
1
60
0 Buy 99.85 15
0.01 Settlement - 985,000 - 985,000 1,000,000 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 1,000,000 99.90 15
1 Coupon 50,000 -864,800 1,000,000 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 1,000,000 - 314,726 99.95 15
2 Coupon + 1,050,000 220,200 — 100.00 15
Reimbursement
terminating after 6 months (1.75 years). The price received by We now show what happens to the different term structures when
the bank is: 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
300,000 * (99.90% + 10% * 0.25) = 307,200
3 months for a period of 6 months. The TSECF does not record any
which is included in the TSCLGC since the operation can be seen cash flow at the inception of the contract, whereas the TSAA shows
as a way to extract BSL from the available assets; the TSAA indi- a reduction of the available quantity of 500,000. After 6 months
cates a reduction of the available quantity down to 700,000. At the bond is returned to the bank (the TSAA increase) and the bank
the end of the contract the bank buys the bond back and pays: receives a fee for the lending, which we assume equal to 3% p.a.:
300,000 * (99.95% + 10% * 0.25) = 314,726 500,000 * (3% * 0.5) = 7,500
which is included in the TSCLGC. The TSAA increases back to The coupon paid during the lifetime of the contract are pos-
1,000,000. The coupon paid during the life of the contract is sessed by the legal owner (i.e., the bank). This can be observed
proportional to the available quantity of 700,000. in Table 7.9.
0 Buy 99.85 15
0.01 Settlement - 985,000 - 985,000 1,000,000 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 1,000,000 99.90 15
1
60
5
-877,500
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Coupon +
41 M
148 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
where we have included the term TSECCF(t0, t0): although it First, we start with the TSECF and the TSECCF of Table 7.3 of
may seem strange, it is simply the cash existing at the initial time Example 7.4.1: the TSECCF is negative between the 7th and 8th
in the balance sheet, so that: 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)
TSECCF(t0, t0) = Cash(t0)
liquidity. In fact, in Table 7.10 the TSAA includes an amount for the
The TSLe is in practice a measure to check whether the financial bond equal to 30 until the 6th year, then in the 7th year an amount
institution is able to cover negative cumulated cash flows at any of 4 is sold at the (expected) price of 99.00, so as to generate a
time in the future, calculated at the reference date t0. liquidity of 3.96, which is included in the TSCLGC thereafter.
Table 7.10 The Term Structure of Expected Liquidity and Its Building Blocks
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
100.00
41 M
OF LIQUIDITY AT RISK Note that the distribution of cash flows ranges from the small-
1
60
Section 7.1 discussed a taxonomy of cash flows according to the possibly but not necessarily, positive ones. Given a confidence ence
1- nt
20
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time and amount of their occurrence, most cash flows are sto- level of a, on the right-hand side of the distribution all cash cassh
h flows
flow
65 ks
duced the term structure of expected cash flows, cumulated 1 - a, are neglected. In the same way, on the left-hand
eft-ha
ft-haand side
s of
-9 ali
58 ak
cash flows and expected liquidity generation capacity: they flow the distribution all cash flows smaller than cf1- - a((tt0, ti; x), whose
11 ah
41 M
into the term structure of expected liquidity which represents total probability of occurrence is still 1 - a, aree not taken into
the main monitoring tool of a Treasury Department. account.
20
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150 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
1M 3M 6M 1Y 1M 3M 6M 1Y Fixed Rate
Date Amount Amount Amount Amount Strike Strike Strike Strike Amount
1 - 1,000,000
2
3 —
4 2,000,000 -500,000
5
6 1,500,000 -5,000,000 2,500,000 2,000,000 - 250,000
7 100,000 200,000 -500,000 1,000
8 1,500,000 -5,000,000 3,000,000 - 1,000,000
9 2,500,000 -5,000,000 2,500,000 2,000,000
10 2,000,000 3,000,000 2,500,000 500,000 25,000
11
12 1,500,000 -5,000,000 2,500,000 2,000,000
13
14 2,000,000 3,000,000 2,500,000 500,000 25,000
- flo as the
TSCF1-a , since they will rapidly diverge upward or downward
5
66
98 er
6
58 ak
capacity jointly computed at some confidence level a. We will For those interested in the details of the simulation,
mulattion,
ion, w
we used the fol-
11 ah
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 TSCF1 - 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 Amount Indexed to Different Libor Fixings and Fixed Cash Flows, for Cash Flows 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 Strike Strike Amount
1 -1,000,000
2
3
4 2,000,000 -500,000 —
5
6 1,500,000 -5,000,000 2,500,000 2,000,000 - 250,000
7 100,000 200,000 -500,000 1,000
8 1,500,000 -5,000,000 3,000,000 -1,000,000
-5,000,000
01
11
65 ks
06 oo
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11 ah
152 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
D
5
j=1
66 Ce
where {d1, d2, c , dD} are all the contracts andjor securi- the liquidity buffer (i.e., the fraction of LGC
C that
att relates
rela
06 oo
82 B
ties generating cash flows at date tm, included in the TSCF to BSL);
-9 ali
58 ak
and the TSLGC, under scenario n. • compute specific measure for one or more
moore securities,
s such
11 ah
41 M
3. At each step m ∈ {1, c , M}, the maximum and mini- as haircuts and adjustments due to a lack of liquidity in their
mum cash flows, at a confidence level of a and 1 - a, dealing in the market;
20
99
1
60
5
66
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1- nt
20
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65 ks
06 oo
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-9 ali
58 ak
11 ah
41 M
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154 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● 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.
1
60
5
66
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65 ks
06 oo
82 B
-9
58
11
Excerpt is Volume 24, Number 1, Winter 2010, pp. 51 to 72 of Journal of Economic Perspectives, by Darrell
rell Duffie.
Du
D
41
20
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155
losses that they have suffered through investments arranged by transactions given the exposure of the clearing bank to Alpha’s ha
as
5
66
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Alpha. Alpha’s managers understand their bank’s vulnerability overall position. Unable to execute trades or to send cash h to
1- nt
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to the flight of its creditors, clients, and counterparties. As the meet its obligations, Alpha declares bankruptcy.
65 ks
06 oo
cracks in Alpha’s finances become more apparent, those who Alpha Bank is a fictional composite, standing for any ny of
o a
82 B
-9 ali
deal with Alpha nevertheless begin to draw back. relatively small group of financial institutions that
hat are
are significant
a sig
si
58 ak
11 ah
In particular, Alpha has been operating a significant prime bro- dealers in securities and over-the-counter derivatives.
ative These
eriva
41 M
kerage business, offering hedge funds and other major investors firms typify relatively large global financial groups
roup that, in
group
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156 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
This article will first review the main lines of business of large Deutsche Bank AG
dealer banks, including: (1) securities dealing, underwriting, Dresdner Kleinwort
and trading; (2) over-the-counter derivatives; and (3) prime Goldman, Sachs & Co.
brokerage and asset management. I will include a brief
HSBC Group
discussion of sources of financing, including off-balance-sheet
structures and short-term secured credit through repurchase JPMorgan
agreements. I then examine the key failure mechanisms of Chase Morgan Stanley
dealer banks. As in the story of Alpha Bank, these include
The Royal Bank of Scotland
the flight of prime-brokerage clients, the sudden disappear-
ance of short-term secured creditors, the defensive reactions Group Société Générale
of derivatives counterparties, and, finally, the loss of cash and UBS AG
securities settlement privileges at a clearing bank.
Wachovia Bank N.A., A Wells Fargo Company
In the concluding section, I consider potential policy Source: New York Federal Reserve Bank.
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 to consider alternatives to government and central-bank last-
Bliss and Kaufman (2006). Since the financial crisis, however, all resort financial support. Among the additional mechanisms that
large dealer banks now operate as regulated banks or within might be used to address large dealer-bank failure processes are
regulated bank holding companies. During the financial crisis, the central clearing of over-the-counter derivatives; dedicated
dealer banks drew support from traditional and new sources “utilities” for clearing tri-party repurchase agreements under
of government and central-bank financing. Concerns remain strict standards; and automatic recapitalization mechanisms,
over the systemic risk that some of these financial institutions such as mandatory rights offerings of equity or forms of debt
could pose to the economy in the future. Although access to that convert to equity contingent on distress triggers.
government support mitigates the systemic risk associated
with catastrophic failures, it also creates a perverse incentive.
The common knowledge that large financial institutions will 8.1 WHAT LARGE DEALER BANKS DO
receive support when they are sufficiently distressed—in order
to limit disruptions to the economy—provides an incentive to I will tend to simplify by treating large dealer banks as members
large financial institutions to take inefficient risks, and for their of a distinct class, although in practice they vary in many
creditors to cooperate by financing them at a lower cost than respects. I focus here on their most significant lines of business.
would be available without the implicit backstop of government These include intermediation of the markets for securities,
1
support. As the financial crisis has made clear, it is important securities lending, repurchase agreements, and derivatives;
605
prime brokerage for hedge funds; and asset management menntt for
66
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1- nt
20
1
The primary dealers that are not part of financial groups represented conduct proprietary trading—that is, speculation on on
n their
the own
th
06 oo
are Cantor Fitzgerald (an inter-dealer broker), Daiwa Securities America accounts. As a part of their asset-management men
ennt businesses,
b
busin some
82 B
-9 ali
Inc., and Mizuho Securities USA Inc. The dealers that are not also dealer banks operate “internal hedge funds”unds” ” and private equity
58 ak
Scotland Group, Société Générale, and Wachovia Bank (now owned by partnerships, of which the bank acts effectively
effecctivel as a general
41 M
2
The relevant research, for example Boot, Milbourn, and Thakor (1999),
66
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nvesto
investor to another. For example, a call option gives an investor tor
1- nt
20
does not find a strong case for the net benefits of forming large diversi-
66 Ce
fied financial conglomerates of this type. There may exist economies of the right to buy an asset in the future at a prearranged d price,
prric
ice,
65 ks
shielding the investor from the risk that the cost of acquiring
acquuiring the
82 B
3
For a case example of lapses in risk oversight, see UBS (2008) “Share-
41 M
holder Report on UBS’s Writedowns,” especially Chapter 5: “Risk ated privately, they can easily be customized d to
t a client’s needs.
Management and Risk Control Activities.” For most over-the-counter derivatives trades,es, one
des, o of the two
20
99
158 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
the amount of exposure to default presented by the failure of back credit default swap positions with each. In this fashion,
shio
h n,
5
66
98 er
counterparties to perform their contractual obligations. These dealer-to-dealer credit default swap positions grew rapidly.
rapid
idly.
1- nt
20
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exposures can be reduced through collateral. For example, Based on data provided by the Depository Trustt and an
ndd Clearing
Clea
65 ks
suppose a hedge who has posted $60 million in collateral Corporation (DTCC) in April 2009, of the current rent aggregate
a
aggr
06 oo
B
with a dealer defaults, leaving the dealer with a portfolio of notional of about $28 trillion in credit default
ault swaps
sswap whose
82
derivatives that would have been worth $100 million had the terms are collected by DTCC’s DerivServ erv Trade
Trrade Information
-9
58
hedge fund not failed. This leaves the dealer with a net loss of Warehouse, over $23 trillion were in the e form of dealer-to-dealer
he
11
credit default swap market stood at over $60 trillion, the total Off-Balance-Sheet Financing
amount of credit default swaps outstanding has been reduced
by over one half through “compression trades,” by which redun- Some large dealer banks have made extensive use of “off-
dant or nearly redundant positions among dealers are effectively balance-sheet” financing. For example, a bank can originate
canceled. 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-
Prime Brokerage and Asset Management pose entity” pays its sponsoring bank for the assets with the
proceeds of debt that it issues to third-party investors. The
Several large dealers are extremely active “prime brokers” to
principal and interest payments of the debt issued by the spe-
hedge funds and other large investors. A prime broker provides
cial purpose entity are paid from the cash flows that it hopes to
clients a range of services, including management of securities
receive from the assets that it has purchased from the sponsor-
holdings, clearing, cash-management services, securities lend-
ing bank.
ing, financing, and reporting (which may include risk measure-
ment, tax accounting, and various other accounting services). Because the debt obligations of a special purpose entity are
A dealer may frequently serve as a major derivatives counter- usually contractually remote from the sponsoring bank, under
party to its prime-brokerage clients. A dealer often generates certain conditions banks have not been required to treat the
additional revenues by lending securities that are placed with assets and debt obligations of such entities as their own, at least
it by prime-brokerage clients. As of the end of 2007, according for purposes of accounting and of regulatory minimum capital
to data from Lipper, the majority of prime brokerage services requirements. In this sense, a special purpose entity is “off bal-
were provided by just three firms: Morgan Stanley, Goldman ance sheet.” Some large dealer banks used special purpose
Sachs, and Bear Stearns, whose prime brokerage business entities to operate much larger loan purchase and origination
was absorbed by JPMorgan when it acquired Bear Stearns in businesses with a given amount of capital than would have been
mid-2008 (Hintz, Montgomery, and Curotto, 2009). possible had they held the associated assets on their own bal-
1
client securities, cash management, brokerage, and alternative A particular form of special purpose off-balance-sheet eet entity
e
82 B
investment vehicles, such as hedge funds and private-equity that was popular until the financial crisis is the “structured
“struc
struccture
-9 ali
58 ak
partnerships that are often managed by the same bank. Such investment vehicle,” which finances residential ial mortgages
tial m
mortg
11 ah
41 M
an “internal hedge fund” may offer contractual terms similar to and other loans with short-term debt sold to o investors
inves such as
those of external stand-alone hedge funds and in addition can money-market funds. In 2007 and 2008, when home h prices fell
20
99
160 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
sales. For the same reason, fire sales by one large bank could ld
60
or regulation.
65 ks
06 oo
82 B
4
In the United States, money market funds, typically
pically ope
pically operating under
-9 ali
Large dealer banks tend to finance their assets in various ways, ollater
llater that they could
to immediately sell many of the forms of collateral
including by issuing bonds and commercial paper. Increasingly party ffails to perform.
receive in the event that a repo counterparty
20
99
prime broker’s own assets and are thus available to the prime
me
5
66
98 er
5
Ewerhart and Tapking (2008) and Hordahl and King (2008) review the
1- nt
20
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behavior of repo markets during the financial crisis. Gorton (April, 2009)
65 ks
6
before and during the financial crisis. In July 2007, corporate bonds and These facilities include the Single-Tranche OMO Program, m, tth
the
he Te
Term
B
structured credit products of many types, both investment grade and Discount Window Program, the Term Auction Facility, tran sition credit
transitional
82
noninvestment grade, had haircuts of 2 percent or less. From the second extensions announced on September 21, 2008, the e Prim
mary
ary D
Primary Dealer
-9
quarter of 2008, many classes of these securities had haircuts in excess ty, th
Credit Facility, the Term Securities Lending Facility, he Co
the Commercial
58
of 20 percent, while a number of classes of securities are shown by Gor- Paper Funding Facility, and the Term Asset-Backed d Sec
Securities Loan
11
41
162 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
7
The text of the SEC rules is available on-line at various places, such as
58
8
the “Securities Lawyer’s Deskbook,” published by the University of Cin- Shortfalls are covered, up to limits, by the Secu
Securities Investor
11
41
Based on analysis by Singh (2009), the exposures of over-the- market value of the portfolio (which is aboutt halfway
alfw between
ha
alfwa
41 M
counter derivatives counterparties to Citibank, after netting and the bid value and the offer value).
20
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164 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
10
60
9
Yavorsky (2008b) describes how many firms involved with Lehman— electronic transfer of federal funds from one bank’s account with the
66
98 er
1- nt
20
hedge funds, buy-side firms, and other dealers—tried in September Federal Reserve to another’s. As far as the interest earned d on its
ts fe
federal
66 Ce
2008 to negotiate offsetting replacement trades that would reduce their funds and its reserve requirements, what matters to a clea ring b
clearing bank on a
65 ks
exposure to Lehman. These trades would only take place if Lehman given day is its federal funds balances as of 6:30 p.m.m. Eaaster The Fed
astern
Eastern.
06 oo
B
declared bankruptcy. Unfortunately, “the close-out session resulted in charges banks a fee of 36 basis points for daylightht ove
ov
overdra of fed-
overdrafts
the replacement of only a relatively limited amount of all the outstand- eral funds. Clearing banks, in turn, may assesss a simmilar fee to dealer’s,
similar
82
ing trades.” The practical problems involved the large number of partici- edera
although the clearing bank’s overdraft in federalal fund
funds would typically
-9
58
pants, the large number of outstanding positions, and the difficulties of be smaller than the sum of the overdrafts of iits cli
client dealers, given
11
agreeing on prices at a time of significant volatility in the market. positive and negative dealer balances can n be nnetted.
41
20
99
Perhaps the most important source of systemic risk is the poten- A further set of proposals addresses the pre-failure resolution of
tial impact of dealer-bank fire sales on market prices and inves- dealer banks that are suffering grievous financial distress. Dealer
tor portfolios. In the recent financial crisis, the risk of fire sales banks could be given regulatory incentives or requirements to
was significantly mitigated by lender-of-last-resort financing issue forms of debt that, contingent on stipulated distress trig-
by central banks (Tucker, 2009), and by capital injections into gers, convert to equity (Flannery, 2005; Squam Lake Working
dealer banks, such as those of the Bank of England and the U.S. Group on Financial Regulation, 2009). Duffie (2009) proposes
Treasury Department’s Troubled Asset Relief Program (TARP). that distress-contingent convertible debt be complemented
Some of these facilities are likely to be costly to taxpayers and with regulations favoring mandatory rights offerings of equity
to increase moral hazard in the risk taking of large dealer banks that, similarly, are automatically triggered by leverage or liquid-
going forward, absent other measures. ity thresholds. These two new instruments can be designed
to recapitalize a financial institution before a destructive run is
Another set of policy steps considers the problems of short-term
likely to commence, and to reduce a financial institution’s incen-
tri-party repos, which are a particularly unstable source of financ-
tives for socially excessive risk taking.
ing in the face of concerns over a dealer’s solvency. Because tri-
party clearing banks have an incentive to limit their exposures to The financial crisis has made clear the need to reconsider the
a dealer bank, they are likely to limit the access of a weakened systemic risks posed by the failure of dealer banks and has pro-
dealer bank to repo financing and to clearing account functions. vided new insights into the mechanics by which they fail. The
Bernanke (2008; see also 2009) has pointed to the potential task of building new institutional mechanisms to address these
benefits of a tri-party repo “utility,” which would have less failure mechanics is timely and urgent.
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 I am grateful for impetus from Andrei Shleifer and Jeremy
of tri-party repo transactions. Yet another approach under dis- Stein, for research assistance from Ross Darwin, Vojislav
cussion is an “emergency bank,” to be financed by repo market Sesum, and Zhipeng Zhang, and for helpful conversations
participants, that could manage the orderly unwinds of repo with Joseph Abate, Tobias Adrian, James Aitken, John Berry,
positions of weakened dealers. The emergency bank would have Robert Bliss, Lucinda Brickler, Jeremy Bulow, John Coates,
access to discount-window financing from the central bank and Bill Dudley, David Fanger, Alessio Farhadi, Peter Fisher,
would insulate systemically critical clearing banks from losses in John Goggins, Jacob Goldfield, Jason Granet, Ken Griffin,
1
the course of the unwinding process. Robert E. Hall, Brad Hintz, Henry Hu, Anil Kashyap, Matt
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cker,
ker,
Till Schuermann, Hyun Shin, Jeremy Stein, Paul Tucker,
06 oo
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Tatjana Zidulina. I also thank David Autor, Chad Jones
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pp. 22–29.
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October 6.
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.gov.uk/pubs/policy/ps09_16.pdf.
11 ah
195–214.
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Flannery, Mark J. 2005. “No Pain, No Gain? Effecting Market Lehman Bankruptcy Docket. 2008a. “Notice of Debtors’ Motion
Discipline via Reverse Convertible Debentures.” Chapter 6 in for an Order Pursuant to Sections 105 and 365 of the Bank-
Capital Adequacy beyond Basel: Banking, Securities, and Insur- ruptcy Code to Establish Procedures for the Settlement or
ance, ed. Hal S. Scott. Oxford: Oxford University Press. Assumption and Assignment of Prepetition Derivative Contracts
Fed Seeks End to Wall Street Lock on OTC Derivatives.” Techni-
Geithner, Timothy. 2008. “Remarks at the Economic Club of
cal Report, Docket Number 1498, November 13.
New York,” New York City, June 9.
Lehman Bankruptcy Docket. 2008b. “Order Pursuant to
Global Association of Central Counterparties. 2009. “Central
Sections 105 and 365 of the Bankruptcy Code to Establish
Counterparty Default Management and the Collapse of Lehman
Procedures for the Settlement or Assumption and Assignment
Brothers.” Technical Report, CCP12, The Global Association of
of Prepetition Derivative Contracts.” Docket Number 2257,
Central Counterparties.
December 16.
Goldman Sachs. 2007. “Goldman Sachs and Various Investors
Leising, Matthew. 2009. “Fed Seeks End to Wall Street Lock on
Including C.V. Starr & Co., Inc., Perry Capital LLC and Eli Broad
OTC Derivatives.” Bloomberg.com, May 6.
Invest $3 Billion in Global Equity Opportunities Fund.” Technical
Report, Goldman Sachs Press Release, August 13. Mackintosh, James. 2008a. “Lehman Collapse Puts Prime Broker
Model in Question.” Financial Times, September 24.
Goldstein, Steve. 2007. “HSBC to Provide $35 billion in Funding
to SIVs—Citigroup Reportedly under Pressure to Move Securi- Mackintosh, James. 2008b. “Flight from Morgan Stanley Broker-
ties onto Its Balance Sheet.” MarketWatch, November 27. age.” Financial Times, September 25.
Gorton, Gary. 2009. “Slapped in the Face by the Invisible Hand: Moyer, Liz. 2007. “Citigroup Goes It Alone To Rescue SIVs.”
Banking and the Panic of 2007+.” April, 2009. (May 9 version: Forbes.com, December 13.
http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf.)
Securities and Exchange Commission. 2004. “Rule 15c3-3:
Forthcoming in Slapped by the Invisible Hand, by Gary Gorton.
Reserve Requirements for Margin Related to Security Futures
Oxford University Press.
Products.” Technical Report, 17 CFR Parts 200 and 240 [Release
Hills, Bob, David Rule, Sarah Parkinson, and Chris Young. 1999. No. 34-50295; File No. S7-34-02] RIN 3235-AI61. August 31.
“Central Counterparty Clearing Houses and Financial Stability.”
Singh, Manmohan. 2009. “Counterparty Risk Post-Lehman Rela-
Bank of England Financial Stability Review, June, pp. 122–134.
tive to pre Bear Sterns.” May.
Hintz, Brad, Luke Montgomery, and Vincent Curotto. 2009.
Singh, Manmohan, and James Aitken. 2009. “Deleveraging after
“U.S. Securities Industry: Prime Brokerage, A Rapidly Evolving
Lehman—Evidence from Reduced Rehypothecation.” IMF Work-
Industry.” Technical Report, Bernstein Research, March 13.
ing Paper 09/42, International Monetary Fund.
Hordahl, Peter, and Michael R. King. 2008. “Developments
Sorkin, Andrew Ross. 2009. Too Big To Fail: The Inside Story of
in Repo Markets During the Financial Turmoil.” BIS Quarterly
How Wall Street and Washington Fought to Save the Financial
Review, December, pp. 37–52.
System—and Themselves. Viking.
International Swaps and Derivatives Association. 2004. “User’s
Squam Lake Working Group on Financial Regulation. 2009. “An
Guide to the 2004 ISDA Novation Definitions.” Technical Report,
Expedited Resolution Mechanism for Distressed Financial Firms:
ISDA Technical Document, New York.
Regulatory Hybrid Securities.” Working Paper, Council on For-
International Swaps and Derivatives Association. 2009. “ISDA eign Relations, April.
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Kelly, Kate. 2008. “Fear, Rumors Touched Off Fatal Run on Bear Making, and Capital.” Technical Report, Speech
eecch Delivered
De
D to
Stearns.” Technical Report, WSJ.com, May 28. the “Bank of Japan 2009 International Conference
nferen
fere on Financial
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Liquidity Stress
Testing
9
Stephen Baird
■ 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.
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Excerpt is Chapter 3 of Liquidity Risk Management: A Practitioner’s Perspective, by Shyam Venkat and Stephen
ephe Baird.
41
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172 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
The objective of the liquidity stress test is to measure the Strategic liquidity represents the cash that is held by the
amount of liquidity the institution must maintain in order to institution to meet future business needs that may arise
ensure continuing ability to meet financial obligations under outside the course of normal operations, but it is not pri-
stressed conditions. In order to construct an effective liquidity marily aimed at supporting the bank during times of stress.
stress testing framework, it is important to clearly define what For example, strategic liquidity may be held to fund future
is meant by “liquidity” for liquidity stress testing purposes. acquisitions or capital expenditure programs. Strategic
Within this context, liquidity refers to funding liquidity risk— liquidity may be redirected to meet contingent liquidity
the risk that the institution will not have adequate capacity to requirement needs. As a pragmatic matter, this will likely be e
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fund its obligations without incurring unacceptable economic feasible only if such liquidity is present via holdings of
o highly
ighly
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liquid assets.
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due to difficulty converting assets into cash—while not the This liquidity taxonomy is illustrated in Figure 9.1.
.1.
1.
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9.2 OVERVIEW OF THE MODEL result from the need to prematurely settle non-contractual
maturity obligations as well as the inability to refund con-
If the objective of the liquidity stress test is to measure the tractual maturity obligations that under normal circum-
amount of required contingent liquidity, then the institution stances could be rolled over. The institution’s framework
must construct a cash flow model that accurately and precisely should clearly define the types of outflows to be modeled,
measures the following components: which typically fall into the categories of retail deposit
outflows, unsecured wholesale funding outflows, secured
Liquid asset buffer. The liquid asset buffer represents the
funding runoff, derivative transaction funding, loss of fund-
contingent liquidity that is currently in place. The liquidity
ing on asset-backed issuances, and drawdown of credit and
stress test framework must clearly define the market and
liquidity facilities.
operational characteristics that securities must meet in order
to qualify for inclusion in the liquid asset buffer. In general, Stressed inflows. Stressed inflows are assumed to partially
requirements should ensure that the liquidity-generating offset the stressed outflows. Inflows may include secured
capacity of securities included in the liquid asset buffer funding transaction maturities, loan repayments from cus-
remains intact even in periods of severe idiosyncratic and tomers, and drawdowns on liquidity facilities available to the
market stress. The fundamental characteristics of liquid asset institution. Depending on the assumptions used in a particu-
buffer securities should include low credit and market risk, lar stress scenario, the level of inflows may be reduced or
ease and certainty of valuation, trading in an active and siz- limited by market conditions.
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able market, and low concentration of buyers and sellers. The Stressed liquid asset buffer. The liquid asset buffer, nett of
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liquid asset buffer should also meet operational requirements stress outflows and stress inflows, indicates the adequacy
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that ensure the liquidity is under the control of the central of the current liquid asset buffer given the stress scenario
scena
cena
ario
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Stressed outflows. Stressed outflows are those assumed The components of the liquidity stress test model
odell are depicted
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174 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
9.3 DESIGN OF THE MODEL Combinations of legal entities and operating units having both
of these characteristics will provide the building blocks of the
The liquidity stress testing model forms an integral component enterprise-level liquidity stress test:
of an end-to-end process that begins with risk identification and Liquidity transfer restrictions. Liquidity may be trapped in
event analysis in order to ensure that the roster of scenarios certain legal entities, potentially creating a distorted view
appropriately captures material liquidity risks (Figure 9.3). 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
Organizational Scope should assess the impact of such restrictions on enterprise-
level liquidity, considering not only a normal operating
The consolidated stress test should be the lynchpin of any
environment but stressed conditions as well. Bank holding
liquidity risk framework. However, an institution may determine
companies, for example, should assume little or no access
there is a need to conduct stress testing on subsidiary entities
to banking subsidiary cash during a crisis due to capital ade-
within the organization. The organizational levels at which a
quacy requirements.
bank may stress liquidity include the parent, subsidiary legal
entities, lines of business, service business units, and shared ser- The existence of liquidity transfer restrictions does not nec-
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vice centers. Each of these cases may be addressed through a essarily give rise to the need for an additional stress test t
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separate liquidity stress test, where necessary. For less material where it can be demonstrated that a subsidiary would ouldd not
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entities or those entities where risk is assessed to be manage- be required to upstream cash to the parent. For orr example,
exxamp an
65 ks
able, less complex entity-level liquidity risk reporting might institution may stress the consolidated entity ity and
annd the
th holding
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be sufficient. As a general rule, the institution should consider company but choose not to test individual ual banking
b
banki subsidiar-
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the organizational level at which (a) liquidity is commingled, ies under the assumption that movementmentt of cash
c from the
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and (b) liquidity oversight has management accountability. parent to the subsidiary would be unrestricted.
unrrestri
estr
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Currency. While the liquidity stress test should be performed a recovery or resolution process taking place is unrealistic.
in the currency of the entity being tested (the home country One circumstance in which the bank may choose to forecast
for the consolidated test), careful consideration should be beyond twelve months is the case where a survival horizon is
taken for the liquidity impact of currency conversion require- calculated under the stress test. For banks with ample liquid-
ments. For example, less established offshore subsidiaries or ity, the survival horizon may extend well beyond this period;
branches sometimes carry a significant currency mismatch, some banks have a survival horizon that may extend as far out
and the settlement time frame for the home country parent as two years, although the extent of the modeled stress will
to swap fund an unanticipated outflow may prove problem- abate beyond the extreme level of severity assumed in the
atic in a crisis. very short term.
Regulatory jurisdiction. For institutions operating in mul- The frequency of cash flow measurement within the overall time
tiple foreign jurisdictions under various regulatory oversight horizon must also be determined. The decision to estimate
regimes, the need to conduct individual stress tests for daily, weekly, or monthly cash flows should balance the benefits
foreign subsidiaries or groups may arise. For example, U.S. of improved precision against the reduced forecasting accu-
regulations require certain foreign banking organizations to racy beyond a certain time frame. Stress models that forecast
conduct liquidity stress tests for intermediate holding compa- daily over a short time frame (e.g., one month) and transition
nies and branches in order to address concerns that foreign to weekly or monthly cash flows for the remaining time horizon
banks operating in the country would otherwise be over- are likely to provide the best balance. The need to forecast daily
reliant on offshore funding. 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
Planning Horizon crisis, the most critical period of stress for the institution may in
The objective of the liquidity stress test is to ensure that fact occur during those first few days.
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 9.4 TESTING TECHNIQUES
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income statement budgeting performed as part of the Historical statistical techniques, such as cash h flow
flow at risk
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58 ak
strategic planning process. Moreover, the likelihood of the (CFaR), model a historical pro forma cash flow w based
base on the
bas
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bank continuing operations indefinitely under stress without observed cash flow volatility of the institution.
uti
tion.
on.
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176 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
impacts.
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tunately for this very reason, there is little data upon which to Distinguish between levels of severity. Assuming g graduat-
umiing
uminng gra
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build reliable, predictive models that can accurately estimate ing levels of severity, for example, by developing
eloping adverse
elopi a
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the minimum level of liquidity an institution can expect to and severely adverse variations of the idiosyncratic
idios yncra scenario,
diossyncra
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58 ak
maintain within a confidence interval. Even in the recent finan- enables the institution to broaden its
ts view
ew of liquidity risk and
vie
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impacts. Doing so will ensure the bank is considering sys- liquidity risk.
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In addition to assumption-based hypothetical scenarios, the ences, bearing in mind any limitations in
n ongoing
o
ongo data
bank may also perform a reverse liquidity stress test. The availability.
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178 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
3. Qualitatively assess and order by rank varying levels of non-agency mortgage-backed securities. The model should
liquidity risk for each segmentation factor, potentially utiliz- also include expected haircut differences between secured
ing a scoring system. financing channels used by the institution, for example,
Federal Home Loan Bank funding, and repo facilities.
4. Develop quantitative modeling assumptions based on any
historical data available, such as experiences during the Developing a scoring system that orders by rank the relative
financial crisis, or available from other sources such as peer liquidity along these various segmentation dimensions can be
benchmarking. a useful framework for this purpose. The institution can then
assign specific haircuts to each type of security and funding
5. Develop matrices of relative modeling assumptions based
channel based on the assessed liquidity risk. The starting
on scored risk levels and baseline historical data.
point for developing liquidity haircuts is a review of current
6. Adjust assumption matrices as appropriate for each stress market conditions (assuming such conditions are normal),
scenario, for example, reflecting differences in relative and comparing these advance rates to what the bank expe-
overall severity or assumptions concerning idiosyncratic or rienced during the financial crisis. If the bank does not have
systemic risk. such data available, it will need to be obtained through peer
The following assumptions can have an outsized impact on the comparisons where possible.
results of the stress test, and should be considered carefully in Deposit outflows. Deposit runoff is, for most institutions, the
developing the model: most significant threat to liquidity and the most important
behavioral dynamic to model. For the typical, heavily deposit- itt
Investment portfolio haircuts. The ability to obtain liquid-
1
on securities as was observed during the crisis. The model Unfortunately, there is a scarcity of historical
orical data
torica da to rely
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58 ak
should include varying haircut assumptions for each security upon in developing deposit runoff assumptions.
assum mptio While
11 ah
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type where liquidity characteristics differ, for example, dif- the runs that occurred during the crisis,
rissis, particularly
p those
ferentiating between agency mortgage-backed securities and at WaMu and Northern Rock, provideovide useful reference
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points, the institution should build a set of detailed deposit a historical period. A more detailed approach would be to
runoff assumptions based on a behavioral segmentation model each position independently.
framework that captures differences in stressed deposit
Other contingent liabilities. The model should address each
behavior.
material source of contingent liquidity outflow, including
Table 9.2 summarizes behavioral differences typically drawdowns of customer credit lines, liquidity facilities, letters
observed in deposit portfolios. The institution should care- of credit, trade financing arrangements, securitization facility
fully analyze the historical behavior of its deposit portfolio— runoff, and other contractual arrangements. Where possible,
preferably at the account rather than portfolio level—to the institution should review the behavior of such contingent
develop an appropriate internal segmentation framework. liabilities during the financial crisis. If historical data is not
Empirical analysis is unlikely to yield a perfect experiment available, conservative assumptions are appropriate.
indicative of behavior during a hypothetical crisis. However,
Non-contractual commitments must also be incorporated
such an analysis is suggestive of customer “stickiness” and
into the model. Particularly for lower stress scenarios, the
provides a more rigorous foundation than high-level, qualita-
institution will still seek to maintain reputational strength and
tive assumptions.
avoid damage to business franchise value. Achieving these
Unsecured wholesale funding. Availability of unsecured objectives may require voluntary financing transactions such
wholesale funding is generally assumed to be heavily as completion of underwriting pipeline deals and repurchase
reduced in a stress scenario, particularly under idiosyncratic of securities issued in order to protect counterparties from
stress. The bank should review each funding channel to dif- mark-to-market losses. Quantitative assumptions for these
ferentiate by key liquidity factors, most significantly overnight requirements can be developed using the projected level of
versus term funding. There is likely to be little historical data activity as appropriate.
available assuming the institution has not experienced a
Business dial back. The liquidity stress test should incorporate
significant stress event. Banks typically apply highly conserva-
a set of realistic assumptions concerning the institution’s abil-
tive assumptions when reflecting on the drastic impact that a
ity to reduce liquidity-draining business activities such as new
stress event is likely to have on wholesale funding availability,
loan origination. These assumptions should be developed
particularly term funding.
through discussions with business unit management, who will
Collateral requirements. Collateral requirements should have a view into the level of reduced funding activity that can
be expected to increase during a stress scenario as a result occur without causing significant reputational problems.
of both valuation impacts on existing collateral as well as
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derivative positions. How the institution develops assump- 9.8 OUTPUTS OF THE MODEL
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ation impacts, which should align to unsecured wholesale The outcome of liquidity stress testing, along with the other o
B
funding models) will depend on the level of detail required. components of the institution’s liquidity risk measurement
asure
emen
82
The institution may choose to review its historical collateral framework, provide the foundation for assessing sing tactical
ssing tacti and
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call levels, particularly during times of stress, and select the structural liquidity relative to internally established
bliished
blisshed limits and
11
most significant liquidity requirement experienced during regulatory expectations. In particular, the liquidity
liquid stress test
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180 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Prospective liquidity position metrics. In addition to measur- • Ensuring the establishment, review, and approval of a
ing the current liquidity position, the bank should measure liquidity stress testing policy. The liquidity stress testing
the prospective liquidity profile of the bank over the stress policy should detail the scenarios to be run, key assump-
horizon. Key indicators of liquidity risk include prospective tions, roles and responsibilities, reporting requirements,
available liquidity, ratios indicative of wholesale funding and limits. The specific structure of liquidity stress testing
dependence (e.g., net non-core funding dependence), and documentation may be tailored to the policy structure
metrics indicative of potential overconcentration in specific of the bank. Many institutions include this policy as an
funding channels (e.g., percentage of funding from brokered appendix or supporting standard to the overall liquidity
deposits). When monitoring prospective liquidity, it is impor- risk management policy or as a component of the con-
tant to highlight any specific stress points along the horizon tingency funding plan. The liquidity stress testing policy
1
where survival would require potentially problematic debt issu- should be renewed at least annually.
560
The institution may choose to establish limits for prospective including major changes to liquidity scenarios
oss and/or
rios a
and/o
65 ks
Capital and performance metrics. In addition to capturing test outcomes and escalating exceptions.
cepttions For certain
xcept
11 ah
41 M
the liquidity impact of the stress test, it is also important to limit tiers, escalation may be required
qu ired to the board of
uired
measure the balance sheet more holistically. For example, directors.
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tory rules and guidance ing example represented by the Basel III LCR, maximizing g
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• Reviewing and approving the liquidity stress test-based the size of the Level 2A portfolio (e.g., by investing in agency
agen ncy
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• Monitoring of liquidity stress test-based limits reduce overall return on assets relative to investing
ing slightly
sslight
82 B
and board are kept well-informed of the bank’s liquidity Conversely, maximizing the liquidity profile
file of
o the portfolio
41 M
risk profile as indicated by the stress testing results at the expense of yield may be equally inefficient.
neffici
effic Armed
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182 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
rtfo
tfo o
the economic capital impact of various liquidity portfolio
5
allocations.
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support it. In order to support efficient and controlled ongo- Liquidity dashboard. Key risk indicators and d performance
per
erform
rform
06 oo
ing stress testing and reporting, the institution should maintain drivers should be tracked on a predefinededd basis
basis and
basis a dis-
82 B
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an information technology infrastructure that performs auto- tributed to risk managers. Liquidity stress
tresss test results may
58 ak
11 ah
mated data collection, aggregation, capturing of market data, be included in an existing risk dashboard
hboaard or
o circulated
41 M
report generation, and analytics. The challenge for many large, separately.
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Second, the capital stress testing framework should include a wholesale operational deposit (to borrow
oww a Basel
Base III LCR
B
11 ah
41 M
a liquidity stress evaluation to assess the impact of any assumption), the cost of carrying this buffer
err should
fe
fer sho be passed
required liquidity impacts on capital adequacy. In conjunction through within the FTP framework.
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184 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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Liquidity Risk
Reporting and
10
Stress Testing
■ 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.
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• the aggregate customer assets and hence, the LTD ratio; subsidiaries) may aggregate the report.
560
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• a forecast of the position for the month-end for each month We provide an example of a daily liquidity report for a com-
com
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to the end of the year. mercial bank at Figure 10.3. This uses inputs from the
e bank’s
b
baank’s
nk’s
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188 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 +/-
Forecast
eca
99 Monthly 38,486 -3,394 50 2,972 -22,889 -4,829 -15,293
loan +/-
20
411 M
omer
Total Customer
15 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: 8- ka
98 li B
Loan-to-deposit %20 oo 95. 94.93 96.17 90.08 88.39 86.08 86.59 85.94 85.78 84.24 82.56 81.59 80.26
k
66 95.74
56 s C
61 en
-9 te
82 r
06
65
60
189
1
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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
99
20
41 M
11 ah
58 ak
-9 ali
82 B
06 oo
65 ks
66 Ce
1- nt
98 er
20
66
560
1
Customer deposits Customer loans LD ratio
3,000 100.00
2,500 95.00
2,000 90.00
1,500 85.00
1,000 80.00
500 75.00
0 70.00
31/12/08
31/1/09
28/2/09
31/3/09
30/4/09
28/5/09
30/6/09
31/7/09
30/8/09
30/9/09
31/10/09
30/11/09
31/12/09
Month-end actuals Forecasts
Figure 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
250 1000
Corporate banking EUR MM
150 600
100 400
50 200
0 0
Current Rolling Up to 1
3 months 6 months 12 months 12 months
1
1 month
60
Corporate banking 78.89 51.94 55.78 25.32 61.08 7.27 0.17 0.00
65 ks
06 oo
Retail banking 112.98 1036.85 0.59 7.49 28.73 69.35 9.65 2.1
14
4
2.14
41 M
1200.00
Corporate banking EUR MM 500.00
1000.00
800.00
300.00
600.00
200.00
400.00
100.00
200.00
0.00 0.00
Up to 1
week 1 month 3 months 6 months 12 months 12 months +
risk factor calculation. The “counterbalancing capacity” in the bank in this example has a survival horizon of only seven
Table 10.2B is the sum of available securities to cover for sud- days under normal circumstances; when the cash flow value
den cash outflows. of liquid securities and other adjustments is included, we see
that the survival period is extended to 27 days. This is still
This spreadsheet is available on the Wiley website supplemen-
below the Basel III requirement, and so on the strength of
tary material accompanying this book.
this report the bank will need to take action to address the
liquidity shortage.
Funding Maturity Gap (“Mismatch”) The full report spreadsheets, with breakdown by product type
Report and incorporating cell formulae, are available on the Wiley
The funding gap report shows the maturity gap (also known website.
as the maturity mismatch) per time bucket, for all assets and
liabilities, with an adjustment for liquid securities. It includes
Funding Concentration Report
1
60
mismatch in graphical form. The key indicates the cash flow for
06 oo
The same report is used to generate the cash flow survival source, or sector, of funds. This includes reliance
liancce on
elianc o intra-
11 ah
41 M
horizon report. This is shown at Figure 10.5. We observe that group funds.
20
99
192 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
00s
Input data
Classification
Marketable Securities CDs
Table 10.4 is an example of a Large Depositor Concentration stress points for a bank’s funding requirement. In a stress situa-
Report for a banking group. In this case “large” is defined as tion a bank can expect un-utilised liquidity and funding lines to
someone that deposits USD 50 million or more; however, a bank be drawn down, as customers experience funding difficulties of
may define it in percentage of total liability terms rather than their own. The existence of undrawn commitments can exacer-
absolute amounts. Generally speaking, a deposit of 5% of total bate funding shortages at exactly the wrong time, which is why
liabilities should be treated as large by ALCO. liquidity metrics include such undrawn commitments. It is also a
reason to report them separately.
In the illustration shown, the largest depositor (“CBS”) exceeds
the internal single-source concentration limit of 10% by a consid- Figure 10.6A is an example of an undrawn commitments report,
erable margin. Assuming that this is a close customer relation- showing trend over time, while Figure 10.6B shows the trend
1
60
ship, the bank will need to increase its liabilities base to bring for both drawn and undrawn committed facilities. These e are
e
5
66
98 er
the share down to limit, or otherwise risk damaging the relation- deta
ailed
aggregate-level reports, the bank will also produce detailed
1- nt
20
66 Ce
ship by asking the depositor to remove some of the funds. breakdowns per customer.
65 ks
06 oo
82 B
-9 ali
Off-balance sheet products such as liquidity lines, revolving This is a simple breakdown of the share
re
e of each
e type of liability
credit facilities, letters of credit and guarantees are potential at the bank. An example is shown att Figure
Figu 10.7. In this case,
20
99
ASSETS 000s 1 Day 2 Days 1 Week 2 Weeks 1 Month 2 Months 3 Months 6 Months *1 Year +1 Year Total
Non-marketable 0
Securities & CDs
Retail time deposit 432 3,533 0 4 4 4,529 9 1,619 420 23,749 34,299
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
Input Data
Liabilities 000s 1 Day 2 Days 1 Week 2 Weeks 1 Month 2 Months 3 Months 6 Months *1 Year +1 Year Total
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
99 Corporate call 60,085 0 0 0 0 0 0 0 0 0 60,085
20
por
Co M
41Corporate time 17,937 94,226 173,805 152,144 94,976 111,413 47,748 18,394 11,475 0 722,118
11 ah
Gove nme
Government
58 k a 3,689 6,005 58,163 109,046 37,671 204,339 54,477 31,341 5,902 1,122 511,755
-9 ali
Liab
Total Liabilities
B
82 ilittie 573,430 371,544 839,386 580,960 438,160 675,900 495,979 342,694 92,512 3,115 4,413,680
194 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
06 oo
comm
Undrawn commitments
ks
65 mitm 273,242
66 Ce
Average remainingning
1 - nt 7.72 Months
duration of liabilities
98 er
ies2
06
656
01
Table 10.2B Cumulative 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
196
Table 10.3 Extract from Maturity Gap Report
Data as of 2 June 2010. All figures in EUR thousands unless otherwise noted.
Liquidity Management – Maturity Mismatch
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
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%
Figure 10.4 Graphical representation, maturity gap report.
1,500,000,000
1,000,000,000
500,000,000
(500,000,000)
(1,000,000,000)
(1,500,000,000)
(2,000,000,000)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 ays ays ays ays ear
(2,500,000,000) d d d d y
0 0 0 5 1
0 –6 0–9 –18 –36 ver
3 6 90 80 O
1
Inflows Outflows Cumulative cash flow Adjusted cumulative cash flow
Figure 10.5 Cash flow survival horizon. 1
605
66
98 er
1- nt
20
66 Ce
the total liabilities of the bank are made up of the following • Repo (high-quality securities);
65 ks
06 oo
Country Total Large Deposits ’000s % of External Country Funding % of External Group Funding
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 plc more than $50m.
Bank plc A B C D E F G
198 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Monetary
tary
06 oo
65 ks
Agency 266 Ce
1- nt
Banque Maghreb eb
9 8 er
20 145,000 4.6% 0.4%
66
560
1
Table 10.4 Continued
Large Depositors as a Percentage of Country and Total Funding
Bank plc A B C D E F G
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;
• Group;
• Net derivatives margin;
Figure 10.6A Undrawn commitment report, subsidiary.
• Capital: undated and dated;
• Primary issuance.
The report format can be set to the user’s desired
choice.
2%
2% 2%
3%
9% Customers: Individuals
Repo: Highly liquid securities
Repo: High-quality securities
Asset-backed securities
Unsecured wholesale
9%
Repo: Other assets
Customers: Large enterprises
Conditional liabilities
1
605
60%
66
98 er
1- nt
20
66 Ce
13%
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
200 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
an early warning of a particular bank experiencing funding Summary and Qualitative Reports
stress if it observes that its funding yield curve is rising mate-
rially above that of its peer group. For individual bank senior Liquidity report MI for senior management should be presented
management, it is difficult to obtain this information about as a 1-page summary of the key liquidity metrics. This can be
other banks; however, it should be possible to get an idea of distributed on a monthly basis or as directed by ALCO, although
the peer group average from the regulator. A comparison to the distribution frequency may be increased during a stress
one’s own funding level is a worthwhile exercise and should period. Keeping the report to one side of A4 will increase the
be undertaken on at least a quarterly basis. chance that the report will actually be read and noted at senior
management level, which is why these reports are an important
Figure 10.8 is an example of a firm-specific yield curve for a
part of liquidity MI. An example of a monthly summary report is
UK bank. Figure 10.9 shows the breakdown of the same bank’s
presented at Figure 10.10.
wholesale funding by volume and product type.
1
605
66
98 er
1- nt
20
66 Ce
65 ks
25.00%
1-week ratio
1-week limit
20.00%
1-month ratio
15.00% 1-month limit
10.00%
5.00%
0.00%
–5.00%
–10.00%
09
09
09
09
09
09
09
09
09
09
09
09
09
09
1/
1/
1/
1/
2/
2/
2/
2/
3/
3/
3/
3/
3/
4/
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
05
12
19
26
02
09
16
23
02
09
16
23
30
06
* Ratios are above the limit
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 MI as desired.
For banking groups that operate across country jurisdictions and In the UK, quantitative liquidity reporting is an integral part
multiple subsidiaries, a qualitative report should be completed for of the regulatory regime. The full requirement applies to
Head Office Group Treasury, on a monthly basis. This will assist the individual liquidity adequacy standards (ILAS) firms. Some
1
group to better understand the liquidity position in each country. smaller institutions and foreign branches are not ILAS firms,,
605
66
In general, the main liquidity reports are required by the regu- summary of the reporting requirements for UK standard
sta
anndard ILAS
-9 a
58 ak
lator, who stipulates their frequency. ALCO should view this firms.
11 ah
41 M
20
99
202 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
FSA047: Daily Flows 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
FSA048: Enhanced ILAS risk drivers and contractual As above As above
mismatch report cash flows across full maturity
spectrum
FSA050: Liquidity Buffer Granular analysis of firm’s market- Monthly 15 business days after
qualifying securities able asset holdings month-end
FSA051: Funding Firm’s borrowings of unsecured Monthly 15 business days after
concentration wholesale funds (excludes primary month-end
issuance), by counterparty class
FSA052: Wholesale Daily transaction prices and Weekly End-of-day Tuesday
liabilities transacted volumes for wholesale
unsecured liabilities
01
FSA053: Retail, SME and Firm’s retail and corporate fund- Quarterly 15 business days after
56
dayys after
aft
20 o
Source: FSA.
20
99
01
56
66
98 er
1- nt
20
66 Ce
65 ks
06 o o
82 B
-9
58
11
Figure 10.12A and B Stress test results: cash flow survival horizon.
41
20
99
204 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
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
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
! "#$"%&% ] ^W ) '_ (!
! ! ' (! ) $ *$+:;+<=>?@ ' J \) $
Is unadjusted. ! 'W $ `c '+: Q f +_ f ^#g
$ K $ ! ( $ + Q f +_ ^ Q f +@!!M Q f +\) $ W +;^
$ ? ) J> \) $ W + ' >
< ! '' $ MQW>W $ !Y @M* ) = `;Q $ *&%%h#=+ W *g>h#=+:
> *%>[&h#[[=+ *&%%h#=+kf *&%%h#=+
Q $ *&%%h#=+:Q $ * =+@ *%>%#h[m=+Y
? J Z [">
*&%%h#%=
\) $ €1,279,200,226
@M `< + +_ ' +_ $) +@
q v €150,116,423 Liabilities
Z $ ! $ ' !
\) $ €1,129,083,803 @M W $ >
money for regulatory purposes, although certain regulatory Bank liquidity models commonly apply the following treatment:
authorities will allow a “behavioural” adjustment of retail depos-
• Derivatives are included to the extent that collateral is pay-
its where it can be shown that these remain fairly stable over
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:
1
Stress Tests – Individual Shocks Sight – 8 Day Sight – 1 Month Probability Impact
Moderate Rating category 2 notch downgrade 2.34% 0.12% 20% 70
Severe Rating category 3 notch downgrade - 15.2% - 18.2% 1% 90
Mark-to-market reduction Light 8.46% 1.35% 60% 20
in value of assets
Moderate 2.34% 0.12% 40% 30
Severe -15.2% - 18.2% 5% 70
Increased haircut on assets Light 8.46% 1.35% 70% 25
Moderate 2.34% 0.12% 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% 100
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% 20
deposits o/night funding
Moderate Reduce customer deposits by 10%, replace with 2.34% 0.12% 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% 20
deposits deposits by 10%, replace with overnight funding
Moderate Reduce Local Authority deposits by 50%, other 2.34% 0.12% 2% 70
Corporate Banking deposits by 35%, replace
99 with overnight funding
20
41 M Severe Reduce Local Authority deposits by 100%, other -15.2% - 18.2% 1% 100
11 ah Corporate Banking deposits by 70%, replace
58 ak
-9 ali with overnight funding
82 B
206 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Withdrawal
rawa
06 aloof
ok intragroup Light Reduce net group liability to EUR500 mm, 8.46% 1.35% 100% 5
deposits 656 s C replace with overnight funding
61 en
-9 te
82 r
06
65
60
1
Table 10.6 Continued
Stress Tests – Individual Shocks Sight – 8 Day Sight – 1 Month Probability Impact
Moderate Reduce net group liability to EUR250 mm, 2.34% 0.12% 70% 20
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% 20
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% 0.12% 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% 10% 90
respondent banks) by 50%, other inter-bank
deposits by 100%, replace with o/night funding
FX Markets
FX rate changes Light Stress GBP and USD FX rates by 15% 8.46% 1.35% 90% 20
Moderate Stress GBP and USD FX rates by 15% 2.34% 0,12% 40% 40
Severe Stress GBP and USD FX rates by 25% -15.2% - 18.2% 20% 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% 0.12% 7% 40
GBR)
Severe Withdrawal of all swap markets -15.2% - 18.2% 2% 50
99 Stress Tests-Combined Shocks Sight – 8 day Sight – 1 month Probability Impact
20
Slow-burn
41S ow-
M liquidity crunch Detailed description of balance sheet shocks -25.5% - 26.7% 2% 85
11 ah
Severe
ever a reputational
58 re kre Detailed description of balance sheetshocks -42.4% - 51.2% 0.50% 100
-9 ali
damage
mage82 B
06 oo
65 ks
66 Ce
1- nt
98 er
20
66
56
99
20
41 M
11 ah
58 ak
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06 oo
65 ks
66 Ce
1- nt
98 er
20
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560
1
Contingency
Funding Planning
11
Chi Lai and Richard Tuosto
■ Learning Objectives
After completing this reading you should be able to:
● Discuss the relationship between contingency funding ● Assess the key components of a contingency funding plan
planning and liquidity stress testing. (governance and oversight, scenarios and liquidity gap
analysis, contingent actions, monitoring and escalation,
● Evaluate the key design considerations of a sound contin- and data and reporting).
gency funding plan.
1
60
5
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1- nt
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65 ks
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-9
58
11
Excerpt is Chapter 7 of Liquidity Risk Management: A Practitioner's Perspective, by Shyam Venkat and Stephen
tephe Baird.
41
20
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209
The European Banking Commission’s 2008 report, “EU Bank’s I. Aligned to business and risk profiles
Liquidity Stress Testing and Contingency Funding Plans,” which II. Integrated with broader risk management frameworks
highlighted the practices of 84 surveyed institutions, noted rec-
III. Operational and actionable, but flexible playbook
ommendations on areas for enhancements, and provided guid-
1
60
ance to supervisors and central banks on areas of focus for their IV. Inclusive of appropriate stakeholder groups
5
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evaluation of the institutions’ CFPs. Since that time, supervisors V. Supported by a communication plan
1- nt
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ing Companies and Foreign Banking Organizations” guidance, CFPs should be considered in the context of the institu-
insti
instit
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required that banking organizations operating in the U.S. with tion’s specific business and risk profiles, including
ding the scope
ud
$50 billion or more in assets establish and maintain a CFP to of business activities, products/asset classes, geographic and
es, g
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210 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
contingency actions that management can undertake in differ- With these key design considerations in mind, d, institutions
inst
ins
stitut
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ent stress scenarios and at graduated levels of severity. These can develop their CFPs using an integrated edd framework
fra
amew that
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58 ak
graduated stress levels should be aligned to EWIs, triggers, and addresses the people, process, data, and reporting dimensions,
nd re
repor
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contingency actions. Through this process, the institution will keeping in mind that the CFP framework orrkk should
sho be tailored to
have a structured roadmap, outlining potential liquidity risks and its business and risk profiles, including
ng the
th scope and scale of its
20
99
tional structure, capabilities, and coverage/responsibilities: in concert, relying on each other to ensure information is avail-
560
markets, industry, institution-specific conditions, and liquidity In any crisis situation, clear and timely communication
un
uniicatio helps the
nicatio
stress testing results. institution demonstrate a sense of control and
nd confidence
cco that
20
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212 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
design exercise.
5
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in separate document)
58 ak
• Methodology
41 M
In addition to incorporating the outcomes of the institution’s • Reducing asset growth through reduced balance transfers
liquidity stress testing, the CFP itself may contain additional • Issuing at-call loans (which can be recalled to provide cash
liquidity-related stress scenarios. These additional scenarios, when needed)
while outside the institution’s broader liquidity risk monitor- • Selling consumer loans and/or credit card receivables
ing and limit structure (as contained within the liquidity stress
• Selling business or business units
test), ensure effective contingency plans are in place in the
event of certain events that could potentially impact liquid- • Raising equity funds through asset sales or issuance
ity. For example, the CFP might include scenarios in which its • Reducing capital distributions
intraday debit cap with Fedwire is exceeded, specific coun- • Curtailing discretionary spending and expenses
terparties fail, or Federal Home Loan Bank funding becomes
unavailable. 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
Contingent Actions or withdrawal of credit in the financial markets could prevent
Based on the liquidity gap analysis, institutions can develop access to existing lines of credit for rolling over short-term obli-
contingent actions/capital recovery actions, including a spec- gations. Lenders may restrict or outright refuse to extend credit
trum of business scoping activities, pricing initiatives, disposi- based on perceptions of the institution’s financial strength and
tion actions, and potential expense control actions, that will exposures to risks. Asset liquidity may decrease precipitously,
help strengthen the institution’s liquidity position. In general, leaving the institution challenged to fund certain business activi-
the applicability and appropriateness of such contingent ties and commitments.
actions should be considered in the context of the nature and In general, a number of market factors can impact the institu-
severity (amount) of capital shortfall, associated timing and tion’s ability to take contingent actions including, but not limited
pattern of the expected capital shortfall, estimated capital to the following:
relief from the contingent action, and the institution’s ability to
• Shutdown of securitization markets
execute internal or external/market activities associated with
such contingent actions. • Restricted access to repo funding due to solvency issues,
credit downgrades, or reputation damage
Examples of contingent actions include, but not are limited to
• Ratings downgrade and subsequent increase in collateral/
the following:
margin requirements
• Maintaining lines of credit that allow borrowing without
• Predatory margin and collateral practices by counterparties
major restrictions on use and reasonable rates
• Increased cash deposit requirements with custodian banks
• Increasing underwriting standards and dialing back lending
• Increased cost-of-funding (i.e., debt yields)
• Adjusting pricing strategies to increase premiums paid on
deposit products in order to entice investors to place depos- • Deposit runoff
1
560
its with the institution • Collapse of interbank market and wholesale funding
66
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1- nt
20
• Shifting allocation from short-term funding to longer-term Management should try to anticipate these challenges ges as well as
lleng
leng
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58 ak
• Increasing issuance of brokered CDs or direct to consumer possible, the CFP should document mitigating ng g actions
act that man-
deposits agement would consider taking to addresss such
suc challenges.
20
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214 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
may actually precipitate a liquidity crunch for the institution. as among the institution’s peer group. Such information can
60
5
66
The CFP should leverage the institution’s liquidity risk monitor- vidual liquidity challenges that an institution
on may
m face;
fa however,
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58 ak
ing and measurement framework. This framework should include they can provide insight into general market
marke et distress
dis and a sys-
11 ah
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a portfolio of measures to monitor both the current liquidity temic withdrawal of liquidity, similar to
o the
t freezing
f of the repo
profile and the anticipated effects of potential liquidity events. markets during the financial crisis. Macro-environment
Macro measures
20
99
Examples of EWIs encompassing market and business factors • Projected net funding requirements to current unused
include: funding capacity. Measures the funding and borrowing
needed to finance the institution’s increased lending activities
• Significant and unexpected drop in stock market indices
and banking activities, and provides an approach to assess
• Downgrade of U.S. Treasury or other sovereign debt rates the institution’s future lending obligations in proportion to
• Spike in market volatility (e.g., VIX) the total funds available at the institution.
• Unexpected catastrophic events (e.g., September 11, 2001, • Non-core funding to long-term assets. Measures the
earthquakes) proportion of longterm funding needs that are supported
• Rapid asset growth funded by potentially volatile liabilities by less stable sources of funding. A higher non-core fund-
ing dependency ratio is indicative of a high dependence on
• Real or perceived negative publicity
volatile funding sources that, during times of financial stress,
• A decline in asset quality
may have limited availability or may only be available at a
• A decline in earnings performance or projections much higher cost.
• Downgrades or announcements of potential downgrades of • Overnight borrowings to total assets. Measures the reli-
the institution’s credit rating by rating agencies ance on overnight funding to fund the institution’s assets
• Cancellation of loan commitments and/or not renewing as the use of this volatile source of funding can expose the
maturing loans institution to increased liquidity risk.
• Wider secondary spreads on the institution’s senior and sub- • Short-term liabilities to total assets. Measures the funding
ordinated debt, rising CDS spreads and increased trading of levels that will need to be rolled over within a predetermined
the bank’s debt short-term time period (e.g., under 30 days, 60 days, 90 days)
• Increased collateral requirements or demand collateral to support the institution’s assets.
for accepting credit exposure to the institution from • Funding sources concentration. The concentration of fund-
counterparties ing sources for an institution is an important measure for
• Counterparties and brokers unwilling to deal in unsecured or understanding which counterparties are most likely to cease
longer-term transactions providing liquidity during a stress event. Liquidity provid-
1
60
• Calls by debt holders for the institution to buy back its debt
06 oo
• Volatility in foreign exchange markets, particularly in the will likely lessen the impact of the loss of any single
s provider
11 ah
41 M
currencies in which the institutions has exposure to and/or and give the institution additional sourcess of
o liquidity
liq to tap
requires as part of its liquidity risk management in the case of a shortfall.
20
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216 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
In designing their CFPs, institutions establish a series of esca- survival. In this situation, the market environment,
vironmen state of
nviron
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58 ak
lation levels properly aligned to the scenarios, contingency the institution, and potential CFP actions ns show
ctions sho similarities to
11 ah
41 M
actions, and liquidity measures, including EWIs and health mea- the circumstances contemplated ass part p of
o the institution’s
sures. While there are no specific guidelines in the number of recovery and resolution planning activities.
activ
20
99
senior management in its approach to understanding the insti- of CFPs consists of individual CFPs that address business-
60
5
66
business activities.
rate on the level of coverage predicted by these measures. In
-9 ali
58 ak
addition, institutions should ensure that existing reports capture Depending on the nature and scope of the institution,
nstituution separate
tution
11 ah
41 M
intraday liquidity positions, track exposure to contingent liabili- CFPs may be necessary to address regulatory requirements. For
ryy requ
ties, and monitor capacity usage in funding sources. example, ring-fenced entities that are supervised
ervis by a different
ervise
20
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218 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Liquidity and Capital • Communication plan with coordination to internal and exter-
nal stake-holders
The advancement of capital and liquidity practices, guided both
Institutions should be mindful that the CFP is a playbook—and
by enhanced expectations from supervisors as well as internally-
as such, it requires updating on a regular basis. Strong CFPs
driven initiatives, has been notable; however, there is still work
will not only provide a menu of options during a time of crisis,
to be done. Historically, capital and liquidity management
but also enhance the overall strategic, business, and risk man-
practices have been highly siloed; however, most recently, insti-
agement capabilities of the institution, ultimately helping to
tutions have started to bring a more integrated approach and
establish further credibility and confidence from the institution’s
view to these areas. This integrated approach will help bring a
external stakeholders.
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
References
strengthen the alignment of the integrated liquidity and capital
stress testing and contingency plans to other enterprise-wide European Central Bank. 2008. “EU Bank’s Liquidity Stress Test-
applications, including recovery and resolution plans, capital ing and Contingency Funding Plans,” European Central Bank
management, enterprise risk management, and other related
capabilities of the institution. SR 10-6. “Interagency Policy Statement on Funding and Liquid-
ity Risk Management,” 2010. OCC, FRB, FDIC, OTS, NCUA
1
60
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65 ks
06 oo
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11 ah
41 M
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99
Managing and
Pricing Deposit
12
Services
■ 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 the 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.
1
605
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1- nt
20
66 Ce
65 ks
06 oo
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58 ak
11 ah
41 M
Excerpt is Chapter 12 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
20
99
221
especially in today’s competitive marketplace. Both the cost action deposits include regular noninterest-bearing demand d
66
98 er
1- nt
20
and amount of deposits that depository institutions sell to deposits that do not earn an explicit interest payment but ut pro-
pro
ro-
66 Ce
the public are heavily influenced by the pricing schedules vide the customer with payment services, safekeeping g of funds,
fund
65 ks
06 oo
and recordkeeping for any transactions carried out utt byy check,
chec
82 B
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1
Portions of this chapter are based on an article by Peter S. Rose in The
deposits that provide all of the foregoing services
ervicces and
ervice an pay inter-
a
41 M
Canadian Banker [3] and are used with permission of the publisher. est to the depositor as well.
20
99
222 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
institution to move funds from a savings account to a transaction This mobile-deposit innovation has centered d initially
i tially in the
init
82 B
-9 ali
account in order to cover overdrafts. The net effect was to pay industry’s leaders, such as JP Morgan Chase, USAA, and Bank
hase,, USA
58 ak
11 ah
interest on transaction balances roughly equal to the interest of America. However, this service will likely
likellyy soon
so be offered by
soo
41 M
Increasingly electronic payment services (such as PayPal) are Time deposits come in a wide variety of types and terms. How-
capturing the consumer’s money in place of banks and other ever, the most popular of all time deposits are CDs—certificates
depository institutions. Banking’s share of “swipe fees” at store of deposit. CDs may be issued in negotiable form—the
registers generally have declined as electronic transactions have $100,000-plus instruments purchased principally by corpora-
taken over. tions and wealthy individuals that may be bought and sold any
number of times prior to reaching their maturity—or in nonne-
gotiable form—smaller denomination accounts that cannot be
Nontransaction (Savings or Thrift) traded prior to maturity and are usually acquired by individuals.
Deposits Innovation has entered the CD marketplace recently with the
development of bump-up CDs (allowing a depositor to switch to
Savings or thrift deposits are designed to attract funds from
a higher interest rate if market interest rates rise); step-up CDs
customers who wish to set aside money in anticipation of future
(permitting periodic upward adjustments in promised interest
expenditures or for financial emergencies. These deposits nor-
rates); liquid CDs (allowing the depositor to withdraw some of
mally pay significantly higher interest rates than transaction
his or her funds without a withdrawal penalty); and index CDs
deposits do. While their interest cost is higher, thrift deposits
(linking returns on these certificates to stock market perfor-
are generally less costly to process and manage on the part of
mance, such as returns on the Standard and Poor’s 500 stock
offering institutions.
index).
Just as depository institutions for decades offered only one
basic transaction deposit—the regular checking account—so it
Retirement Savings Deposits
was with savings plans. Passbook savings deposits were sold
to household customers in small denominations (frequently In 1981, with passage of the Economic Recovery Tax Act,
a passbook deposit could be opened for as little as $5), and the U.S. Congress opened the door to yet another deposit
withdrawal privileges were unlimited. While legally a depository instrument—retirement savings accounts. Wage earners and
institution could insist on receiving prior notice of a planned salaried individuals were granted the right to make limited con-
withdrawal from a passbook savings deposit, few institutions tributions each year, tax free, to an individual retirement account
insisted on this technicality because of the low interest rate (IRA), offered by depository institutions, brokerage firms, insur-
1
paid on these accounts and because passbook deposits tend ance companies, and mutual funds, or by employers with quali-
5 60
to be stable anyway, with little sensitivity to changes in interest fied pension or profit-sharing plans. There was ample precedent
ceden
eden nt
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20
66 Ce
rates. Individuals, nonprofit organizations, and governments can for the creation of IRAs; in 1962, Congress had authorized ze
edd finan-
finan-
65 ks
hold savings deposits, as can business firms, but in the United cial institutions to sell Keogh plan retirement accounts,
ts, available
nts, av
availa
06 oo
82 B
States businesses could not place more than $150,000 in such a to self-employed persons.
-9 ali
deposit.
58 ak
Some institutions offer statement savings deposits, evidenced retirement, purchases of new homes, and childrens’
dren education,
hild
ldren
only by computer entry. The customer can get monthly printouts modified the rules for IRA accounts, allowing
ing individuals
in with
20
99
224 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Each of the different types of deposits we have discussed typi- savings deposits—interest-bearing thrift accounts—to the th
5
66
98 er
cally carries a different rate of interest. In general, the longer the public. As Table 12.1 shows, time and savings deposits rrepre-
osits repre
1- nt
20
66 Ce
maturity of a deposit, the greater the yield that must be offered sented more than four-fifths of the total depositss held
hel by all
eld
ld
65 ks
06 oo
to depositors because of the time value of money and the U.S.-insured commercial banks by 2010. Not surprisingly,
surp
prisin
prising then,
B
frequent upward slope of the yield curve. For example, NOW interest-bearing deposits and nontransactionion deposits,
tion d
depo both
82
accounts and savings deposits are subject to immediate with- of which include time and savings deposits, s, have
osits, hav captured
-9
58
drawal by the customer; accordingly, their offer rate to custom- the majority share of all deposit accounts.
ntts. In contrast, regular
nts.
11
ers is among the lowest of all deposits. In contrast, negotiable demand deposits, which generally pay little
lit or no interest and
41
20
99
Deposit Type or Category 1983 1987 1993 1998 2001 2007 2010*
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 10 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
1
rates. The presence of substantial amounts of core deposits in The dominant holder of bank deposits inside e thee United
Uni States
11 ah
41 M
smaller banks helps explain why large banks in recent years have is the private sector—individuals, partnerships,
ps, and
ps, an corpora-
acquired so many smaller banking firms—to gain access to a tions (IPC)—accounting for three-quarterss of all
a U.S. deposits.
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226 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
CHECK CLEARING FOR THE 21ST CENTURY In 2004, the Check 21 Act became law, permitting depository
ACT (CHECK 21) institutions to electronically transfer check images instead
of checks themselves, replacing originals with substitute
Paper checks are being processed much faster these days checks. These are photographed copies of the front and
and more businesses and consumers are going electronic. In back of the original check that can be processed as though
past years depositors used to count on “float” time between they were originals. The front will say: “This is a legal copy of
the moment they wrote a check and the time funds were your check. You can use it in the same way you would use the
actually removed from their checking account. With float original check.” Thus, substitute checks provide proof that
the check writer could often beat the check back to his bank you paid a bill just as would be the case if you had the origi-
and deposit more money just in time. Today, however, funds nal check.
often get moved out of one account into another the same
day. Increasingly financial firms are capturing the float that Check 21 carries a number of benefits for both depositors
used to benefit depositors. and depository institutions. It protects depositors against
loss from substitute checks. The depositor can contact his
At the heart of the newly emerging check system is a process or her deposit institution to request a refund when the use
known as electronic check conversion, which takes informa- of substitute checks has led to an error that cost the deposi-
01
tion from the check you have written and electronically deb-
56
its your account, often on the spot. Your check is not sent by sharply reducing the cost of check clearing, especiallyly in
ecially
1- nt
20
66 Ce
through the normal clearing process used in the past. Indeed, doing away with the necessity of shipping bundles es of checks
chec
65 ks
some merchants will stamp “void” on your check and give it around the country. However, from the customer‘s
mer‘ss point
poin of
06 oo
right back to you once they have electronically transferred view more bounced checks and overdraft charges
harges are
arge a likely.
82 B
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the data it contains. Moreover, more depository institutions (For further information about Check 21 and the rights and
58 ak
are neither returning checks to their deposit customers nor obligations of depositors and institutions,
ons, see, especially,
11 ah
41 M
WHO OFFERS THE HIGHEST DEPOSIT Why are the foregoing institutions generally among the
INTEREST RATES, AND WHY? leaders in offering deposit interest rates? One reason is they
expect to earn relatively high returns on their consumer and
Customers interested in purchasing the highest-yielding credit card loans, giving them an ample margin over deposit
interest-bearing deposits and the managers of depository costs.
institutions interested in discovering what deposit interest
yields their competitors are offering can consult newspapers In the case of Internet-based banking institutions these
or go online to key websites—for example, www.banx.com unique electronic firms must attract the public away from
or www.Bankrate.com. more traditional institutions and often provide few services,
so they must offer exceptional deposit rates to attract the
Among the key types of deposit rate information available funds they need. Moreover, virtual banks typically have
are these: relatively low fixed (overhead) costs, allowing these firms to
• The average yields (APY) offered on CDs purchased bid higher for the public‘s deposits.
through security brokers who search the marketplace On the negative side, however, many virtual banks have not
every day for the highest yields available on large deposits been as successful in attracting customers as have traditional
(usually close to $100,000 in size). depository institutions in recent years. Indeed, the most
• A list of those depository institutions offering the highest successful firms at attracting customer deposits recently have
1
60
yields (APYs) on retail deposits (typically $500 to $25,000 been multichannel depository institutions—offering both
5
66
98 er
minimum denomination) and jumbo CDs (usually carrying traditional and online services through the same institution— n—
1- nt
20
66 Ce
an opening balance of about $100,000 or even larger). indicating that many customers are more likely to use online line
65 ks
machines.
58 ak
228 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
commercial deposits. Moreover, the average size of a personal tion, the individual depository institution has little control over ver
er
560
transaction account normally is less than one-third the average its prices. It is the marketplace, not the individual financial
ancia
nciaall firm,
firm
66
98 er
1- nt
20
size of a commercial account, so a depository institution receives that ultimately sets prices. Financial institutions, like
e most
ke mo
m ost other
o
66 Ce
65 ks
substantially more investable funds from commercial demand businesses, are price takers, not price makers. In n such
suuch a mar-
06 oo
deposits. However, competition posed by foreign financial- ketplace, management must decide if it wishes es to
she
he t attract
at more
82 B
-9 ali
service firms for commercial transaction accounts has become deposits and hold all those it currently hasas by offering
offe
off deposi-
58 ak
11 ah
so intense that profit margins on these accounts often are razor tors at least the market-determined price, e, or whether
rice, w it is willing
41 M
Steagall Act. These legal interest rate ceilings (Regulation for example, more depositories are now levying fees for
5
66
98 er
Q) were designed to protect depository institutions from excessive withdrawals, customer balance inquiries, bounced ncedd
1- nt
20
66 Ce
“excessive” interest rate competition for deposits, which checks, stop-payment orders, and ATM usages, as well ell as
65 ks
06 oo
could allegedly cause them to fail. Prevented from offering raising required minimum deposit balances. The resultsesults
esult
82 B
higher explicit interest rates, U.S. depositories competed of these trends have generally been favorable to depository
depos
d
-9 ali
58 ak
instead by offering free bank-by-mail services, gifts ranging institutions, with increases in service fee income
come e generally
gen
11 ah
41 M
from teddy bears to toasters, and convenient neighborhood outstripping losses from angry customers closingosing their
clo
branch offices. accounts.
20
99
230 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
against a deposit. On the other hand, U.S. government secu- Funds deposited by a corporation, partnership,, or u unincorporated
uninc
uninco
06 oo
B
rities, shares in mutual funds, safe deposit boxes, and funds business or association are insured up to the
e maximum
maximu allowed by
82
stolen from an insured depository institution are not covered by law and are insured separately from the personal
persoonal accounts
a of the
-9
58
FDIC insurance. Depository institutions generally carry private company’s stockholders, partners, or members.
mbers Funds deposited
em
11
insurance for these items. by a sole proprietor are considered to be ppersonal funds, however,
41
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99
price funds sources for a financial-service institution. The reason For example, if the bank raises its offer rate on new deposits
5
66
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is that frequent changes in interest rates will make historical from 7 percent to 7.5 percent, Table 12.2 shows the marginal inal
nal
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average cost a treacherous standard for pricing. For example, cost of this change: Change in total cost = $50 million
65 ks
if interest rates are declining, the added (marginal) cost of rais- * 7.5 percent - $25 million * 7 percent = $3.75 millio million
on
06 oo
B
ing new money may fall well below the historical average cost - $1.75 million = $2.00 million. The marginal costost rrate,
ate, tthen, is
82
over all funds raised. Some loans and investments that looked the change in total cost divided by the additional funds raised, or
onal ffund
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58
profitable when measured against the lower marginal interest $25 million
41
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232 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
There, total profit tops out at $1.5 million. It would not pay the Thus, the customer pays a price conditional
dittiona on how he or she
bank to go beyond this point, however. For example, if it offers uses a deposit account.
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THE TRUTH IN SAVINGS ACT will they be placed in a noninterest-bearing account?) if the
customer does not remember to renew his or her deposit.
In November 1991, the U.S. Congress passed the Truth in (Generally, customers must receive at least 10 days’ advance
Savings Act, which requires depository institutions to make notice of the approaching maturity date for deposits over
greater disclosure of the terms attached to the deposits they one year to maturity that are not automatically renewed.) If
sell the public. On September 14, 1992, the Federal Reserve a change is made in terms that could reduce a depositor’s
Board issued Regulation DD to spell out the rules that depos- yield, a 30-day advance notice must be sent to the depositor.
itories must follow to conform with this law.
Depository institutions must send to their customers the
The Fed’s regulation stipulates that consumers must be fully amount of interest earnings received, along with the annual
informed of the terms on deposit plans before they open a new percentage yield earned. The annual percentage yield (or
account. A depository institution must disclose the minimum APY ) must be calculated using:
balance required to open the account, how much must be
APY earned = 100 [(1 + Interest earned/Average account
kept on deposit to avoid paying fees or obtain the promised
yield, how the balance in each account is figured, when interest balance)(365/Days in period) - 1]
actually begins to accrue, any penalties for early withdrawal,
options available at maturity, reinvestment and disbursement where the account balance is the average daily balance kept
options, advance notice of the approaching end of the depos- in the deposit for the period covered by each account state-
it’s term if it has a fixed maturity, and any bonuses available. ment. Customers must be informed of the impact of early
withdrawals on their expected APY.
When a consumer asks for the current interest rate the offering
institution must provide that customer with the rate offered For example, suppose a depositor had $1,500 in an interest
within the most recent seven calendar days and also provide bearing account for the first 15 days and $500 in the account
a telephone number so consumers can get the latest offered for the remaining 15 days. The average daily balance in this
rate if interest rates have changed. On fixed-rate accounts case is $1,000, or [($1,500 * 15 days + $500 * 15 days)/
offering institutions must disclose to customers what period 30 days]. Suppose the account has been credited with $5.25 in
of time the fixed rate will be in effect. On variable-rate depos- interest for the latest 30-day period. Then the APY earned is:
its institutions must warn consumers that interest rates can
APY = 100 [(1 + 5.25/1000)365/30 - 1] = 6.58 percent
change, how frequently they can change, how a variable inter-
est rate is determined, and specify if there are limits on how In determining the balance on which interest earnings are
1
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far deposit rates can move over time. For all interest-bearing figured, the depository institution must use the full amount of
5
the principal in the deposit for each day, rather than count-
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which interest is compounded and credited. ing only the minimum balance that was in the account on n one
one
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automatically renewed on its own, the renewed deposit is interest on the full principal balance are prohibited.. Deposit
De
epos
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Customers must also be told if their account is automatically those accounts held by individuals for a personal,
onal,, family,
fam or
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household purpose.
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234 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
HOW U.S. DEPOSITORY INSTITUTIONS after the maturity date to withdraw the funds without being
SHOULD DISCLOSE THE TERMS ON THEIR charged a penalty.
DEPOSIT SERVICES TO CUSTOMERS Both the Truth in Savings Act and the Federal Reserve’s
In order to help institutions selling deposit services in the Regulation DD stipulate that advertising of deposit terms
United States conform to the Truth in Savings Act, the Fed- may not be misleading. If interest rates are quoted in an
eral Reserve Board provides managers with examples of advertisement, the institution must tell the public what the
proper disclosure forms to use to inform customers of the other relevant terms of the deposit are, such as the minimum
terms being quoted on their deposits. For example, the Fed balance needed to earn the advertised yield and whether any
has provided an example of a proper disclosure form for cer- fees charged could reduce the depositor’s overall yield.
tificates of deposit as shown below. The Federal Reserve has recently developed sample adver-
tisements to guide managers in making sure that advertising
Sample Disclosure Form for XYZ Savings Bank contains all the essential information the consumer needs.
One-Year Certificate of Deposit For example, the sample advertisement form for CDs shown
below was developed recently by the Federal Reserve Board.
Rate Information The interest rate for your account is
5.20% with an annual percentage yield of 5.34%. You will be The sample advertisement illustrates the basic require-
paid this rate until the maturity date of the certificate. Your ments for legitimate advertising of deposits under the Truth
certificate will mature on September 30, 2017. The annual in Savings Act: (a) deposit rates must be quoted as annual
percentage yield assumes interest remains on deposit until percentage yields (APY), (b) the dates and minimum balance
maturity. A withdrawal will reduce earnings. required must be explicit, and (c) the depositor must be
warned of penalties or fees that could reduce the yield.
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 Bank XYZ Always Offers You Competitive CD Rates!!
example, checks).
Certificate of Deposit Annual Percentage Yield (APY)
Minimum Balance Requirements You must deposit $1,000
to open this account. You must maintain a minimum balance 5-year 6.31%
of $1,000 in your account every day to obtain the annual 4-year 6.07%
percentage yield listed above.
3-year 5.72%
Balance Computation Method We use the daily bal-
ance method to calculate the interest on your account. This 2-year 5.25%
method applies a daily periodic rate to the principal in the 1-year 4.54%
account each day.
6-month 4.34%
Transaction Limitations After the account is opened, you
may not make deposits into or withdrawals from the account 90-day 4.21%
until the maturity date. APYs are offered on accounts
Early Withdrawal Penalty If you withdraw any principal from 2010 through 2017.
before the maturity date, a penalty equal to three months' The minimum balance to open an account and obtain
interest will be charged to your account. the APY is $1,000. A penalty may be imposed for early
withdrawal.
Renewal Policy This account will be automatically renewed
For more information call: (202) 123-1234.
at maturity. You have a grace period of ten (10) calendar days 1
60
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Free pricing, on the other hand, refers to the absence of effective interest rate paid may be less than the he going
g
gooing rate on
65 ks
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a monthly account maintenance fee or per-transaction investments of comparable risk. Many depository ory institutions
osito in
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charge. Of course, the word free can be misleading. Even if have found free pricing decidedly unprofitable ble because
ofitab
fitab b it
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a deposit-service provider does not charge an explicit fee tends to attract many small, active deposits
epossits that
th earn positive
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for deposit services, the customer may incur an implicit fee returns for the offering institution only
nlyy when
whe market interest
in the form of lost income (opportunity cost) because the rates are high.
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Bank A Bank B
If balance falls below $200 $3.00 per mo. If balance falls below $100 $2.00 per mo.
65 ks
06 oo
Fee for more than two Fee for more than three
58 ak
11 ah
Exhibit 12.1 Example of the use of conditional deposit pricing by two banks serving the same
e market
ma area.
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236 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
2. The cost that sewing different types of depositors will pres- Households and businesses consider multiple factors, not just
ent to the offering institution—most institutions today price price, in deciding where to place their deposits, recent stud-
deposit plans in such a way as to cover all or at least a sig- ies conducted at the Federal Reserve Board, the University of
nificant portion of anticipated service costs. Michigan, and elsewhere suggest. As shown in Table 12.3, these
studies contend that households generally rank convenience,
service availability, and safety above price in choosing which
12.8 PRICING BASED ON THE TOTAL financial firm will hold their transaction account. Moreover, famil-
CUSTOMER RELATIONSHIP AND iarity, which may represent not only name recognition but also
safety, ranks above the interest rate paid as an important factor
CHOOSING A DEPOSITORY in how individuals and families choose a depository institution to
hold their savings account.
Related to the idea of targeting the best customers for special
treatment is the notion of pricing deposits according to the
number of services the customer uses. Customers who pur-
chase two or more services may be granted lower deposit fees Factoid
compared to the fees charged customers having only a limited
There is research evidence today that the interest rates
relationship to the offering institution. The idea is that selling
banks pay on deposits and the account fees they charge
a customer multiple services increases the customer’s depen-
for deposit services do influence which depository institu-
dence on the institution and makes it harder for that customer
tion a customer chooses to hold his or her account. Inter-
to go elsewhere. In theory at least, relationship pricing pro-
estingly, rural financial-service markets appear to be more
motes greater customer loyalty and makes the customer less
responsive to interest rates and fees than do urban markets,
sensitive to the prices posted on services offered by compet-
on average.
ing financial firms.
Table 12.3 Factors in Household and Business Customers’ Choice of a Financial Firm for Their Deposit Accounts
(ranked from most important to least important)
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
2. Availability of many other services. 2. Interest rate paid, 2. Whether bank will be a reliable
60
4. Low fees and low minimum balance. location). 3. Quality of bank officers.
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operations services
services are provided.
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Source: Based on studies by the Federal Reserve Board, Survey of Consumer Finances.
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THE CONTROVERSY OVER DEPOSIT to get signed up even before you use the service. Then, if
OVERDRAFT PROTECTION the lender has to cover your bad checks, you will have to
pay off the loan the lender extended to you (normally within
Financial managers, customers, and government regulators 30 days) plus pay a substantial contract interest rate (say,
have weighed in recently on one of the most controversial ser- 18 percent). The combined charges plus short-term nature
vices financial institutions offer today. That service is overdraft of the overdraft loan may force you to pay an actual interest
protection (sometimes called “bounce protection”). If you acci- rate (measured by the APR) of 200 percent or more. To some
dentally overdraw your deposit account, this service is designed observers these loans resemble predatory lending, especially
to make sure your incoming checks and drafts are paid and that for low-income individuals who may need short-term credit
you avoid excessive NSF (not sufficient funds) fees. just to get by each month.
There are a variety of these deposit protection plans, but Moreover, customers, knowing they will be covered if they
most commonly your bank will set you up with a line of credit spend too much, may tend to run repeated overdrafts, wind-
(say, $1,000) in return for an annual fee (perhaps $25 to $50 ing up paying large amounts of interest instead of preparing
per year). Another type of overdraft plan calls for you to for the possibility of overdrafts by building up their savings.
maintain a second account from which the financial-service Moreover, feeling they are safe, people may tend to avoid
provider will transfer enough money to pay any overdrafts. balancing their account statement each month, making more
What’s so controversial about that? frequent overdrafts likely. Faced with adverse public and
After all, as long as you don’t write checks or drafts that are regulators’ comments some financial firms have reduced or
too large and go beyond your credit limit the financial-service eliminated their overdraft fees.
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provider pays all your overdrafts and saves you from insuf- Still, this is a service that has remained popular, especially
5
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ficient funds charges both from the service provider and from
98 er
the hassle of contacting the merchant who received your bad most important bills (e.g., home mortgage payment ent and
annd util-
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substantial revenues for the financial firm. You pay a fee just the bottom line and increases profits.
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238 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
function—secure adequate shelter, food, education, a job, and under current U.S. law (especially the USA Patriot Act). Others
ers
60
5
health care—without access to certain financial services? who can submit acceptable ID find most conventional al deposit
deposit
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telephone services. Many people believe these services are so approval for credit because most lending institutions
tutio prefer to
institution
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essential for health and comfort they should be provided at make loans to those customers who keep ep deposits
depos with them.
depos
11 ah
over other financial institutions. One of the most important of deposit services because of their nonexistent or low interest es
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these aids is deposit insurance, in which the government guar- rates and the higher service fees these accounts usuallyy carry.
carrry.
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antees most of the deposits these institutions sell. If depository In contrast, nontransaction, or thrift, deposits generally
allly have
rally h
65 ks
institutions benefit from insurance backed ultimately by the the advantage of a more stable funding base that at allows
ows a
allo
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public’s taxes, do they have a public responsibility to offer some depository institution to reach for longer-termm and
and higher-
hig
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services that are accessible to all? If yes, how should they decide yielding assets.
11 ah
41 M
which customers should have access to low-price services? • The most popular deposit-pricing methods dss today
tod is condi-
Should they insist on imposing a means test on customers? tional pricing. In this case the interest rate
ate the
tth customer may
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240 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
KEY TERMS
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
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Regular and special $235 $294 $337 $378 est rate in order to maximize total profits (excluding
(exxcl
cludin
ludin
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242 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
$600 million in new deposit money, which it expects 8. The National Bank of Mayville quotes an APY of 2.75 per-
to invest at a 4.25 percent yield. Management believes cent on a one-year money market CD sold to one of the
that an offer rate on new deposits of 2 percent would small businesses in town. The firm posted a balance of
attract $100 million in new deposits and rollover $2,500 for the first 90 days of the year, $3,000 over the
funds. To attract $200 million, the bank would prob- next 180 days, and $3,700 for the remainder of the year.
ably be forced to offer 2.25 percent. New Day’s fore- How much in total interest earnings did this small busi-
cast suggests that $300 million might be available at ness customer receive for the year?
2.50 percent, $400 million at 2.75 percent, $500 million
at 3.00 percent, and $600 million at 3.25 percent. What Internet Exercises
volume of deposits should the institution try to attract
1. Your education has paid off. You have stepped five years
to ensure that marginal cost does not exceed marginal
into the future and are reviewing your bank accounts. The
revenue?
money has just piled up. You have a joint account with
6. R&R Savings Bank finds that its basic transaction account, your fianceé containing $265,000 to be used for your
which requires a $1000 minimum balance, costs this first home. You have a joint account with your mother
savings bank an average of $3.25 per month in servic- containing $255,000, and you have an account in your
ing costs (including labor and computer time) and $1.25 own name with $155,000 for the necessities of life. All
per month in overhead expenses. The savings bank also three accounts are at the Monarch National Bank. Go
tries to build in a $0.50 per month profit margin on these to the following FDIC website www2.fdic.gov/edie and
accounts. What monthly fee should the bank charge each have Edie determine the insurance coverage. How much
customer? is uninsured? Can you describe the rules determining
Further analysis of customer accounts reveals that for coverage?
each $100 above the $1,000 minimum in average bal- 2. How has the composition of deposits changed at
ance maintained in its transaction accounts, R&R Sav- your favorite local depository institution over the past
ings saves about 5 percent in operating expenses with 10 years? You can find this deposit information for banks
each account. (Note: If the bank saves about 5 percent and savings institutions at the FDIC’s website. Utilize the
in operating expenses for each $100 held in balances Statistics on Depository Institutions link at www2.fdic
above the $1,000 minimum, then a customer maintaining .gov/sdi. Using the points made in this chapter, explain
an average monthly balance of $1,500 should save the why your local institution’s mix of deposits is changing
bank 25 percent in operating costs.) For a customer who the way it is. How can depository institution managers
consistently maintains an average balance of $1,200 per influence the trends occurring in the composition of their
month, how much should the bank charge in order to deposits?
protect its profit margin?
3. Which depository institutions currently quote the highest
7. Lucy Lane maintains a savings deposit with Monarch interest rates on checking accounts? Savings accounts?
Credit Union. This past year Lucy received $10.75 in Money market deposits? Three- and six-months CDs?
interest earnings from her savings account. Her savings Visit www.fisn.com,bankcd.com and www.banx.com for
deposit had the following average balance each month: the answers.
January $450 July $450 4. Compare your local depository institution’s interest
rates on six-month and one-year certificates of deposit itt
1
March 300 September 550 or visit its website) with the best rates on these
ese same
hese sam
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May 225 November 625 quoting the highest deposit interest ratess in the
t United
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What was the annual percentage yield (APY) earned on between your local institution and
annd those
th posting the
Lucy’s savings account? highest interest rates?
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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 120 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
www2.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
01
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244 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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-
100 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
2010 and 68.20 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-Total Asset BB&T with Peers
80% 100%
90%
70%
80%
60%
70%
50% 60%
40% 50%
40%
01
30%
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30%
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20%
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10% 10%
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0% 0%
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BB&T Peer Group BB&T Peer Group BB&T Peer Group BB&
&T
BB&T Peer Group
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Selected References
For a discussion of recent trends in deposit services, see these 8. McNulty, James E. “Do You Know the True Cost of Your
sources: Deposits?” Review, Federal Home Loan Bank of Atlanta,
October 1986, pp. 1–6.
1. Gerdes, Geoffrey R,; Jack K. Walton II; May X. Liu; and
Darrel W. Parke. “Trends in the Use of Payment Instruments For a discussion of recent trends in deposit service availability
in the United States.” Federal Reserve Bulletin, Spring and service fees, see:
2005, pp. 180–201.
9. Hannan, Timothy H. “Retail Fees of Depository Institutions,
2. Santomero, Anthony M. “The Changing Patterns of 1994–99.” Federal Reserve Bulletin, January 2001,
Payments in the United States.” Business Review, Federal pp. 1–11.
Reserve Bank of Philadelphia, Third Quarter 2005, pp. 1–8.
For a discussion of the impact of the Truth in Savings Act on the
3. Rose, Peter S. “Pricing Deposits in an Era of Competi- cost of bank regulatory compliance, see:
tion and Change.” The Canadian Banker, vol. 93, no. 1
10. Elliehausen, Gregory, and Barbara R. Lowrey. The Cost of
(February 1986), pp. 44–51.
Implementing Consumer Financial Regulation; An Analysis
For a discussion of the controversy over lifeline banking of the Experience with the Truth in Savings Act. Staff
services, see: Study No. 170, Board of Governors of the Federal Reserve
System, December 1997.
4. Good, Barbara A. “Bringing the Unbanked Aboard.”
Economic Commentary, Federal Reserve Bank of For an international view of reaching out to unbanked custom-
Cleveland, January 15, 1999. ers, see, for example:
For a discussion of the role of depositors in disciplining bank risk 11. Skelton, Edward C, “Reaching Mexico’s Unbanked,
taking and bank behavior, see especially: “Economic Letter, Federal Reserve Bank of Dallas, vol, 5,
no. 7 (July 2008), pp. 1–8.
5. Vaughan, Mark D.; and David C. Wheelock. “Deposit Insur-
ance Reform: Is It Déjà Vu All Over Again?” The Regional For a close view of the Federal Deposit Insurance Corporation’s
Economist, Federal Reserve Bank of St. Louis, October most recent study of unbanked and underbanked customers see
2002, pp. 5–9. in particular:
6. Federal Deposit Insurance Corporation. “Privatizing 12. Federal Deposit Insurance Corporation. “Findings from the
Deposit Insurance: Results of the 2006 FDIC Study.” FDIC FDIC Survey of Bank Efforts to Serve the Unbanked and
Quarterly 1, no. 2 (2007), pp. 23–32. Underbanked,” FDIC Quarterly, vol. 3, no. 2 (First Quarter
2009), pp. 39–47.
For a discussion of deposit pricing techniques, see these studies:
1
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246 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● Distinguish between the various sources of non-deposit ● Calculate overall cost of funds using both the historical
liabilities at a bank. average cost approach and the pooled-funds approach.
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Excerpt is Chapter 13 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
via C. Hudgins.
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247
support the loan”—is not well received by their customers. management as discussed in Chapters 5 and 18. Liability man- an-
n
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Denial of a credit request often means the immediate loss of a agement consists of buying funds, mainly from other financial
ncial
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20
66 Ce
customer account and perhaps the loss of any future business institutions, in order to cover good-quality credit requests
estts and
ests a
65 ks
1
Portions of this chapter are based on an article by Peter S. Rose in The domestic Federal funds market, or borrowing g abroad
abro through
11
248 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
First National Bank and Trust Company Balance Sheet (Report of Condition)
Table 13.1 illustrates the basic idea behind liability manage- correspondent banks in New York and London and negoti-
ment. In this instance, one of a lender’s business custom- ated with nonbank institutions with temporary cash surpluses,
ers has requested a new loan amounting to $100 million. resulted in raising the entire $50 million by borrowing domes-
However, the deposit division reports that only $50 million tic Federal funds, borrowing from a subsidiary part of the
in new deposits are expected today. If management wishes same holding company that sold notes (commercial paper) in
to fully meet the loan request of $100 million, it must find the open market, selling investment securities under a security
another $50 million from nondeposit sources. Some quick repurchase agreement, and borrowing Eurocurrencies from
work by the lender’s money market division, which contacted branch offices abroad.
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 Third, financial firms have gotten much better at managing
that nondeposit borrowings are most often short term rather interest rate risk than used to be the case. As we saw in Parts
than long term. Why would the liability manager rely so heav- Two and Three, they now have a lot of risk-management tools
ily upon short-term debt, especially overnight loans? Hasn’t to work with.
she heard about interest rate risk and the danger that the Moreover, many assets institutions hold are also short term,
lender may be forced to borrow short term over and over including some overnight and intraday loans. Financial-
again at higher and higher interest rates to fund a loan? service managers have learned to keep a rough balance
1
Yes, but there are good reasons for “going short” in most
liabilities in order to protect against liquidity crises. Finally,
Fina ly,
5
tomer likely is standing there waiting for his loan. Today there
66 Ce
may not be enough time to find and negotiate long-term market interest rates, perhaps this liability manager err is in a
age
65 ks
term deposits may soon roll in. row’s borrowing costs should be lower than n today’s
oday’s costs.
tto
-9 a
market as a key source of short-term money to meet both loan down. Financial firms in need of immediate funds can negotiate
560
demand and unexpected cash emergencies. a loan with a holder of surplus interbank deposits or reserves
ves at
a
66
98 er
1- nt
20
66 Ce
the Fed, promising to return the borrowed funds the next xt day
ex day if
Table 13.3 shows the relationship between the size of banks
65 ks
need be.
06 oo
smallest-size banks (each under $100 million in assets) sup- The main use of the Fed funds market today is stilltill the
the tradi-
tr
-9 ali
58 ak
port only a small share (about 4 percent) of their assets by tional one: a mechanism that allows depository
ory institutions
in
nstitu short
11 ah
41 M
nondeposit borrowings. Among the largest institutions (over of reserves to meet their legal reserve requirements
re men or to satisfy
emen
$1 billion in assets), however, nondeposit borrowings covered loan demand by tapping immediately usable ble funds
fu from other
20
99
250 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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.
1
60
The largest U.S. commercial banks By performing all of these functions, the Fed funds market k effi-
rke
5
The smallest U.S. commercial areas of greatest need. To help suppliers and demanders
ema
ma nders of Fed
an
and
65 ks
banks (under $100 million in funds find each other, funds brokers soon appeared red to trade
peare
06 oo
82 B
Note: Thrift institutions include savings and loan associations and sav- banks, play a role similar to that of funds
ds brokers
brroker for smaller
11 ah
41 M
ings banks insured by the Federal Deposit Insurance Corporation. depository institutions in their region. An
An accommodating
acc bank
Source: Federal Deposit Insurance Corporation. buys and sells Fed funds simultaneouslyusly in
i order to make a
20
99
the lender until the loan is repaid. Term loans are longer-term
1- nt
20
66 Ce
2
are automatically renewed each day unless either borrower As a result of losses on RPs associated with the collapse
pse of
o tw
two gov-
-9 ali
58 ak
or lender decides to end this agreement. Most continuing ernment securities dealers in 1985, Congress passed ed
d the
e Gov
Government
11 ah
ernmment securities to
Securities Act, which requires dealers in U.S. government
41 M
contracts are made between smaller respondent institutions report their activities and requires borrowers and lende
ende to put their RP
lenders
and their larger correspondents, with the correspondent ocatio of collateral.
contracts in writing, specifying the nature and location
20
99
252 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
+ 100
56
deposit
66
98 er
1- nt
20
66 Ce
65 ks
leadership of the Bank of New York, JP Morgan Chase, and the nstrumment until
lender taking possession of those particular instruments
06 oo
82 B
Fixed Income Clearing Corporation (FICC). What is a GCF RP? the loan matures. In contrast, the general-collateral
colla
ollaatteral GCF RP
-9 a
58 ak
How does it differ from the traditional RP? has been used for low-cost collateral substitution.
utio Borrower
bstittution
11 ah
collateral might include, for example, any obligation of the Trea- during daylight hours in deciding what to do with collateral
560
66
sury or a federal agency. Thus, the same securities pledged at securities. GCF RPs can make more efficient use of collateral,ral,
al,
98 er
1- nt
20
66 Ce
the beginning do not have to be delivered at the end of a loan. lower transactions cost, and help make the RP market somewhat
so
ome
me ewhat
what
65 ks
and brokers so that less money and securities must be trans- Overall, however, the RP market has contracted
ted somewhat
some
s
11 ah
41 M
ferred. Finally, GCF RPs can be reversed early in the morning recently, especially during the 2007–2009 credit
dit crisis,
red
edit cr due to
and settled late each day, giving borrowers greater flexibility concern over the quality and market value
e of securities
sse being
20
99
254 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
pledged as collateral for these loans. Moreover, one of the fac- institutions operating in the United States may be eligible for
tors that contributed significantly to the well-publicized troubles loans granted by the Federal Reserve Bank in their particular
of Bear Stearns and Lehman Brothers, leading investment banks, region. The Fed will make the loan through its discount window
was their inability to find adequate support from the RP market. 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.)
Borrowing from Federal Reserve Banks
Each loan made by the Federal Reserve banks must be backed
For a depository institution with immediate reserve needs, a via- by collateral acceptable to the Fed. Most depository institutions
ble alternative to Fed funds and RPs is negotiating a loan from a keep U.S. government securities in the vaults of the Federal
central bank for a short period of time. For example, depository Reserve banks for this purpose. The Fed will also accept certain
Table 13.6 Borrowing Reserves from the Federal Reserve Bank in the District
Liabilities Liabilities
66 Ce
the Federal
41 M
in supporting a troubled depository institution with loans. Gen- ing to supplement deposit growth was given a significant
5
66
98 er
erally speaking, undercapitalized institutions cannot be granted boost early in the 1960s with the development of a new kind
1- nt
20
66 Ce
discount window loans for more than 60 days in each 120-day of deposit, the negotiable CD. This funding source is reallyreaally
llly a
65 k
06 oo
period. Long-term Fed support is only permissible if the borrow- hybrid account: legally, it is a deposit, but, in practical
cal terms,
terms
t
82 B
ing institution is a “viable entity.” If the Fed exceeds these limi- the negotiable CD is just another form of IOU issued
ssuedd to tap
t tem-
-9 ali
58 ak
tations, it can be held liable to the FDIC for any losses incurred porary surplus funds held by large corporations,ons, wealthy
wea
weal
w indi-
11 ah
41 M
by the insurance fund should the troubled institution ultimately viduals, and governments. A CD is an interest-bearing
t
t-bea receipt
fail. Overall, the Fed’s discount window is not a particularly evidencing the deposit of funds in the accepting
ceptin depository
20
99
256 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
The Fed’s Term Auction and Securities Lending the Treasury securities it holds in exchange for the dealers’
Facilities as Sources of Medium-Term Credit triple-A–rated securities for a period of up to 28 days. This
move seemed to help stabilize markets the Fed had targeted,
The turmoil in the financial marketplace during 2007–2009 at least for a time. Later in 2011 the Fed supplemented its
gave rise to a “credit crunch” among lending institutions weapons with a policy called “twist”, buying long-term bonds
worldwide. In particular, the demand for loans bearing one- and selling short-term financial instruments to stimulate long-
to six-month maturities—longer than normal Federal funds term investment.
loans, RPs, and discount window loans—soared as financial
managers desperately searched for medium-term money. Actually the Fed has broad power to provide emergency
credit in “unusual” and “exigent” circumstances. For exam-
In December 2007, concerned that its current monetary ple, Section 13, Paragraph 3, of the Federal Reserve Act
policy tools were not adequate to provide liquidity to sup- allows the Fed to lend money to “any individual, partner-
port the collapsing subprime mortgage market, the Federal ship, or corporation” on the affirmative vote of at least five
Reserve System launched a new source of temporary credit members of the Federal Reserve Board. The Fed first made a
known as the Term Auction Facility (TAF). The Fed began substantial volume of these Section 13 loans to nonbank enti-
announcing how much it would be willing to loan deposi- ties during the Great Depression of the 1930s and continued
tory institutions for 28-day periods at interest rates below its to do so for almost 20 years, especially during World War II
conventional discount rate. The Fed set up an auction system to increase production. Most recently in 2008 the New York
for these medium-term loans very much like the way Treasury Fed loaned $29 billion to help support the buyout of trou-
bills are sold, using a single-price auction with sealed bids. bled security dealer Bear Stearns by JP Morgan Chase.
Auctions of 28-day loans were held biweekly as 2008 began.
Some authorities in the field have suggested that the Fed’s
Then in March 2008, with several key financial markets new credit facilities should be retained in the central bank’s
(including mortgages, auto loans, credit card receivables, and arsenal of policy weapons, giving the Fed new tools to deal
student loans) imperiled by a deepening shortage of liquid- with liquidity crises and avoid direct pressure on key inter-
ity, the Fed set up a Term Securities Lending Facility (TSLF) est rates. Other experts, however, have contended that the
to put a floor of liquidity under these troubled markets. Pri- Fed’s recent, unprecedented actions have simply gone too
mary security dealers (who work regularly with the Federal far, encouraging inflation and failing to invoke the discipline
Reserve) were invited to borrow from the Fed, pledging as of the marketplace on those individuals and institutions who
collateral qualified triple-A–rated securities backed by home were, in effect, gambling in the housing and credit markets
mortgages, student loans, and auto and credit card loans. and threatening the stability of the entire financial system.
For its part the Fed promised to temporarily swap some of
institution for a specified time period at a specified interest rate enough—generally sold in multiples of $1 million—to appeal to
or specified formula for calculating the interest rate. major corporations. Negotiable CDs would be confined to short
maturities, ranging from seven days to one or two years in most
There are four main types of negotiable CDs today. Domestic
cases, but concentrated mainly in the one- to six-month maturity
CDs are issued by U.S. institutions inside the territory of the
range for the convenience of CD buyers. And the new instrument
United States. Dollar-denominated CDs issued by banks outside
would be negotiable—able to be sold in the secondary market
the United States are known as EuroCDs. The largest foreign
any number of times before reaching maturity—in order to pro-
banks active in the United States (such as Deutsche Bank and
vide corporate customers with liquidity. To make the sale of nego-
HSBC) sell CDs through their U.S. branches, called Yankee CDs.
tiable CDs in advance of their maturity easier, they were issued in
Finally, nonbank savings institutions sell thrift CDs.
bearer form. Moreover, several dealers agreed to make a regular
During the 1960s, faced with slow growth in checkbook depos- market in negotiable CDs carrying maturities of six months or less.
ess.
1
60
designed this marketable deposit to compete for funds with Interest rates on fixed-rate CDs, which represent
repr
repre the major-
other well-known money market instruments. It was made large ity of all large negotiable CDs issued,
d, are quoted on an
20
99
Eurodollars are dollar-denominated deposits placed in bank In general, whenever a deposit is accepted by a bank
ank denom
d
denominated
enom
-9
rrenccy, th
in the units of a currency other than the home currency, that deposit is
58
offices outside the United States. Because they are denomi- curren
urren market began
known as a Eurocurrency deposit. While the Eurocurrency
11
orldwi today.
in Europe (hence the prefix Euro), it reaches worldwide
20
99
258 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 -100 correspondent
other foreign bank -100
banks + 100 bank +100
(Eurodollars
Deposits of U.S. Eurodollar loan
borrowed)
correspondent to U.S. bank +100
bank doing
the borrowing + 100
(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 +100 correspondent
other foreign bank +100
banks -100 bank -100
(Eurodollars
Deposits of U.S. Eurodollar loan
borrowed)
correspondent to U.S. bank -100
bank doing
the borrowing -100
(Eurodollars
borrowed)
Major banks and their large corporate customers practice arbi- generally sold at a discount from face value through security
trage between the Euro and American CD markets. For example, dealers or through direct contact with the issuing company.
if domestic CD rates were to drop significantly below Euro interest
A substantial portion of this paper—often called industrial
rates on deposits of comparable maturity, a bank or its corporate
paper—is designed to finance the purchase of inventories of
customers could borrow in the domestic CD market and lend those
goods or raw materials and to meet other immediate cash
funds offshore in the Euromarket. Similarly, an interest rate spread in
needs of nonfinancial companies. Another form of commercial
the opposite direction might well lead to increased Euroborrowings
paper—usually called finance paper—is issued mainly by finance
with the proceeds flowing into CD markets inside the United States.
companies (such as GE Capital Corporation) and the affiliates
of financial holding companies (such as HSBC Finance Corpo-
1
60
During the 1960s and 1990s large banks and finance companies ition
tio
ona
same organization, giving these institutions additional al funds
fun to
65 ks
06 oo
faced with intense demand for loans found a new source of make new loans. Table 13.8 summarizes the process
proce ess of
o indirect
82 B
loanable funds—the commercial paper market. Commercial borrowing through commercial paper issued ed by
ued b affiliated
aff firms.
-9 ali
58 ak
paper consists of short-term notes, with maturities normally This funds source tends to be high in volume
volum
olumme and
an moderate in
11 ah
41 M
ranging from three or four days to nine months, issued by cost but also volatile in available capacity
ty and
cit
ity an subject to credit
well-known companies to raise working capital. The notes are risk. Recently foreign banks, such as Barclays
Barc Capital, have
20
99
Step 2. The Affiliated Corporation Purchases Loans from Lenders That Are Part of the Same Organization
Lending Institution Affiliated Corporation
Liabilities Liabilities
Assets and Net Worth Assets and Net Worth
Loans -100 Cash account -100
Reserves +100 Loans
purchased
from lending
institution +100
accelerated their mining of both European and American paper Also, because most assets and liabilities held by depository insti-
markets despite the pressures of the Great Recession. 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
Long-Term Nondeposit Funds Sources
to larger financial firms in recent years.
The nondeposit sources of funds discussed to this point are
Because of the long-term nature of these funding sources,
mainly short-term borrowings. The loans involved usually range
they tend to be a sensitive barometer of the perceived risk
from hours to days, occasionally stretching into weeks or months.
exposure (particularly the risk of default) of their issuing insti-
However, many financial firms also tap longer-term nondeposit
tutions. In 1990, for example, when there were fears of major
funds stretching well beyond one year. Examples include mort-
bank defaults, the capital notes of troubled Southeast Banking
gages issued to fund the construction of buildings and capital
Corp. and the Bank of Boston carried annual yields of close to
notes and debentures, which usually range from 5 to 12 years in
20 percent, while notes issued by the Bank of New England
maturity and are used to supplement equity (owners’) capital.
were trading at a discount equal to only about one-fifth of their
These longer-term nondeposit funds sources have remained face value. By 2010 nearly $150 billion in capital notes and
relatively modest over the years due to regulatory restrictions debentures (subordinated to the claims of depositors) had been
and the augmented risks associated with long-term borrowing. issued by U.S. insured depository institutions.
CONCEPT CHECK
13.9. What are the advantages of borrowing from the Fed- 13.11. Posner State Bank borrows $10 million in primary
1
eral Reserve banks or other central banks? Are there credit from the Federal Reserve Bank of Cleveland.
60
5
66
any disadvantages? What is the difference between Can you show the correct entries for granting and
98 er
1- nt
20
66 Ce
Lombard rate, and why might such a rate be useful in 13.12. Which institutions are allowed to borrow from
om the
th
he
06 oo
82 B
13.10. How is a discount window loan from the Federal popular for many institutions?
11 ah
41 M
Reserve secured? Is collateral really necessary for 13.13. Why were negotiable CDs developed?
d?
these kinds of loans?
20
99
260 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
13.4 CHOOSING AMONG information gathered from frequent contacts between the finan-
cial firm’s officers and both existing and potential customers.
ALTERNATIVE NONDEPOSIT
The second decision that must be made is how much in deposits
SOURCES
and other available funds is likely to be attracted in order to finance
With so many different nondeposit funds sources to draw upon, the desired volume of loans and security investments. Projections
managers of financial firms must make choices among them. In must be made of customer deposits and withdrawals, with special
using nondeposit funds, funds managers must answer the fol- attention to the largest customers. Deposit projections must take
lowing key questions: into account current and future economic conditions, interest rates,
and the cash flow requirements of the largest customers.
1. How much in total must be borrowed from these sources to
meet funding needs? The difference between current and projected outflows and
inflows of funds yields an estimate of each institution’s available
2. Which nondeposit sources are best, given the borrowing
funds gap. Thus,
institution’s goals, at any moment in time?
Available funds = Current and projected loans and
gap (AFG) investments the lending institution
Measuring a Financial Firm’s Total Need
desires to make - Current and (13.3)
for Nondeposit Funds: The Available expected deposit inflows and other
Funds Gap available funds
The demand for nondeposit funds is determined basically by the For example, suppose a commercial bank has new loan requests
size of the gap between the institution’s total credit demands that meet its quality standards of $150 million; it wishes to pur-
and its deposits and other available monies. Managers respon- chase $75 million in new Treasury securities being issued this
sible for the asset side of the institution’s balance sheet must week and expects drawings on credit lines from its best corpo-
1
60
choose which of a wide variety of customer credit requests they rate customers of $135 million. Deposits and other customer
too er
5
66
98 er
will meet by adding direct loans and investment securities to funds received today total $185 million, and those expec
expected
xpeccted in
1- nt
20
66 Ce
the institution’s asset portfolio. Management must be prepared the coming week will bring in another $100 million.on.
n TThis bank’s
b
65 ks
to meet, not only today’s credit requests, but all those it can estimated available funds gap (AFG) for the comin
coming week will be
ng w
06 oo
82 B
reasonably anticipate in the future. This means that projections as follows (in millions of dollars):
-9 ali
58 ak
4. The size of the institution that requires more funds. Although low compared to most other borrowing rates, the
effective Fed funds rate prevailing in the marketplace tends
5. Regulations limiting the use of alternative funds sources.
to be volatile, fluctuating around the central bank’s target
(intended) Fed funds rate. The key advantage of Fed funds is
Relative Costs their ready availability through a simple phone call or online
Managers of financial institutions practicing liability manage- computer request. Moreover, their maturities often are flex-
ment must constantly be aware of the going market interest ible and may be as short as a few hours or last as long as
rates attached to different sources of borrowed funds. Major several months. The key disadvantage of Fed funds is their
lenders post daily interest rates at which they are willing to com- volatile market interest rate—its often wide fluctuations (espe-
mit funds to other financial firms in need of additional reserves. cially during the settlement day that depository institutions
In general, managers would prefer to borrow from the cheapest are trying to meet their legal reserve requirements) that make
sources of funds, although other factors do play a role. planning difficult.
Table 13.9 Money Market Interest Rates Attached to Nondeposit Borrowings and Large ($100,000 +) CDs
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 1.68 1.41 3.27 5.07 0.20
(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
1
60
Selling Eurodollar deposits 4.80 5.38 5.44 6.45 1.39 1.55 3.51 5.32 0.39
66 Ce
(3-month maturities)
65 ks
06 oo
**Posted by the Federal Reserve banks. Beginning in 2003 the quoted discount rate on loans from the Federal Reserve banks is the primary
mary credit
e prim
58 ak
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
ge around
ound 50 basis
e aro
11 ah
41 M
262 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 = 0.0651 or 6.51 percent
borrowed to access these funds $24 million
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 *
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
1
= *
60
access funds staff time, facilities, borrowed Effective CD (0.07 * $25 million + $0.0075 * $25
5 million)
25 illion
llion
5
=
66
98 er
(13.6)
66 Ce
=
06 oo
Net investable funds requirements (if any), deposit insurance = 0.0807 or 8.07 percent
58 ak
=
11 ah
Then the average interest cost of deposits and money market borrowings is:
65 ks
06 oo
82 B
Weighted
-9 ali
expense
20
99
264 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 12 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
12 percent 100
= 10 percent + * = 10 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 $100 million in the institution.
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
01
(Continued )
20
99
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,
most types of deposits, but they are clearly not as stable a fund- would be inclined to borrow in the Fed funds market. However,
ing source for most institutions as time and savings deposits. 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 Risk Factor the funds need plays a key role as well.
The managers of financial institutions must consider at least
two types of risk when selecting among different nondeposit The Size of the Borrowing Institution
sources. The first is interest rate risk—the volatility of credit
The standard trading unit for most money market loans is
costs. All the interest rates shown in Table 13.9, except most
$1 million—a denomination that may exceed the borrowing
central banks’ discount rates, are determined by demand and
requirements of the smallest financial institutions. For example,
supply forces in the open market and therefore are subject to
Eurodollar borrowings are in multiples of $1 million and usually
erratic fluctuations. The shorter the term of the loan, the more
are available only to money-center financial firms with the high-
volatile the prevailing market interest rate tends to be. Thus,
est credit ratings. Large negotiable CDs from the largest deposi-
most Fed funds loans are overnight and, not surprisingly, this
tory institutions are preferred by most investors because there is
market interest rate tends to be the most volatile of all.
an active secondary market for prime-rated CDs. Smaller depos-
Management must also consider credit availability risk. There itory institutions may not have the credit standing to be able to
is no guarantee in any credit market that lenders will be willing sell the largest negotiable CDs. The same is true of commercial
and able to accommodate every borrower. When general credit paper. In contrast, the central bank’s discount window and the
conditions are tight, lenders may have limited funds to loan and Fed funds market can make relatively small denomination loans
may ration credit, confining loans only to their soundest and that are suitable for smaller depository institutions.
most loyal customers. Sometimes a financial firm may appear so
risky to money market lenders they will deny credit or make the Regulations
price so high that its earnings will suffer. Experience has shown
Federal and state regulations may limit the amount, frequency,
1
and use of borrowed funds. For example, in the United States CDs C
CD
5
66
credit and, if necessary, pay more for any funds they receive.
06 oo
As we have seen, some funds sources may be difficult to access example, during the late 1960s and early 1970s, 0ss, when
0s, wh the Fed-
immediately (such as commercial paper and long-term debt eral Reserve was attempting to fight inflationon with
wit tight-money
wi
20
capital). A manager in need of loanable funds this afternoon policies, it imposed legal reserve requirements
men for a time on Fed
99
266 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
sheet and to use market interest rates as the control lever. are loaned by one financial institution to another.
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KEY TERMS
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customer relationship doctrine, 248 discount window, 255 available funds gap,, 261
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7. Wells Fargo Bank borrowed $150 million in Fed funds from sources of funds for Best-of-Times and makeake a manage-
ma
11 ah
JP Morgan Chase Bank in New York City for 24 hours to ment decision on what sources to use. Be e prepared
prep
pre to
41 M
fund a 30-day loan. The prevailing Fed funds rate on loans defend your decision.
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268 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
10. Surfs-Up Security Savings is considering the problem of try- 0.25 percent in noninterest costs. Management estimates
ing to raise $80 million in money market funds to cover a the cost of stockholders’ equity capital at 12 percent before
loan request from one of its largest corporate customers, taxes. (The bank is currently in the 35-percent corporate tax
which needs a six-week loan. Assume that market interest bracket.) When reserve requirements are added in, along
rates are at the levels indicated below: with uncollected dollar balances, these factors are estimated
to contribute another 0.75 percent to the cost of securing
Federal funds, average for week just concluded 1.98% checkable deposits and 0.50 percent to, the cost of acquir-
ing time and savings deposits. Reserve requirements (on
Discount window of the Federal Reserve Bank 2.25
CDs (prime rated, secondary market): Eurodeposits only) and collection delays add an estimated
0.25 percent to the cost of the money market borrowings.
One month 2.52
a. Calculate June Bug’s weighted average interest cost on
Three months 2.80
total funds raised, figured on a before-tax basis.
Six months 3.18 b. If the bank’s earning assets total $700 million, what is its
Eurodollar deposits (three months) 3.00 break-even cost rate?
c. What is June Bug’s overall historical weighted average
Commercial paper (directly placed):
cost of capital?
One month 2.33
12. Inspiration Savings Association is considering funding a
Three months 2.70 package of new loans in the amount of $400 million. Inspi-
ration has projected that it must raise $450 million in order
Unfortunately, Surfs-Up’s economics department is forecast-
to have $400 million available to make new loans. It expects
ing a substantial rise in money market interest rates over the
to raise $325 million of the total by selling time deposits at
next six weeks. What would you recommend to its funds
an average interest rate of 1.75 percent. Noninterest costs
management department regarding how and where to raise
from selling time deposits will add an estimated 0.45 per-
the money needed? Be sure to consider such cost factors as
cent in operating expenses. Inspiration expects another
legal reserve requirements, regulations, and what happens to
$125 million to come from noninterest-bearing transac-
the relative attractiveness of each funding source if interest
tion deposits, whose noninterest costs are expected to be
rates rise continually over the period of the proposed loan.
2.00 percent of the total amount of these deposits. What
Alternative scenario: is the Association’s projected pooled-funds marginal cost?
What if Surfs-Up’s economists are wrong and money mar- What hurdle rate must it achieve on its earning assets?
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 Internet Exercises
needed? 1. In terms of size, which banks in the U.S. financial system
11. June Bug Bank and Trust has received $750 million in total seem to rely most heavily on deposits as a source of fund-
funding, consisting of $200 million in checkable deposit ing and which on nondeposit borrowings and liability man-
accounts, $400 million in time and savings deposits, agement? To provide an example for the numbers reported
$100 million in money market borrowings, and $50 million in Table 13.3, go to the FDIC’s Institution Directory at
in stockholders’ equity. Interest costs on time and savings http://www2.fdic.gov/idasp/ and search by city and state
1
costs of raising these particular deposits equal approxi- hometown or somewhere you enjoy visiting. Write te down
rite d
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mately 0.50 percent of their dollar volume. Interest costs the BHC ID of your selected bank. Then go to o www2
wwww2
65 ks
on checkable deposits average only 0.75 percent because .fdic.gov/sdi/ to compare your small BHC C with h two larger
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many of these deposits pay no interest, but noninterest BHCs—Bank of America (BHC ID 1073757) 375
75
577)) and JP Morgan
-9 a
58 ak
costs of raising checkable accounts are about 2 percent Chase (BHC ID 1039502). Compare e andd contrast
con Deposits/
11 ah
of their dollar total Money market borrowings cost June Total Assets and Liabilities/Total Assets
Asssets for
f the three BHCs
41 M
Bug an average of 2.75 percent in interest costs and to illustrate your point.
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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?
1
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270 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Part Two: Analyzing the Data for Interpretation B. Once you have looked at the big picture using the
aggregated measure of volatile liabilities to total assets,
A. Volatile liabilities include large-denomination time depos-
observe the comparative and trend differences of its
its, foreign-office deposits, Federal funds purchased,
components, especially FHLB advances, Federal funds
securities sold under agreements to repurchase, and
purchased, and securities sold under agreements to
other borrowings. These are the risk-sensitive sources
repurchase as a proportion of total assets,
used in liability management You can compare the col-
umns of row 131 to get a sense of the proper answers C. Write one or two paragraphs discussing your BHC’s use
to the following questions; (1) Is your BHC increasing its of liability management from year to year and in com-
reliance on liability management? (2) Is your bank using parison to its contemporaries.
liability management more than its peers?
Selected References
For a fuller explanation of recent developments in nondeposit 4. Rose, Peter S. “The Quest for New Funds: New Dimensions
funding see: in a New Market,” The Canadian Banker, vol. 94, no. 5
(September/October 1987), pp. 436–455.
1. Fleming, Michael J.; and Kenneth D. Garbade. “The Repur-
chase Agreement Refined—The GCF Repo,” Current Issues 5. Stevens, Ed. “The New Discount Window,” Economic
in Economics and Finance, Federal Reserve Bank of New Commentary, Federal Reserve Bank of Cleveland, May 15,
York, vol. 9, No. 6 (June 2003), pp. 1–7. 2003, pp. 1–4.
2. Fleming, Michael J.; and Kenneth D. Garbade. “Repurchase To examine the Federal Reserve System’s recent addition to its
Agreements with Negative Interest Rates,” Current Issues sources of borrowed funds for troubled depository institutions
in Economics and Finance, Federal Reserve Bank of New in need—the TAF or Term Auction Facility—see especially the
York, vol. 10, no. 5 (April 2004), pp. 1–7. parallel auction procedure recently used for Treasury bills:
3. Maloney, Daniel K.; and James B. Thomson. “The Evolv- 6. Rose, Peter S.; and Milton H. Marquis. Financial Institutions
ing Role of the Federal Home Loan Banks in Mortgage and Markets, E-book, 11th edition, New York: McGraw-Hill/
Markets,” Economic Commentary, Federal Reserve Bank of Irwin, 2011, Chapters 10–13.
Cleveland, June 2003, pp. 1–4.
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Repurchase
Agreements
14
and Financing
■ 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.
Excerpt is Chapter 12 of Fixed Income Securities: Tools for Today’s Markets, Third Edition, by Bruce Tuckman
man and
a Angel Serrat.
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273
months later, for settlement on August 31, 2010, at a purchase in the position of counterparty B, lending money while taking g
5
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rate of .23%. Using the actual/360 convention of most money est and returning the collateral. Holding collateral makes
kes the
th
65 ks
06 oo
market instruments, and noting that there are 92 days between lender less vulnerable to the creditworthiness of a counterparty
counnterp
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May 31, 2010, and August 31, 2010, the repurchase price is
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274 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
€106 million against the €111.772 million of securities and, of When the bunds are ultimately sold to some buyer, r, the
e desk
des
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the repo, using the proceeds from the sale of the e bunds
bun to
bu
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1
In risk management parlance, however, this is called a right-way risk. repay the repo loan and using the returned ed collateral
collate
ollat to make
-9 ali
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If a repo borrower, typically a well-established financial institution, delivery of those bunds to that buyer. If no o buyer
buy is found
11 ah
fund. Without haircuts the cash amounts shown would be the delivery of a particular bond are called special trades and they
hey
e
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trade depend on the creditworthiness and negotiating power of cussed further later in this chapter.
65 ks
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58
2
Currently, the “Volcker rule” is envisioned as limiting the magnitude of ing because the same trade that is a reverse repo o for tthe borrower of a
41
276 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
tution’s difficulties, the loss of financing is often the killing blow. confidence-sensitive, and could become unavailable e att
ble
5
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The same argument, of course, applies to all leveraged investors, a time of market stress, while secured borrowing based
ng ba
ased
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like part of the hedge fund world. To the extent that a firm bor-
65 ks
06 oo
4
and other secured financing counterparties can result in fire sales, As an operational aside, term repo financing usual
usua
usually
ly inc
includes rights of
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substantial losses, and possible bankruptcy. substitution that enable the borrower of cashh who needs to sell a par-
o nee
11 ah
The risks of repo funding juxtaposed with those of repo investing bonds of comparable value and quality.
5
create tensions between borrowers and lenders of cash as well as Source: http://fcic.gov/hearings/pdfs/2010-0505-Friedman.pdf
/2010
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research-Tri-Party-Repo20100203.pdf
5
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8
This is the reason that overnight repo trades are called that and
d not
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one-day trades.
6
65 ks
he tri
nate this transfer of intraday risk from repo lenders to the tr
ttri-party
i-part repo
imply that Bear Stearns relied on customer cash and customer securities
-9 al
agents.
58 ak
10
businesses of the firm. In the spectrum of financing stability, customer See “Written Statement of Barry Zubrow Before
re th
the
he Fin
Financial Crisis
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278 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
11
Lehman Brothers Holdings Inc., and Official Committee of Unsecured
41 M
Creditors of Lehman Brothers Holdings Inc., against JPMorgan Chase could reasonably provide . . . . Lehman man executives
hm
Bank, N.A. agreed to pledge additional collateral,
llate
llater and . . . did not
20
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after the Fed had hurriedly lowered its target for thehe fed
ed funds
fe fu
82 B
Each day there is a GC rate for each bucket of collateral and wide spreads prevailed in the months after the failure
failur of
fa
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41 M
each repo term. The most commonly cited GC rates are for Lehman Brothers.
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280 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Special rates for a particular issue to a particular date are deter- followed by the old, followed by the double-old, etc. Table 14.1
mined by the demand of borrowing that issue to that date rela- lists the more recent 10- and 30-year U.S. Treasury bonds along
tive to the supply available. This statement is obvious in some with representative overnight repo rates and spreads as of May
ways, but the important point is that the demand and supply 28, 2010. The special spreads equal the GC rate minus the
to borrow and lend issues is not the same as the demand and respective bond repo rates.
supply to buy and sell issues. In fact, because some owners of
Table 14.1 illustrates how the more recently issued bonds at
U.S. Treasuries, for institutional reasons, do not lend bonds in
each maturity trade more special. The table also shows that the
repo markets, the amount of a particular issue available for bor-
OTR 10-year trades more special than the OTR 30-year, a regu-
row might be somewhat less or very much less than the amount
larity that has been true for some time. The discussion now turns
outstanding, depending on the distribution of ownership of
to why special rates are related to the auction cycle.
that issue across various types of institutions. Put another way,
a bond that trades rich relative to neighboring bonds, implies Current issues tend to be the most liquid.12 This means that
a high demand to own that bond relative to the outstanding their bid-ask spreads are particularly low and that trades of large
supply. But the bond may or may not trade very special in repo size can be conducted relatively quickly. This phenomenon is
depending on the extent traders want to short it relative to the partly self-fulfilling. Since everyone expects a recent issue to be
supply available for borrow. Given this reasoning, predicting liquid, investors and traders who require liquidity flock to that
the special spreads of individual bonds is quite difficult. Having issue and thus endow it with the anticipated liquidity. Also, the
said that, there is one predominant explanatory factor for spe- dealer community, which trades as part of its business, tends to
cial spreads in the United States, namely, the auction cycle: the own a lot of a new issue until it seasons and is distributed to
most recently issued bonds of each maturity trade special. This buy-and-hold investors. As a matter of historical interest, the
is the topic of the next subsection. 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
Special Spreads in the United States to that of shorter maturities, in particular of the 10-year.
and the Auction Cycle The extra liquidity of newly issued Treasuries makes them ideal
As mentioned, the U.S. government sells bonds of different candidates not only for long positions but for shorts as well.
maturities according to a fixed schedule. As of this writing, for Most shorts in Treasuries are for relatively brief holding periods:
s:
1
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12
This effect is particularly pronounced in the United States.
tes. In Ge
Ger-
66 Ce
the-run (OTR) or current issue while all other issues are called uture
tures cont
many, the deliverability of a bond into highly liquid futures contracts
65 ks
06 oo
off-the-run (OFR). However, the second most recently issued is the best determinant of liquidity. See “Liquidity Prem mia in German
Premia
82 B
bond of a given maturity does have its own designation as the Government Bonds,” by Jacob W. Ejsing and Jukka ukka
kka Sihvo
S
Sihvonen, European
-9 ali
old issue; the third most recent as the double-old issue; etc. As a
11 ah
general rule, at each maturity, the OTR trades the most special, futures contract deliverability.
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13
Note that data from the aftermath of the Lehman bankruptcy,
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Events at that time will be discussed in the next subsection. to July 2010, Part III.
11 ah
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282 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
(14.2) the special rate were 0% or less, the special rate should never
be less than 0%. Equivalently, the special spread should not
The projected (and realized) 10-year auction schedule as of
exceed the GC rate.14
May 28, 2010, was a re-opening of the current 31⁄2s of May 15,
2020, both in the middle of June and July, to be followed by Figure 14.8 superimposes the Fed’s target rate for fed funds on
the issue of a new OTR in the middle of August 2010. In light the overnight, 10-year special spread. Clearly, over all but the
of the discussion in this subsection and the historical evidence, most recent period, the special spread has been limited by the
the special spread would be expected to increase into these level of rates. The level of rates, therefore, is part of the expla-
auctions. According to the implied forward spreads, the spread nation for the periods of relatively high and relatively low special
is projected to increase into the June re-opening. The 31⁄2s are spreads observed in this figure and in Figures 14.4 through 14.6.
projected to stay special into and somewhat past the July and
In 2009, however, the treatment of fails changed. In October
August auctions as well, but, for the period September 30 to
and November 2008, as part of the reaction to the Lehman
December 31, the forward special spread is only one basis point.
bankruptcy that September, fails to deliver the 10-year OTR
In other words, by the time the then-current 10-year has been
climbed to record levels, $5.311 trillion in the week ending
around for a month, the specialness of the 31⁄2s is projected to
October 22, relative to a pre-crisis average of $165 billion.15
have dissipated.
Regulators were extremely unhappy with the situation as it was
viewed as a threat to the liquidity and efficiency of the U.S. Trea-
Special Spreads in the United States sury market. With their prodding, an industry group called the
Treasury Market Practices Group adopted a penalty rate for fails,
and the Level of Rates
which took effect on May 1, 2009, equal to the greater of 3%
By graphing special spreads rather than special rates, Fig- minus the fed funds target rate or zero. Essentially, when the fed
ures 14.4 through 14.6 hide a factor that has historically limited funds rate is near zero, the penalty is near 3%, i.e., failing to
special spreads. Until very recently, there was no explicit pen- deliver $100 million of a bond costs $100mm * 3%/360 or
alty for a fail, i.e., for failing to deliver a bond that had been $8,333 per day. As the fed funds rate increases, the penalty falls.
sold. This has implied that the special rate could not fall below The logic there is that since higher interest rates are typically
0%. Reason as follows. If a trader had shorted the OTR 10-year
1
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14
This is not strictly true because there are such non-monetary costssts
ts o
of
66
98 er
receive the cash from the sale and, consequently, would lose
1- nt
20
gative
ative
fails as regulatory capital requirements. For a case study on negative
66 Ce
one day of interest on that cash. But what if the trader could epurcchase
epur
OTR 10-year special rates in the second half of 2003, see “Repurchase
65 ks
borrow the bond overnight in the repo market at 0%, i.e., lend
82 B
h/curr
/currrent_
rent_
Number 5, April 2004. www.newyorkfed.orglresearch/current_issues/
58 ak
ics of that borrow to the trader is the same as failing: in both ci10-5/ci10-5.html
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284 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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Liquidity Transfer
Pricing: A Guide
15
to Better Practice
■ 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 transfer
identify best practices for the governance and implemen- pricing (zero cost, average cost, and 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.
1
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Excerpt is Financial Stability Institute Occasional Paper No. 10, by Joel Grant.
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287
overnight) funding.
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In this regard, LTP forms part of the funds transfer pricing (FTP) process.
06 oo
2
This claim is supported by the Basel Committee on Banking Supervi- Many of the systems were unable to attribute the he costs,
osts, bene-
co
-9 ali
58 ak
sion (BCBS), which reported that many of the basic yet fundamental
fits, and risks of liquidity appropriately to respective
spect
pect
ctive businesses,
tive b
11 ah
more information, see Liquidity Risk: Management and Supervisory and at a sufficiently granular level. This resulted
ed in product mis-
te
Challenges, BCBS, (February 2008). pricing, which distorted profit and performance
manc assessments.
mance
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288 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Liquidity
cushion
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 15.1.2 Regulatory Developments
1
3
Bonus pools often neglected other risks, not just liquidity, and the
41 M
cost of capital employed to generate such profits. This is the subject of to liquidity supervision and regulation”.
n””. The
Th group’s initial
another paper. mandate was to review and evaluate te liquidity
liq supervision
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Extant guidance is broad but merely encourages banks to How well an institution is governed can bear heavily on whether
include liquidity risk in their internal pricing mechanisms, with- group-wide objectives are met. While institutions with strong
out providing specific help.5 For example, Principle 4 of the internal controls are more likely to achieve their goals, institu-
BCBS Principles on Sound Liquidity Risk Management and tions with weak internal controls are more prone to the
Supervision states that: “a bank should incorporate liquidity
6
costs, benefits and risks in the internal pricing, performance See Recommendation 2 in Second Part of CEBS’s Technical Advice to
measurement and new product approval process for all signifi- the European Commission on Liquidity Risk Management, September
2008, which is available at http://www.eba.europa.eu/getdoc/bcadd66
cant business activities (both on- and off-balance sheet), 4-d06b-42bb-b6d5-67c8ff48d11d/20081809CEBS_2008_147_(Advice-
thereby aligning the risk-taking incentives of individual busi- on-liquidity_2nd-par.aspx.
ness units with the liquidity risk exposures their activities create 7
Available at http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:
for the bank as a whole” (p 3). L:2009:302:0097:0119:EN:PDF.
8
The Committee of European Banking Supervisors (CEBS) Guidelines on Liquidity Cost Benefit Allocation, CEBS, October
1
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Publications/Standards%20and%20Guidelines/2010/Liquidity%20
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ecte
mission (COSO) defines internal control as “a process, effecteded by an
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erson
rsonnel, d
entity’s board of directors, management and other personnel, designed
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4
These papers can be accessed via http://www.bis.org/list/bcbs/sac_1/
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chievvemen
to provide “reasonable assurance” regarding the achievementemen of
index.htm.
11 ah
pera
ations reliability
objectives in the effectiveness and efficiency of operations,
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5
A complete list of principles and/or recommendations provided by able la
of financial reporting, and compliance with applicable laws and regula-
various regulatory and non-regulatory bodies is included in Appendix 1. tions” (http://www.coso.org/resources.htm).
20
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290 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
10
66 Ce
differently than they would if they were fully exposed to the risk (www
06 oo
.wikipedia.com). For example, a bank might be more inclined to engage considered to be poor practice. On a separate but
te bu related issue,
ut rel
B
in risky behaviour, knowing that it will be bailed out if the risks turn bad. banks with large trading businesses that participated
articcipate in the
partic
82
Adverse selection, on the other hand, is a process whereby bad results survey also applied insufficient haircutss to many
m of the traded
-9
For example, a used car salesman might sell a car, which he knows has assets they held. These banks clearly underestimated
unndere
dere the likeli-
11
includes the application of higher funding charges to trading risks of liquidity to be attributed to appropriate business
1- nt
20
66 Ce
positions that are more likely to become “stale” (ie positions that activities. Many of the pre-2009 LMIS employed by banks nkss that
anks t
65 ks
were included in the survey were too basic, and thiss limited
mited the
lim
82 B
banking book). Banks in this category are also enhancing existing effectiveness and efficiency of the LTP process. In n some
ome cases,
so c
-9 ali
58 ak
risk controls and limits to better manage liquidity risk exposures. for example, the basic and rigid nature of LMISMIS meant
mean
m that
11 ah
41 M
The follow-on effects from these enhancements are improving certain business activities failed to receive a charge
charg for the cost
ch
charg
risk-adjusted profit measures, and this is prompting business of liquidity or, conversely, a credit for the benefit
bene of liquidity.
20
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292 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
15.2.3 Remuneration Practices Recognising these weaknesses, many of the banks that
took part in the survey are developing their respective LTP
If designed well, incentive pay can have enormous benefits. It processes to ensure that profit and performance measures
encourages behaviour that is consistent with the culture of an include the relevant costs for liquidity (and capital, although
institution, and assists management in achieving group-wide this is a separate issue). Under the new regime, assets will
objectives. On the other hand, poorly designed remunera- receive a charge for the cost of liquidity consistent with the
tion can promote perverse behaviours such as excessive risk- positions that are funded. In addition to this, many of the
taking, which could severely impact the performance of an larger banks in the survey are moving towards re-designing
institution.
1
to the GFC. “High short-term profits led to generous bonus cial and risk control should be compensated in a manner
man that
06 oo
82 B
11
Principles for Sound Compensation Practices,
ctice
es,
s, FS
FSB, (April 2009) is
41 M
liquidity risk in off-balance sheet exposures. These banks Reference or “base” rate used
60
were used to manage funding liquidity risk. These are discussed Maturity
in more detail below. Figure 15.2 Zero cost of funds approach
pproa to LTP.
20
99
294 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Table 15.1 Costs and Benefits of Funds Under an Average Cost Approach
5
66
98 e r
1- nt
20
Term in years 1 2 3 4 5
66 Ce
65 ks
However, in much the same way as one “average” rate for Moreover, some institutions ignored maturity mismatch
fund users ignores the heightened liquidity risk in longer-term liquidity risk by not appropriately match-funding originated
assets, having one “average” rate for fund providers ignores the transactions in their funds transfer pricing (FTP) systems on
increased benefits of liquidity in longer-term liabilities. That is, a cash-flow basis. When combined with average costs of
Table 15.2 Costs and Benefits of Funds Under a Separate Average Cost Approach
1
60
Term in years 1 2 3 4 5
5
66
98 er
1- nt
20
296 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
transaction at par. This is the term liquidity premium. Itt reflects reflects
66
98 er
tive for them to comply. Third, under this approach, the LTP
is considered to be a much better measure of the he ccost o of liquid-
65 ks
If the same loan was originated more recently it would have ve been
bee
een
1- nt
20
As the name implies, non-amortising bullet loans provide no lights one of the major weaknesses of the average cost ost of
o funds
fun
82 B
repayments (cash flows) throughout the life of the loan. Since chang
hangges in the
method, viz., its inability to immediately reflect changes
-9 ali
58 ak
all principal and interest is repaid at maturity, a funding com- actual market cost of funds. For banks in the survey
surveey employing
em
11 ah
41 M
mitment is required for the entire life (term) of the loan. Hence, this approach, it would have encouraged businessin
ness
ess units
u to write
using a matched-maturity marginal cost of funds approach, long-term loans at the expense of short-term rm deposits.
de
20
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298 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 20 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
15.3.6.2 Amortising Loans 25 or 30 years at origination, but their actual maturity will vary
Unlike non-amortising bullet loans, amortising loans do provide depending on factors such as repayment frequency and repay-
repayments (cash flows) throughout the life of the loan. Since a ment amount.
portion of principal (and interest) is repaid prior to maturity, a The uncertainty surrounding future cash flows makes it more
funding commitment is not normally required for the entire life difficult to calculate an appropriate charge for the commit-
(term) of the loan. This is because, at some point between origi- ment of funds required to service these types of loans. For
nation and maturity, the loan becomes self-funding. example, a simple tenor-weighted (blended) term liquidity
Consider the simplest loan type in this category, a five-year premium cannot be derived because of the unknown timing
linearly amortising bullet loan with a principal amount of of future cash flows.
$1 million. If you think of this as five separate annual loans, Consider a standard $500,000 variable rate mortgage, with
each of $200,000, using a matched-maturity marginal cost of a contractual term of 25 years. Attributing a 25-year term
funds approach, this loan (assuming it was originated pre-crisis) liquidity premium essentially overcharges the loan for the
should have received a charge of: 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.13 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
the entire portfolio, instead of to each individual transaction..
1
60
Another method used by banks to calculate the charge for the use
06 oo
calculating an IRR using the rates depicted from the swap curve, and an
(15.1)
82
IRR using the rates depicted from the marginal cost of funds curve. The
-9
difference between the resulting rates is the rate used to charge busi-
58
ness units for the use of funds. For more detail, and an example of this where Pi = principal amount in distribution
buttion i, P = amount of
11
more often withdrawn (hot or volatile part). Making this his dis-
d -
dis
65 ks
06 oo
14
The WAL is not the time it takes to repay 50 per cent of the loan. tinction is important, because if a bank were to simplymplyy apply
app
82 B
That would be a median calculation. The WAL is an average. Only in the a matched-maturity marginal cost of funding approach,
ppro oach, all
-9 ali
58 ak
special case of when the interest rate on the loan is zero, will 50 per cent
demand deposits would only receive a credit ditit based
baased on the
11 ah
be repaid at the WAL. As the interest rate increases from zero, less than
41 M
50 per cent of the loan will be paid at the WAL. This is because most of overnight term liquidity premium. Given this iss is likely
lik to be very
the initial repayments comprise interest and not principal. close to zero, which translates to a cheapp funding
fund source for
20
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300 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
15.3.7 Summary level the transaction, product, or business unit for the costs of
covering this outcome.
Failing to price liquidity is unacceptably poor LTP practice for a
Banks carry a liquidity cushion, a “buffer” of highly liquid assets
bank, and supervisors should not tolerate this failing.
or, alternatively, stand-by liquidity to help them survive periods
The average cost approach to LTP is simple, but has two major of unexpected funding outflows. A graphical illustration of this
defects. First, it neglects the varying maturity of assets and is depicted in Figure 15.8.
liabilities by applying a single charge for the use and benefit of
In December 2010, the BCBS published two global standards for
funds and, second, it lags changes in banks’ actual market cost
liquidity risk. First, a Liquidity Coverage Ratio (LCR) to ensure
of funding. These defects essentially promote maturity trans-
banks have sufficient high quality liquid assets to meet their daily
formation, which inherently exposes banks to more structural
net cumulative cash outflows during an idiosyncratic shock, for a
(mismatch/funding) liquidity risk.
period of one calendar month. Second, a net stable funding ratio
Overall, a matched-maturity marginal cost of funds approach (NSFR) aimed at reducing banks structural liquidity risk by
promotes better LTP practice. It is more complex than the encouraging the use of longer-term funding of assets and other
pooled average cost of funds approach, but it has some sig- business activities.15 The move to make banks more self-suffi-
nificant advantages. First, it recognises that the costs and cient and stable over a longer period is in part to reduce the
benefits of liquidity are related to the maturities of assets and burden of central banks having to act as the lender-of-last-resort,
liabilities, and therefore allows higher rates to be assigned to and the potential implications of moral hazard as a result of
products that use or provide liquidity for longer periods of these actions.
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 15.4.1 Liquidity Cushions: A Principle
funds, and therefore relies on the actual market cost of funds. of Liquidity Risk Management
Banks should be encouraged to move towards this approach,
if they are not already doing so. 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
15.4 LTP IN PRACTICE: MANAGING also reinforced by Principle 12, which states that “a bank
CONTINGENT LIQUIDITY RISK should maintain a cushion of unencumbered, high quality liquid
assets to be held as insurance against a range of liquidity stress
tress
1
60
straightforward. However, the same cannot be said about There should be no legal, regulatory or operational
tiona
ionaal impedi-
imp
65 ks
06 oo
contingent commitments such as lines of credit, collateral ment to using these assets to obtain funding”g” (p
ng ( 4).
82 B
funding scenarios only. Having little or no regard for prolonged be attributed back to businesses via the LTP process. While this
5
66
98 er
sized to protect the banks from larger-scale unexpected (contin- survey, generally through incorporating a liquidity premium
emiu um in
65 ks
06 oo
gent) outflows. On a separate but related issue, one of the flaws the LTP process, most simply averaged the cost across
crrosss all a
cro assets
82 B
historical data. This meant that events that had not previously 16
The survey identified that this is the typical method
hod b
banks use to cal-
occurred were neglected. culate the cost of carry.
20
99
302 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Liabilities and
60
contingent almost immediately and always. But the recent market rk tur-
arke
5
Asset
66
98 er
All assets receive an Both, liabilities and contingent applying higher funding charges to assetss held ld as part of
hel
he
eld
82 B
recoup the cost of carry charge via LTP for the cost of
58 ak
Figure 15.9 Recouping the cost of carrying a liquidity charges applied depend on banks’ assumptions surrounding
s’ a
assum
cushion via LTP. the length and severity of potential
ntial market
m disruptions. If,
20
99
significant funding included: credit card loans and investments, FSI Occasional Paper No 10
trading positions and derivatives, revolving lines of credit, and Figure 15.10 Toward better management of
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
1
draw on the remaining credit and that the cost of term fund- nd--
nd
66
98 er
1- nt
20
a line of credit with a limit of $10 million has $4 million already ing assets in the liquidity cushion is 18 bps (depicted fromom
66 Ce
derived as: charged for the cost of contingent liquidity risk should
sho uld be
ou b
82 B
-9 al
equal to:
58 ak
11 ah
41 M
20
99
304 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
granular level.
60
• Profit pools, which were used to determine bonuses to that present significantly greater amounts of fundinging liquidity
ding lliquid
1- nt
20
66 Ce
employees, were derived from unadjusted revenues, without risk. Finally, banks should have in place limits and
an
ndd adequate
adeq
a
65 ks
any regard to the risks (liquidity and capital) taken to gener- controls to curb over-trading behaviour.
06 oo
82 B
• Probably the most striking example of poor practice was that dent risk and financial control personnel.
onnell. Senior
Sen management
11 ah
41 M
some banks applied a zero charge for the cost of funding should also be involved in the LTP process.
prroces
prooces Meetings should
liquidity based on the premise that liquidity was a free good. be held regularly, and include various
rious stakeholders such as
20
99
1
560
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
99
306 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Basel Committee on Banking “A bank should incorporate liquidity costs, benefits and risks in the internal pric-
Supervision (BCBS) ing, performance measurement and new product approval process for all significant
business activities (both on- and off-balance sheet), thereby aligning the risk-taking
Principle 4 of “Principles for Sound Liquid-
incentives of individual business lines with the liquidity risk exposures their activities
ity Risk Management and Supervision”
create for the bank as a whole” (p 3).
(September, 2008).1
European Commission (EC) “Robust strategies, policies, processes and systems shall exist for the identification,
measurement, management and monitoring of liquidity risk over an appropriate set
Point 14 in Annex V of “Directive
of time horizons, including intra-day, so as to ensure that credit institutions main-
2009/111/EC of the European Parliament
tain adequate levels of liquidity cushions. Those strategies, policies, processes and
and of the Council of 16 September”.2
systems shall be tailored to business lines, currencies and entities and shall include
adequate allocation mechanisms of liquidity costs, benefits and risks” (L302/116).
Committee for European Banking “Institutions should have in place an adequate internal mechanism – supported
Supervisors (CEBS) where appropriate by a transfer pricing mechanism – which provides appropriate
incentives regarding the contribution to liquidity risk of the different business activi-
Recommendation 2 in “Second Part
ties. This mechanism should incorporate all costs of liquidity (from short to long-
of CEBS’ Technical Advice to the
term, including contingent risk)” (p 8).
European Commission on Liquidity Risk
Management” (September, 2008).3
The Institute for International “Firms should ensure that they have in place effective internal transfer pricing poli-
Finance (IIF) 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
Recommendation III.4 of “Final Report
pricing should take closely into account the liquidity of relevant underlying assets;
of the IIF Committee on Market Best
the structure of underlying liabilities, and any legal or reasonably anticipated repu-
Practices: Principles of Conduct and Best
tational contingent liquidity risk exposures. Transfer pricing should be designed to
Practice Recommendations” (July, 2008).4
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).
Counterparty Risk Management Policy “The Policy Group recommends that all large integrated financial intermediaries
Group III (CRMPGIII) 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
Recommendation IV-17 of “Contain-
funding to businesses that use funding and credits the benefits of funding to busi-
ing Systemic Risk: The Road to Reform”
nesses that provide it. This must encompass both on- and off-balance sheet activi-
(August, 2008).5
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).
1
60
1
5
Available at http://www.bis.org/publ/bcbs144.pdf.
66
98 er
1- nt
20
2
Available at http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0097:0119:EN:PDF.
66 Ce
65 ks
3
Available at http://www.eba.europa.eu/getdoc/bcadd664-d06b-42bb-b6d5-67c8ff48d11d/20081809CEBS_2008_147_(Advice-on-liquidity_2nd-par.aspx.
uidity_
_2nd-
06 oo
82 B
4
Available at http://www.iif.com/press/press+releases+2008/press+75.php.
-9 ali
58 ak
5
Available at http://www.crmpolicygroup.org/.
11 ah
41 M
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The US Dollar
Shortage in Global
16
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.
1
60
5
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9
58
11
Excerpt is BIS Working Paper No. 291, by Patrick McGuire and Götz von Peter.
41
20
99
309
1
60
The historical usage of the term “dollar shortage” (notably by Kindle- mation embedded in banks’ balance sheets. Although data
5
berger (1950), and Triffin (1957)) refers to the main structural monetary
66
98 er
problem of the postwar period, namely the global scarcity of gold and
66 Ce
dollar assets which resulted from chronic US current account surpluses. positions impossible, we argue that information on counterparty
untter
te
erpart
65 ks
The use of the term here refers to the difficulty banks face in securing
06 oo
2
58 ak
“National banking system”, the primary unit of analysis in this paper, with the sector of the counterparty, with interbank
erban nk positions
po
11 ah
in a particular country (eg US banks, German banks, Swiss banks), as having a shorter maturity than positions vis-à-vis
v non-bank
à-vis
vis n enti-
opposed to banks located in a particular country. ties. This yields a lower-bound estimate off banks’
bank US dollar
ban
20
99
310 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
3
20
ing patterns since 2000 which set the stage for the US dollar
B
4
shortage and policy responses examined in Sections 4 and 5. Stigum and Crescenzi (2007) describe in detailill howw ban
banks use deriva-
82
The final section concludes, and the data appendix provides tives to hedge their international operations.. In sso
some
ome circumstances,
-9
detail on the BIS international banking statistics and the con- inst a depreciation of the
tions (eg to insulate capital/asset ratios against
11
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 311
6
60
issues, such as the extent to which different banks rely on the same fund
fund-
66
98 er
5
If a bank borrows more than it invests in currency i, it can swap the
1- nt
20
erlookked.
ing patterns or trade and invest in the same direction, can be overlooked.
66 Ce
but to realise this claim the bank must come up with as much domestic national banking statistics compiled from underlying data reporep
ported
orted by
reported
B
domestic assets, then the foreign currency funding gap is measured centres. As described in the appendix, the analysis in th
thiiss pap
this paper relies
-9
case where Ai = 0, the gap simply equals foreign currency short-term ional
onal banking statistics
immediate borrower basis (CBS) and the BIS locational
11
i ). by residency (LBSN).
20
99
312 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
(in either the local currency or a foreign currency); (iii) positions booked
1- nt
20
offices vis-à-vis residents of the home country. Only by splicing the CBS
82 B
9
and the LBSN can these four components be assembled into a consoli- For banks’ home offices, the figures in Table 16.16.1 includ
iinclude
nclud cross-border
-9 ali
58 ak
dated whole for each banking system (see Table A in the appendix). lending in all currencies and lending to residents
ents of
o th the home country in
11 ah
The remaining component, banks’ “strictly domestic” activity, or posi- es, tthe fig
foreign currencies. For banks’ foreign offices, figures include cross-
41 M
tions booked by home offices vis-à-vis residents of the home country in border and local claims in all currencies, ie the
he co
complete balance sheet
the domestic currency, is not included in the BIS banking statistics. of the foreign office. See footnote 8.
20
99
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 313
Banking system BE CA CH DE ES FR IT JP NL UK US
1
Number of banks 18 17 23 1,801 96 135 724 106 49 17 33
2
Total assets ($bn) 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
4
Foreign claims($bn) 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
6
Home cntry 42 23 18 44 27 51 39 75 27 44 22
office location (%)5
Foreign claims, by
UK 6 18 30 22 28 6 5 6 20 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
7
OFC 3 9 21 7 2 6 2 6 6 14 24
Other 6 7 4 4 24 10 17 3 13 15 22
Assets booked by 42 26 80 27 22 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
large 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-à-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. What Tables 16.1 and 16.2 make clear is that “bank nationality”
In five countries (BE, CH, DE, JP and UK), banks’ cross-border and “bank residency” are fundamentally different concepts.
1
60
positions accounted for almost half of that country’s external Positions booked by offices in any one country are generally a
5
66
98 er
assets at end-2007, and as much as a quarter in five other small part of that banking system’s global consolidated balance alance
ance
ce
e
1- nt
20
66 Ce
countries (CA, ES, FR, IT and NL). The offices of foreign banks sheet (Table 16.1), yet cross-border positions booked byy banks’baanks’
65 ks
alone accounted for nearly 40% of the United Kingdom’s exter- offices in any one country can be large relative to that
hat host
ho
ost
06 oo
82 B
nal assets. In contrast, positions booked by the home offices country’s external asset position (Table 16.2). This
iss has
haass implica-
imp
-9 ali
58 ak
of domestic banks were much larger in the case of Belgium, tions for how one should interpret a “nationall balance
bala ance sheet”,
11 ah
Germany, Japan and Switzerland. the unit of analysis used in a growing literature
e on international
ure i
41 M
20
99
314 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
4
Cross-border bank claims / external assets (%)
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 ($bn)
All banks 191 40 146 1,568 - 89 11 -294 1,690 149 -1,274 - 754
Domestic banks 160 64 117 1,339 68 123 -130 1,623 207 -400 - 814
Foreign banks 32 -24 30 229 -157 -111 -165 67 -59 - 874 60
Pre-crisis: change in net positions Q4 2000–Q2 2007 ($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 -63 631 161 -190 - 420
Foreign banks 30 -8 2 290 -106 - 84 -113 140 -51 -490 - 152
During crisis: change in net positions Q2 2007–Q4 2007 ($bn)
External assets -5 - 23 128 5 - 202 111 -16 193 53 46 - 108
All banks 51 17 25 277 -18 - 32 - 41 284 49 - 269 7
Domestic banks 47 24 14 327 10 -46 -18 301 39 -107 - 194
Foreign banks 3 -6 10 - 50 -29 14 - 23 -16 10 -162 200
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).
1
3
60
Cross-border claims (including inter-office claims) booked by banks’ offices located in the country in the column heading.
5
66
98 er
4
Ratio of cross-border bank claims to gross external assets (row 1).
1- nt
20
66 Ce
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 315
10
Lane and Shambaugh (2009a) construct estimates of the currency
1- nt
20
66 Ce
composition of the external asset and liability positions for a large sam-
How did banks finance this expansion, especially their foreign
forrei
eign
65 ks
ple of countries, and show that the effect of exchange rate movements
06 oo
is sizeable. Lane and Shambaugh (2009b) and Faria and Mauro (2009) currency asset positions? This section examines cross-currency
ss-ccurre
urre
B
build on this by investigating the determinants of countries’ long and funding, or the extent to which banks invest in one currency
ccurre
82
short currency positions. See Lane and Milesi-Ferretti (2001) for back- and fund in another. This requires a breakdownwn by
b currency
cu of
-9
ground, Forbes (2008) for an analysis of capital flows into the United
58
States, and Tille and van Wincoop (2007) and Devereux and Sutherland banks’ gross foreign positions, as shown in Fig
Figure
gure 16.2, where
11
316 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
All banks, by currency1 European banks (all currencies) 2 Other banks (all currencies) 2
US
USD German Belgian
24 Japanese
EUR UK Dutch 8 4
Canadian
JPY French
Other 18
6 3
12
Swiss
4 2
6
2 1
0
0 0
00 01 02 03 04 05 06 07 08 00 01 02 03 04 05 06 07 08 00 01 02 03 04 05 06 07 08
1 2
Estimated totals for 19 banking systems (see data appendix). Foreign claims excluding claims on residents of the home country
booked by banks’ foreign offices.
Sources: IMF; BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure 16.1
For some European banking systems, foreign claims are primar- UK banks, for example, borrowed (net) in sterling (some
ily denominated in the home country (or “domestic”) currency, $550 billion in mid-2007, both cross-border and from UK resi-
typically representing intra-euro area crossborder positions dents) in order to finance their corresponding long positions in
(eg Belgian, Dutch, French and German banks). For others US dollars, euros and other foreign currencies. By mid-2007,
(eg Japanese, Swiss and UK banks), foreign claims are predomi- their long US dollar positions stood at $200 billion, on an esti-
nantly in foreign currencies, mainly US dollars. mated $2 trillion in gross US dollar claims. Similarly, German
and Swiss banks’ net US dollar books approached $300 billion
Foreign currency assets often exceed the extent of funding in
by mid-2007, while that of Dutch banks surpassed $150 billion.
the same currency. This is shown in Figure 16.3, where, in each
In comparison, Belgian and French banks maintained a relatively
panel, the lines indicate the overall net position (foreign assets
neutral overall US dollar position prior to the crisis, while
minus liabilities) in each of the major currencies.11 If we assume
Spanish banks had borrowed US dollars to finance euro lending
that banks’ on-balance sheet open currency positions are small,
at home, at least until mid-2006.13
these cross-currency net positions are a measure of banks’ reli-
ance on FX swaps. Many banking systems maintain long posi- Taken together, Figures 16.2 and 16.3 thus show that several
tions in foreign currencies, where “long” (“short”) denotes a European banking systems expanded their long US dollar posi-
positive (negative) net position. These long foreign currency tions significantly since 2000, and funded them primarily by bor-
positions are mirrored in net borrowing in domestic currency rowing in their domestic currency from home country residents.
from home country residents (recall equation (16.1)).12 This is consistent with European universal banks using their retail
banking arms to fund the expansion of investment banking
activities, which have a large dollar component and are concen-
11
The “unknown” liabilities in Figure 16.2 have been allocated (by trated in major financial centres. In aggregate, European banks’
currency) in Figures 16.3–16.5 using information on the currency split
from the BIS International Debt Securities database (see the appendix combined long US dollar positions grew to roughly $700 billion n
1
for explanation).
5
66
98 er
12
As mentioned in footnote 8, banks’ “strictly domestic” positions are
1- nt
20
66 Ce
not reported in the BIS banking statistics. Their gross positions in their
13
65 ks
domestic currency booked by their home offices vis-à-vis home country The long net foreign claims of Japanese banks and d the sho
short net
06 oo
residents are therefore unknown, but their net position (shown as the foreign claims of US banks mirror the (cumulative) curre
current a
current ac
account posi-
82 B
shaded area in Figure 16.3) can be inferred as a residual from the bal- ting
ing the
tions of their respective home countries, reflecting t de degree to which
-9 ali
58 ak
ance sheet identity (see equation (16.1) and data appendix). German domestic banks’ home offices accommodate e inte
inter
ernatio
rnatio
international capital trans-
11 ah
banks’ foreign claims in Figure 16.2, for example, comprise all of their fers. However, for the reasons elaborated in Se ection 16.3.1, the relation-
Section
41 M
foreign currency positions, but their euro positions only vis-à-vis counter- ship between a country’s external position and th the foreign assets of the
parties outside Germany. banks headquartered there is tenuous.
20
99
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 317
0 0 0
–3 –2 –2
–6 –4 –4
3
Spanish banks French banks Belgian banks
1.0 4 1.4
0.5 2 0.7
0.0 0 0.0
–0.5 –2 –0.7
–1.0 –4 –1.4
–1.5 –6 –2.1
4
Dutch banks Japanese banks US banks
3.0 2 1.5
1.5 1 0.0
0.0 0 –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
Positive (negative) values are assets (liabilities). 2 For UK banks, gross positions in domestic currency booked by these banks’
home offices. 3 Prior to Q4 2005, local liabilities in local currency (LLLC) vis-à-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-
1
60
à-vis advanced economies are available from Q4 2002. The contraction in positions in Q3 2008 in part reflects the sale of some
5
66
98 er
Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure 16.2
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
99
318 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
0 0 0
2
–300 –500 –1,200
Dom (residents)
3
Dom (crossborder)
–450 –750 –1,800
4
Spanish banks French banks Belgian banks
50 300 100
0 0 0
0 0 0
European countries are estimated. The contraction in positions in Q4 2008 in part reflects the sale of some business units
5
66
98 er
of Fortis. 5 Local positions (LCLC and LLLC) vis-à-vis advanced economies are available from Q4 2002. The contraction in positionss
1- nt
20
in Q3 2008 in part reflects the sale of some business units of ABN AMRO.
66 Ce
65 ks
Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure
urre 16
16.3
6.3
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
99
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 319
exchange reserves.
66
98 er
over 70% of these positions are vis-à-vis non-bank private entities. Alterna-
1- nt
20
19
66 Ce
tive sources of data also indicate that the bulk of these positions is likely The figures on net interbank lending to other (unaffiliated) banksank
ks should
should
65 ks
to be transactions with nonbank counterparties. For instance, BankScope be interpreted with caution. Incomplete reporting of inter-officefice
ce ppositi
positio
positions
06 oo
data suggest that European bank subsidiaries in the United States book makes it impossible to precisely pin down banks’ net position on visa-vi
visa-v
vvisa-vis
B
a small share (below 5%) of their total assets as interbank assets. Data on other banks, and hence their net FX swap position, which ch is backe
backed out
82
foreign banks’ offices in the United States from the Federal Reserve H.8 as a residual. In Figures 16.4 and 16.5, the solid blue liness and the corre-
-9
release point in the same direction. Thus, our estimate of US dollar posi- mate
sponding shaded areas are the primary set of estimates; es; the dashed blue
58
tions vis-à-vis non-banks (in Figures 16.4 and 16.5) is the sum of banks’ rnativ estimates (see
lines and corresponding dashed black lines are alternative
11
41
international US dollar positions in non-banks and their local US positions. data appendix). This problem is particularly severere for Swiss banks.
20
99
320 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
200
100
0
0
0
–100
–200
–200
–200
100 100 50
50 50 25
0 0 0
500 250
100
0
250
–250
0 0
–500
–250
–750
–100
–500 –1,000
information on inter-office positions (see data appendix). 3 The estimated net position vis-à-vis non-banks is the sum of net
56
66
98 er
international claims on non-banks and net local claims on US residents (vis-à-vis all sectors) booked by the US offices of the reporting g
1- nt
20
bank. See footnote 16 in the main text. 4 Implied cross-currency funding (ie FX swaps) which equates gross US dollar assets and nd
66 Ce
liabilities. The dashed black line is an alternative measure of cross-currency funding which makes use of the available information tiion on
65 ks
inter-office positions (see data appendix). 5 Prior to Q4 2005, local liabilities in local currency (LLLC) vis-à-vis some large Eu
06 oo
Euro
European
rop p
pean
82 B
6
countries are estimated. The contraction in positions in Q4 2008 in part reflects the sale of some business units of Fortis. rtis. Local
tis. Locc
Lo
-9 ali
positions (LCLC and LLLC) vis-à-vis advanced economies are available from Q4 2002. The contraction in positions in Q3 3 20
200808 in part
58 ak
11 ah
Sources: BIS consolidated statistics (immediate borrower basis); BIS locational statistics by nationality. Figure 16.4
20
99
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 321
–0.4
–8
–0.8 –12
Net USD positions, by counterparty sector Net USD positions vis-à-vis non-banks
4 6
Monetary authorities Lower bound
5 8
Other banks 1.0 Lower bound (incl MMF) 6
6 9
Non-banks Upper bound
7
Cross currency Vis-à-vis
0.5 public sector
10 4
0.0 2
–0.5 0
–1.0 –2
00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08
1
Estimates are constructed by aggregating the on-balance sheet cross-border and local positions reported by Belgian, Dutch, French,
2
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-à-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-à-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-à-vis non-banks is estimated as the sum of net international positions vis-à-vis non-banks and net local US positions (vis- à-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
non-banks. 10 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
1
60
had met this need by tapping the interbank market ($432 billion) makes it difficult to identify precisely total liabilities to these coun-
5
66
98 er
20
58 ak
In the BIS locational banking statistics, several countries (eg Figure 16.4 understate liabilities to official monetary ryy aut
thoriti
horit
authorities for all
11 ah
Germany, Japan and the United States) do not report liabilities (in for- those banking systems which have offices in Japan, an, annd wh
and which receive
41 M
eign currency) vis-à-vis domestic official monetary authorities, which deposits from Japanese monetary authorities.
20
99
322 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
25
60
2008; by Q1 2009, the writedowns of European banks and broke brok ers ha
brokers had
66
98 er
21
1- nt
20
The alternative estimates in Figure 16.5 (bottom left panel) for net reached $441 billion (Bloomberg).
66 Ce
(dashed black line) were $127 billion and $620 billion, respectively, in
06 oo
European banks’ US dollar claims fell by $1.5 trillion n (17 7%). IIt is difficult
(17%).
mid-2007.
82 B
22
58 ak
Japanese banks’ foreign claims on the public sector stood at $627 of assets still on bank balance sheets (see BISS (20
(200 09a) ffor discussion).
(2009a)
11 ah
billion at end-2007, or 29% of their foreign claims. These public sector eflect
cts
ts the restructuring of
In addition, part of the overall reduction reflects
41 M
shares are higher than for any other banking system. several major European banks.
20
99
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 323
Vis-à-vis residents of the United States1 Vis-à-vis non-US residents, by counterparty sector 2
Gross local claims (lhs) Related foreign offices
3,000 Gross local liabilities (lhs) 600 Other banks 250
Net claims (rhs) Non-banks
0 300 0
–3,000 0 –250
00 01 02 03 04 05 06 07 08 09 00 01 02 03 04 05 06 07 08 09
1 2
Vis-à-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). However, 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.27 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,28 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
mated net FX swap positions.30
to help their head offices replace US dollar funding previously
obtained from the market.29 When asset writedowns are positive, the accuracy of the esti-
mated US dollar funding gap thus depends on the extent to
From the onset of the crisis to end-Q1 2009, the lower bound
which banks actually unwound the funding positions supporting
estimate of European banks’ US dollar funding gap declined by
these written-down assets. If banks closed out all these funding
positions by, for example, buying US dollars in the spot market,
27
The range of rescue programmes and their effects are reviewed in BIS
then the original estimate of the US dollar funding gap (solid
(2009b) and ECB (2009). green line in Figure 16.5, lower left panel) is correct through
28
European banks with an established presence in the United States can end-Q1 2009. If, on the other hand, banks have not closed out
borrow against collateral from the facilities the Federal Reserve makes their funding positions, but rather rolled them over, then the
1
60
available to depository institutions. A number of European banks have observed measure will underestimate the true funding gap
5
Reserve is captured in banks’ local liabilities in local currency vis-à-vis that the bulk of European banks’ writedowns (estimated ed by
by
65 ks
29
Similarly, Cetorelli and Goldberg (2008) present evidence that inter- zero, will the sum of the three components of nett sho ort-te liabilities
short-term
58
nationally active US banks often rely on internal markets, ie borrow from llar
lar fu
be identically equal to the (negative of) the US dollar funding gap (net
11
41
324 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
The arrows indicate the direction of flows (where known); light shaded arrows represent US dollars
66 ok
provided to other central banks, dark arrows represent other currencies (evaluated at the average
20 o
98 B
p
exchange rate during Q4 2008). The thickness of the arrows is proportional to the size of central bank swap
8- ka
lines, as announced; where swap lines are unlimited, the figure shows maximum usage instead, derived ed
from auction allotments (Figure 16.8). The ASEAN swap network is not shown.
15
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 325
100 50 25
0 0 0
Q1 08 Q3 08 Q1 09 Q3 09 Q4 08 Q1 09 Q2 09 Q3 09 Q1 08 Q3 08 Q1 09 Q3 09
1
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).
also entered regional swap arrangements to distribute their mercial banks around the world, including those that have no US
respective currencies across borders. subsidiaries or insufficient eligible collateral to borrow directly
from the Federal Reserve System.
On 13 October 2008, the swap lines between the Federal
Reserve and the Bank of England, the ECB and the Swiss The quantities of US dollars actually allotted through US dollar
National Bank became unlimited to accommodate any quantity auctions in Europe provide an indication of European banks’ US
of US dollar funding demanded. The swap lines provided these dollar funding shortfall at any point in time (Figure 16.8). Most
central banks with ammunition beyond their existing foreign of the Federal Reserve’s international provision of US dollars was
exchange reserves (Obstfeld et al (2009)), which in mid-2007 indeed channelled through central banks in Europe, consistent
amounted to $294 billion for the euro area, Switzerland and the with the finding that the funding pressures were particularly
United Kingdom combined, an order of magnitude smaller than acute among European banks. Once the swap lines became
our lower-bound estimate of the US dollar funding gap.31 unlimited, the share provided through the Eurosystem, the Bank
In providing US dollars on a global scale, the Federal Reserve of England and the Swiss National Bank combined was 81%
effectively engaged in international lending of last resort. (15 October 2008), and it has remained in the range of 50–60%
The swap network can be understood as a mechanism by which since December 2008.
the Federal Reserve extends loans, collateralised by foreign
How successful has the international policy response been?
currencies, to other central banks, which in turn make these
While it is too soon for conclusive answers, the immediate
funds available through US dollar auctions in their respective
effects have been largely positive. Reflecting considerable
jurisdictions.32 This made US dollar liquidity accessible to com-
demand in the aftermath of the Lehman bankruptcy, the amount
of US dollars provided globally through international dollar swap
31
Line “Foreign currency reserves (in convertible foreign currencies)” from lines surged in October 2008, and peaked at $583 billion in
the IMF Template on International Reserves and Foreign Currency Liquid- December 2008 (Federal Reserve Statistical Release H.4.1).
1
60
32
66 Ce
stated that the swap lines are to provide US dollar funding via the
06 oo
central banks to financial institutions abroad. The foreign currencies their historical peak in autumn 2008. Baba and Packerckker (2009b)
((2009
(200
82 B
obtain and disburse the foreign currencies to US banks. extensive distress-selling of dollar-denominated
ted assets,
a and
20
99
326 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
33
At the same time, banks’ increased reliance on the public availability A broader message of this paper is that vulnerabilities in the
of US dollar funding may have delayed the necessary restructuring of international financial system are best measured along the con-
their balance sheets. tours of banks’ consolidated balance sheets, rather than along
34
The international swap arrangements are not unprecedented. A net- national borders. This is because (i) stresses build up across the
work of swap lines, also centred on the Federal Reserve Bank of New balance sheet—as mismatches between the maturity, currency
York, was set up in 1962 to support dollar parities in the Bretton Woods
system of fixed exchange rates (Kindleberger (1996)). and counterparty of assets and liabilities—and (ii) the consoli-
35 dated balance sheets of the relevant decision-making units
Effective lending of last resort requires sufficient resources to reassure
markets that the means of payment will remain available in all circum- (ie banks) transcend national borders. The dataset constructed
stances (Bagehot (1873)). As the ultimate issuers of currencies, central for this paper provides a fairly comprehensive picture of banks’
banks are the natural lenders of last resort, which some take to imply that funding patterns at the level of national banking systems. The he
1
60
tionally (Capie (1998), Schwartz (1999)). The recent literature on the design
66
98 e
1- nt
of the IMF or its lending policies takes into account its limited resources and
66 Ce
focuses on moral hazard issues (Fischer (1999), Lerrick and Meltzer (2003)). cannot be identified with the home country’s residency-based
esidency-
65 ks
06 oo
36
The regulation and supervision of banks remains decentralised, and statistics alone, and (ii) banks’ cross-border posit
positions
p ition are large
itions
82 B
banks outside its regulatory and supervisory reach (Jeanne and Wyplosz
41 M
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 327
currencies (LLLC).
66
98 er
1- nt
20
37
58 ak
or jurisdiction—including major offshore financial centres. Each The sectoral breakdown distinguishes positions vis-à-v
vis-à-vis
is-à-vis no
non-banks,
11 ah
bank office reports its cross-border claims and liabilities (XBC ions
ons (w
positions are further divided into inter-office positions (within the same
and XBL) as well as foreign currency claims and liabilities vis-à-vis iliated banks.
bank group) and positions vis-à-vis other (unaffiliated)
20
99
328 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Breakdowns by
The combined dataset thus yields, for 19 banking systems, across borrowing countries in the CBS) should correspond to
foreign claims and liabilities on a worldwide consolidated basis total foreign claims reported in the CBS. That is,
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 This serves as a consistency check across the two datasets for
positions, the residency of the counterparty is known by con- the asset side of the balance sheet. There is no correspond-
1
ing check on the liability side since banks do not report foreign
eign
ign
60
terparty is unknown).
1- nt
20
66 Ce
In principle, for each banking system, total INTCb (summed The match is not as satisfactory for Swiss
wissss and US banks. Discrep-
wiss
across reporting countries in the LBSN) plus LCLC (summed ancies arise for three main reasons. First, the set of reporting
20
99
Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 329
38
This is problematic in the case of US banks, since the major US invest-
06 oo
tries), but were not included in the CBS reported by the United States
58 ak
until Q1 2009, the last quarter of our sample. of International Money and Finance, forthcoming.
mingg
g.
11 ah
41 M
20
99
330 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Bagehot, W (1873): Lombard Street: a description of the money Fukao, M (1991): “Exchange rate movements and capital-asset
market, New York: Scribner, Armstrong & Co. ratio of banks: on the concept of structural positions”, BOJ
Monetary and Economic Studies, 9(2), September.
Bank for International Settlements (2009a): “Highlights of inter-
national banking and financial market activity”, BIS Quarterly Goodhart, C (1995): The central bank and the financial system,
Review, June. MIT Press.
— (2009b): “An assessment of financial sector rescue pro- Jeanne, O and C Wyplosz (2003): “The international lender
grammes”, BIS Papers, no 48, July. of last resort: how large is large enough?”, in M Dooley and
J Frankel (eds), Managing currency crises in emerging markets,
Bernanke, B (2008): “Policy coordination among central banks”,
University of Chicago Press, pp 89–118.
speech at the Fifth European Central Bank central banking con-
ference, Frankfurt, 14 November. Kindleberger, C (1950): The dollar shortage, MIT Press and
John Wiley & Sons, Inc.
Capie, F (1998): “Can there be an international lender of last
resort?”, International Finance, 1(2), pp 311–25. — (1996): Manias, panics, and crashes—a history of financial
crises, John Wiley & Sons, Inc.
Cetorelli, N and L Goldberg (2008): “Banking globalization,
monetary transmission, and the bank lending channel”, NBER Lane, P and G M Milesi-Ferretti (2001): “The external wealth of
Working Papers, no 14101. nations: measures of foreign assets and liabilities for industrial
and developing countries”, Journal of International Economics,
Chang R and A Velasco (2000): “Financial fragility and the 55(2), pp 263–294.
exchange rate regime”, Journal of Economic Theory, 92,
pp 1–34. Lane, P and J Shambaugh (2009a): “Financial exchange rates
and international currency exposures”, American Economic
— (2001): “A model of financial crises in emerging markets”, Review, forthcoming.
Quarterly Journal of Economics, 116, pp 489–517.
— (2009b): “The long of short of it: determinants of foreign
Devereux, M and A Sutherland (2009): “Valuation effects and currency exposure in external balance sheets”, NBER Working
the dynamics of net external assets”, Journal of International Papers, no 14909.
Economics, forthcoming.
Lerrick, A and A Meltzer (2003): “Blueprint for an international
Diamond, D and R Rajan (2001): “Liquidity risk, liquidity cre- lender of last resort”, Journal of Monetary Economics, 50,
ation, and financial fragility: a theory of banking”, Journal of pp 289–303.
Political Economy, 109(2), pp 287–327.
McCauley, R (1984): “Maturity matching in the euromarkets”,
— (2006): “Money in a theory of banking”, American Economic New York Federal Reserve Quarterly Review, 9(1), pp 33–5.
Review, 96(1), pp 30–53.
Mishkin, F (1999): “Global financial instability: framework,
European Central Bank (2009): EU banks’ funding structures and events, issues”, Journal of Economic Perspectives, 13(4),
policies, May. pp 3–20.
Faria, A and P Mauro (2009): “Institutions and the external capi- Morgan, G and S Smith (1987): “Maturity intermediation and
tal structure of countries”, Journal of International Money and intertemporal lending policies of financial intermediaries”,
Finance, 28, pp 367–91. Journal of Finance, 42(4), pp 1023–34.
1
Fischer, S (1999): “On the need for an international lender of Obstfeld, M, J Shambaugh, and A Taylor (2009): “Financial
60
5
last resort”, Journal of Economic Perspectives, 13(4), instability, reserves, and central bank swap lines in the
e panic
he anic of
pa o
66
98 er
1- nt
20
Flannery, M and C. James (1984): “Market evidence on the Peek, J and E Rosengren (2001): “Determinants
nts of
o the Japan
B
effective maturity of bank assets and liabilities”, Journal of premium: actions speak louder than words”,
s”, Journal
Journ of Interna-
82
Money, Credit and Banking, 16(4,1), pp 435–45. tional Economics, 53, pp 283–305.
-9
58
11
41
20
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Chapter 16 The US Dollar Shortage in Global Banking and the International Policy Response ■ 331
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.
1
560
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
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332 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● Differentiate between the mechanics of foreign exchange ● Assess the causes of covered interest rate parity violations
(FX) swaps and cross-currency swaps. after the financial crisis of 2008.
Excerpt is by Claudio Borio, Robert McCauley, Patrick McGuire, and Vladyslav Sushko, from BIS Quarterlyy Review.
Rev
41
20
99
333
1
Also, unlike in earlier US dollar funding stress episodes (Cetorelli
Cetorelli
Cetor
06 oo
ets/au
ts/auutora
utorat
bank swap lines: https://apps.newyorkfed.org/markets/autorates/
58 ak
after these strains dissipated. The basis has widened since fxswaps-search-result-page.
11 ah
41 M
334 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
70 40 3 80
0 0 2 60
–70 –40 1 40
–140 –80 0 20
–210 –120 –1 0
06 08 10 12 14 16 06 08 10 12 14 16 06 08 10 12 14 16
USD/AUD USD/EUR USD/JPY Libor-OIS spread (lhs): Rhs:
2
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 a premium in FX swaps. In this case, rearranging the CIP
interest rates on two otherwise identical assets in two differ- equation yields the following relationship between (F - S),
ent currencies should be equal once the foreign currency risk r and r*:
is hedged:
exchanged at the spot rate, S, and then repaid at the ferent currencies. At maturity, the borrowed amounts are
66
98 e
pre-agreed forward rate, F, at maturity. The implicit rate exchanged back at the initial spot rate, S, but duringng thee life
1- nt
20
66 Ce
of return in an FX swap is determined by the difference of the swap the counterparties also periodically excexchange
cha
ange
65 ks
between F and S, and the contract is typically quoted in interest payments. In a cross-currency basis swap, t rrefer-
wap, the
06 oo
forward points (F - S). If the party lending a currency via FX ence rates are the respective Libor rates plus the
us tth basis, b.
he ba
82 B
-9 ali
swaps makes a higher or lower return than implied by the Again, if the forward points (F - S) are greater
er than
reate th war-
58 ak
interest rate differential in the two currencies, then CIP fails ranted by CIP, then, assuming a oneperiod
eriod maturity, the
d mat
1 ah
41 M
to hold. Typically, the US dollar has tended to command basis, b, will effectively be the amount by
b wwhich the interest
20
99
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 335
rate on one of the legs has to be adjusted so that the parity Even if risk premia in the underlying transaction are low, CIP
with the pricing of FX swaps holds: 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-
In the above example, the FX swap implied US dollar rate, portional to the hedging demand multiplied by the per-dollar
F
S (1 + r*), exceeds actual US dollar Libor, 1 + r, if the party balance sheet costs of FX derivatives exposures:
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 In each of the above examples, the price that is actually set
the corresponding currency, while the other counterparty in in FX derivatives is that of the forward leg of the swap, F.
effect receives an equivalent discount when borrowing the As shown, CIP arbitrageurs will pass on their balance sheet
other currency. costs of taking the other side of FX hedging demand via FX
swaps as wider forward points, (F - S), than warranted by
A number of factors can cause CIP to fail. For example,
CIP. The per-dollar balance sheet costs themselves are repre-
market liquidity in the underlying instruments may evapo-
sented by rp in this example. Since markets have to clear, the
rate, so that the difference between bid and ask prices for
aggregate position of CIP arbitrageurs when the US dollar is
forward and spot transactions is non-trivial. For simplicity,
at a premium in FX swaps will be equal to the aggregate net
let us assume that r* is sufficiently small, so that 1 + r* ≈ 1.
position of currency hedgers. The latter will be paying the
Denoting by Sa the spot ask rate and by Fb the forward bid
forward points, (F - S), to hedge their US dollar assets.
rate, CIP deviations due to a drop in market liquidity will be
given by: What are some of the real-world counterparts to rp in non-
crisis times? In aggregate, rp will reflect any costs that banks
or other participants assign to deploying their balance sheet
in CIP arbitrage, which in turn will reflect their risk manage-
ment practices. For individual players, these practices may
CIP can also fail because of credit risks in the underlying even include absolute credit limits that would set a maximum
investments. If CIP arbitrage is conducted by global banks for the underlying exposures to the underlying instruments
borrowing and lending in the respective Libor markets, then and counterparties. Even without strict limits, the funding
a rise in counterparty credit risks in the interbank markets, cost of the capital allocated to the arbitrage activity, notably
typically captured using Libor-OIS spreads, could result in to the (current and potential future) derivatives exposures
CIP deviations. Similarly, if banks or asset managers engage involved, will prevent the basis from closing when it opens up
in CIP arbitrage using government bonds in the two cur- owing to changes in hedging demand.
rencies, then deviations might result from differences in
sovereign credit risks, typically measured using sovereign The specific constraints, and hence the instruments involved,
CDS spreads. will also depend on the players acting as arbitrageurs. For
instance, for highly rated supranational and quasi-govern-
More generally, suppose r and r* are the respective risk-free ment agencies, which can arbitrage the long-term basis
rates and rp is the risk premium for the underlying investment thanks to their top credit rating by issuing bonds in US dol-
over the duration of the swap. Then CIP deviations measured lars at attractive rates and then swapping them out, rp is
using risk-free rates will be given by: 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.
1
5 60
66
98 er
In recent years, the textbook CIP arbitrage framework has been Packer (2009), Coffey et al (2009), Mancini-Griffoli and Ranaldo
analdo do
1- nt
20
66 Ce
challenged in two ways. Initially, the focus was on the con- (2012), Levich (2012)); and the euro area sovereign debt ccrisis
bt cri
risis in
65 ks
06 oo
straints on arbitrage arising from the banks’ counterparty credit 2011–12 (McCauley and McGuire (2014), Ivashina et al ((2015
(2015)).
B
surfaced during crisis episodes. These episodes included the Since 2014, attention has shifted to other factors
ors and
facto a con-
-9
58
Japanese banking crisis (the “Japan premium”, Hanajiri (1999)); straints. Most studies have invoked some no notion
otion of capital
11
the onset of the GFC in 2007–08 (eg Baba et al (2008), Baba and constraints of CIP arbitrageurs in the face
ce of FX swap funding
41
20
99
336 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
6
20
3
He et al (2015) take the currency basis as given, to study the effects of ation of it
extend asset duration so as to match the rising duration its liabilities
06 oo
82 B
FX swap market dislocations on the ability of non-US banks to supply US as yields in the euro area fell to very low levels.
-9 ali
4
Transaction costs also appeared to play a temporary role for some cur- rket:: in th
leveraged investors in the target bond market: the case of bonds, this
41 M
rencies in the aftermath of the Swiss National Bank’s abandonment of err the short-term financing
is equal to the excess of the bond yield over
the currency peg (Pinnington and Shamloo (2016)). cost (“the carry”), plus or minus a price gain o
or loss on the bond.
20
99
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 337
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 USD bn
375 150 24
250 75 12
125 0 0
0 –75 –12
06 08 10 12 14 16 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- Limits to Arbitrage: Why the Basis Does
mental level, monetary (Box 17.3) and financial conditions, as
Not Close
well as institutional differences across the respective jurisdic-
1
60
tions, largely determine the extent of foreign currency funding Structural changes in how market participants have been pricing cin
5
66
98 er
and investment flows in the first place. market, credit, counterparty and liquidity risks post-crisis have
1- nt
20
66 Ce
8
This would be so if the other sources of FX hedging demand co-move
82 B
positively with those we identify. The exclusion of speculative demand may and related balance sheet constraints, arbitrage now w incurs
incu a
-9 ali
58 ak
actually make it harder for us to find a relationship with hedging demand, cost per unit of balance sheet. This cost is passedd on to
assed t the
11 ah
9
could push down the forward rate even as hedging demand pushed it up. For a conceptual discussion, see Duffie (2016).
16).
99
338 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
While these risks and costs exist all the time, participants have The first is conceptual. Some financial institutions play the dual
been managing them more actively post-crisis. Before the GFC, role of putting pressure on the basis and arbitraging it. For
these risks were not fully priced in the relevant markets and, instance, banks’ business models may lead them to fund them-
partly as a result, dealer banks had raised their leverage to selves through swaps in order to hedge their balance sheet
dangerous levels (Shin (2010)). The crisis brought them to light. mismatches, even as they act as arbitrageurs. This means that
Since then, pressure from shareholders, creditors and prudential proxies for their swap positions conflate their two roles. How-
authorities has reinforced and hard-wired participants’ aware- ever, and despite such ambiguity, our results suggest that the
ness. As a result, leverage has declined and there has been less balance sheet hedging motive dominates.
willingness to deploy the balance sheet for activities that make The second relates to data availability. No statistics fully cover the
heavy demands on it, such as arbitraging the basis. hedging demand for a given currency; tough choices and approx-
Changes in regulation have reinforced market pressures for a imations are needed. Hence, we focus on the three main sets of
tighter management of balance sheet risks. For example, players—banks, institutional investors and nonfinancial firms—and
changes related to credit value adjustments have sought to even there we have to make a number of assumptions.
incentivise dealers to price the counterparty risk in their deriva- For banks, our benchmark measure is their “funding gap” in the
tives portfolios more accurately. Similarly, potential future expo- US dollar.12 The funding gap, derived from the BIS international
sure adjustment charges in both Basel III and US leverage ratios banking statistics, is an estimate of banks’ demand for hedging
require market participants to hold capital in proportion to their through the FX swap market (McGuire and von Peter (2009,
derivatives and other exposures.10 2012), Fender and McGuire (2010)). Specifically, for banks head-
The bottom line is clear. These tighter limits on arbitrage make quartered in a particular country (eg Japan or Australia), we mea-
it harder to narrow the basis whenever it opens up as a result of sure the difference between their consolidated global on-balance
pressures that reflect underlying order imbalances. In particular, sheet assets and liabilities in a particular foreign currency. Assum-
even in the absence of bank funding strains like those seen dur- ing that banks hedge their currency risk, the resulting gap indi-
ing the GFC, a sufficiently high net demand for currency hedges cates the size of their off-balance sheet position in a given
could result in persistent deviations from CIP. currency, which will largely be managed by FX swaps.13
Can our framework help explain how the sign and, possibly, the
size of the basis vary across currencies? We test this by juxtaposing
1
12
Except in the case of Sweden, where we also look at the euro
uro (see
see
5
below).
1- nt
20
66 Ce
13
Partly owing to data limitations, we do not include US ba b
banks’
anks’ cor-
65 ks
timated n
timate
responding positions. US-headquartered banks’ estimated ne
net long
06 oo
82 B
10
This need not result from individual pricing decisions. For instance, compared with non-US banks’ net long dollar posit tions As a result, the
tions.
positions.
58 ak
internal credit limits may constrain individual balance sheets and, in bulk of our analysis can safely focus on the latter
er.
r.
latter.
11 ah
41 M
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 339
0 –12 –36
The solid vertical lines in the left-hand panel correspond to the following ECB monetary policy announcements: 8 May 2014, 5 June 2014,
605
22 August 2014 (Jackson Hole), 22 January 2015 and 21 January 2016. The green vertical line corresponds to the (“disappointing”) 3 December
66
98 er
2015 ECB announcement. The orange vertical line indicates the 6 November 2015 US job report. The dashed vertical lines in the left-hand
1- nt
20
66 Ce
panel correspond to the following Bank of Japan monetary policy announcements: 4 April 2013, 31 October 2014, 29 January 2016 plus the
65 ks
16 September 2015 (S&P) Japan downgrade. The same dates are used to calculate the basis reaction around the announcement dates.
06 oo
82 B
1 See Borio and Zabai (2016) for a survey of unconventional monetary policy measures that documents and discusses these effects.
ects. On th
the
11 ah
relationship of central bank deposit rate changes and the currency basis, see Bräuning and Ivashina (2016, Table IX).
41 M
20
99
340 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
10 10 10 2.5
0 0 0 0.0
1Foreign 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 currency, many such firms do not hedge dollar debt (eg
investors have more opportunity to diversify without buying Borio (2016)).17
foreign currency assets, given the size of the global dollar
Graph 2 shows indicators of hedging demand from the various
financial markets.15
sectors for four jurisdictions for which we were able to obtain
For non-financial firms, we consider bonds outstanding issued better data: Australia, the euro area, Japan and Sweden. A posi-
by corporations headquartered outside the country, drawing tive value for a bar indicates net borrowing of US dollars against
on BIS international debt securities statistics. For instance, we local currency via swaps (positive net FX hedging demand vis-à-
take euro issues by US firms to fund their dollar operations, vis the US dollar) for the corresponding sector, while a negative
and exclude issues by banks to avoid double-counting.16 We value shows net dollar lending. The figures are scaled by GDP.
do not include dollar issuance by non-US firms because,
The graph reveals clear differences across countries and sectors.
given the predominance of the US dollar as an invoicing
Especially noteworthy is the position of the banking sector rela-
tive to that of institutional investors. Where banks have a surplus
of domestic currency deposits relative to domestic currency loans,
they use the FX swap market to borrow dollars to hedge their dol-
15
Three quarters of US investors’ holdings of foreign bonds were dollar- lar lending. In doing so, they compete with domestic institutional
denominated at the end of 2014 (US Treasury et al (2016)). In general, investors that use swaps to hedge their dollar investments. As a
hedge ratios for foreign equity holdings are low and well below those
1
60
for bonds, so that they are less of an issue (although those of Japanese
5
shares are often hedged). Hilander (2014, p 13) reports a 20% hedge
66
98 er
1- nt
20
Moreover, given that credit spreads favour one currency nccy over
over a
another,
16
65 ks
We could also include domestic currency issuance by foreign firms incentives to issue and put pressure on the basis are boun nd to be one-
bound
06 oo
from outside the United States, which may hedge into the US dollar ce, where
sided. In the case of the dollar/euro pair, for instance, w spreads
82 B
(given its extensive international use), or hedge back into eg the have favoured issuance in euros, euro area issuers ers in
n dolla
dollars have typi-
-9 ali
58 ak
Australian dollar or Canadian dollar through the US dollar. So, our cally been toprated European supranationalss and d agen
agencies, which can
11 ah
figure should best be regarded as a lower bound. At the same time, otch
afford to issue in USD thanks to their topnotch h cred
creditworthiness. These
41 M
not all issuance need be hedged: some firms may prefer to incur s,, acti
institutions in effect operate as arbitrageurs, actively harvesting the basis
currency risk in an attempt to lower their funding costs further. (see also below). They do the same in the e Aus
Australian dollar market.
20
99
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 341
EA EA
–40
CH
JP –60
–80
–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 In the case of Sweden, the dollar basis is negative, even though
to the size of the potential imbalance. This is the case in Japan, banks are in the same position as those in Australia in that cur-
where they have used domestic yen deposits to fund their expan- rency. However, the euro/krona basis is positive. This reflects the
sion abroad, mainly in dollars, by making heavy use of swaps. By fact that the FX swap euro market, rather than the dollar market,
contrast, in Australia and Sweden the banking sector provides a is the marginal funding source for excess krona lending (darker
natural counterpart to institutional investors’ hedging needs. That colour bars), since swapping out of euros is more expensive than
is, given the large domestic currency mortgage book relative to out of dollars. Accordingly, the picture in Sweden resembles that
the domestic deposit base, banks rely on the FX swap market for in Australia once the right currency pair is chosen.18
funding. This offsets institutional investors’ hedging demand.
Focusing exclusively on the position of the banking sector in US
The hedging needs of US corporate bond issuers, which add dollars (or euros for Sweden) confirms the previous finding. In
to those of domestic institutional investors, are in general quite a sample of eight economies (now including also Canada, Nor-
small compared with those of other sectors. The main exception way, Switzerland and the United Kingdom), the banks’ position
is the recent experience in the euro area, where US nonfinan- is consistent with the sign of the basis (Graph 3). This also sug-
cial firms’ issuance in euros has surged since 2014. This reverse gests that, in our sample, when banks are in the opposite posi-
yankee issuance reflects the fact that euro-denominated cor- tion to institutional investors, their hedging needs are typically
porate credit spreads have fallen significantly relative to those larger, so that they end up being the swing factor. Note also that
in dollars, largely because of ECB bond purchase programmes Australian and Swedish banks’ position is indeed exceptional:
(Boxes 17.2 and 17.3). banks typically add to resident institutional investors’ hedging
needs, rather than offsetting them. In the case of the euro area,
The sign of the basis aligns quite well with these indicators.
1
EUR/USD pair from less than $28 billion to as much as $250 250 bil-
$2 b
06 oo
demand and hence more costly than in the cash market. The
82 B
18
Hilander (2014, Table 5) shows that, in addition to
o Sw
Swedish
wedish banks, foreign
41 M
Australia, where banks offset institutional demand for hedges by stors, balancing them
banks too provide currency hedges to Swedish investors,
lending dollars in the swap market, the currency basis is positive. against the hedges provided to non-Swedish holdersders oof Swedish bonds.
20
99
342 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
FX hedging demand by sector FX hedging demand and the basis FX hedging demand and the basis
(Jan 2008–Dec 2015)
USD trn USD trn Basis points
1.2 1.20 0 0
Three-year basis, bp
0.9 1.05 –25 –25
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 trillion. During this period, banks needed dollars to
finance their overseas loan expansion and to hedge their own
TIME SERIES: THE YEN/DOLLAR CASE foreign bond holdings.19 Since 2015, Japanese banks have
also relied more on FX swaps for USD funding due to the
We next test our hypothesis by examining the time series of the
lower availability of wholesale USD funding, because of US
yen/dollar basis. This has been the most extreme and persistent
MMFs’ disinvestment from foreign banks’ certificates of
non-zero basis among the major currencies, with banks and insti-
deposit and time deposits in anticipation of upcoming US
tutional investors both bidding for hedges. Moreover, it is the
MMF reform. Japanese banks have been especially affected,
currency pair for which better data on the evolution of institu-
as they have been the largest foreign bank issuers of unse-
tional investors’ hedging needs are available. Before turning to
cured paper in US money markets; approximately two thirds of
the evidence, a few facts can help set the context.
19
The figures for Japanese banks’ net US dollar positions, which hich
ich are
5
66
derived from the BIS international banking statistics, include dee bo oth
bothth th
these
1- nt
20
66 Ce
Japanese banks, institutional investors and US non-financial banks’ own dollar positions and those managed on behalf hallff off thei
their cli-
65 ks
is not known how much of trust account positions iss he edged However,
hedged.
82 B
the crisis: from $0.9 trillion in 2009 to over $1.2 trillion in 2015 for the analysis that follows, it is the dynamics of the e serie
series rather than
-9 ali
et do
lars held on behalf of clients in the total net ollar p
dollar position of Japanese
41 M
The banking sector has been the main driver, with its esti- banks and their hedge ratios are relatively stable
table then the inclusion of
stable,
mated dollar funding gap growing from around $0.6 trillion to these positions should not bias our results. ts.
20
99
Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 343
The basis and the US–JP repo spread differential The basis and quarter-end jumps in the repo spreads 3
Basis points Basis points Basis points
70 35 20 200
0 0 0 0
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 500
implied volatility index; standard deviation, in percentage points per annum. 3 Repo spreads and currency basis calculated using the
respective OIS rates.
their $600 billion of liabilities in New York is unsecured funding the picture would be similar for other maturities. Pre-crisis, the
(Pozsar and Smith (2016)).20 basis was very small and stable, regardless of hedging volumes;
post-crisis, it has tracked them remarkably closely. In particular,
Thus, Japanese banks’ reliance on swaps to fund their foreign
an increase in hedging demand has coincided with a widening
assets has reduced their capacity to serve as counterparties to
of the basis further into negative territory.
non-bank hedgers in cross-currency markets and to arbitrage
the basis. In particular, Japanese life insurers’ search for yield
overseas has led them to increase FX-hedged investments in US Tighter Limits to Arbitrage and the Basis
dollar-denominated bonds (with average hedge ratios of
60–70%).21 Issuance of samurai bonds has not played a signifi- The sudden break in the basis during the GFC points to the
cant role, owing to the thin corporate bond market in Japan. emergence of the limits to arbitrage discussed above. But is
it possible to find more direct evidence of these new balance
Confirming our hypothesis, after a clear break during the GFC, a sheet constraints? Some developments are consistent with them.
remarkably close relationship emerged between variations in our
measure of hedging demand and the basis (Graph 4, centre and First, as the GFC raised awareness of counterparty risk, many
right-hand panels). This is shown using the three-year basis, but market participants switched from unsecured to secured fund-
ing sources, notably repo markets. Reliance on the repo market
constrains the arbitrageurs’ flexibility, since the borrower cannot
20
Assets under management have been migrating from prime US insti- obtain funds without having the underlying security to pledge as
1
60
tutional MMFs to government MMFs due to the reform to be phased in collateral. Since mid-2014, the Bank of Japan’s move to increase eas
as
5
in October 2016. By August 2016, prime MMFs had lost more than $360
66
98 er
lost substantial amounts of MMF funding, inducing them to seek other lateral), even as the Federal Reserve stopped its net purchases,
purc
urccha
h
hases,
65 ks
21
We obtained the time-varying hedge ratios of Japan’s life insurance repo funding. As a result, arbitraging the yen/dollar
ollar basis has
-9 ali
58 ak
companies by courtesy of Barclays FICC Research team; see Barclays become more expensive, and the basis has widenedwidenned even
e when
11 ah
for Japan’s pension funds (dominated by the unhedged Government Pen- financial market volatility (the VIX) has remained
need within
w normal
sion Investment Fund) are low, and therefore ought not to affect the basis. ranges (Graph 5, left-hand panel).
20
99
344 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Foreign bank claims on the Japanese official sector1 and European supranationals’2 cumulative issuance in euros
JPY/USD basis and US dollars and EUR/USD basis
Basis points USD bn Basis points USD bn
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- (Box 17.1 and Du et al (2016)). This activity is reflected in the ris-
end spikes, along with repo rates, indicating that arbitrage has ing share of US dollar bond liabilities of major euro area supra-
become harder (Graph 5, right-hand panel). This has coincided national agencies compared with their home currency (ie euro)
with the greater importance attached to quarter-end reporting bond liabilities (Graph 6, righthand panel). However, such “issu-
and regulatory ratios following regulatory reforms. ance arbitrage” slowed when the interest rate swap rate fell
below the US Treasury yield in Q3 2015. Since such supranation-
Third, the riskiness of claims on the Japanese official sector
als have to issue at rates above US Treasury yields, this inversion
may also have played a significant role. Banks’ exposures to
of US dollar interest rate swap spreads sharply increased their
the Japanese official sector are already sizeable relative to their
costs of placing a 7- to 10-year bond in US dollars and swapping
equity. As the basis widened, BIS reporting banks, especially
it into euros.22
big US, French and UK banks, increased their claims on the
Japanese official sector from about $200 billion in Q4 2014 to
$323 billion at the end of 2015, no doubt in part reflecting their Regression Results
arbitrage activities (Graph 6, left-hand panel). At the end of the
period, their exposure to the Japanese official sector, including We next test for the presence of a link between hedging
both the central bank and the government, represented 10–19% demand and the basis as well as the role of arbitrage constraints
of their equity. The widening of the yen/dollar basis following econometrically. Specifically, we add our quantitative indicator
Standard & Poor’s downgrade of Japan in 2015 highlights the of aggregate hedging demand to standard specifications of the
basis.23 Our results provide evidence for such a link.
1
22
At the end of 2013, major euro area supranationals als ha
had
ad $6
$660 billion
06 oo
ed
d $1
bonds. In the following six quarters, they issued 192
92 b
$192 bi
billion in dollar
58 ak
agencies have relied on their funding cost advantage to arbi- bonds and only $178 billion in euro bonds, poin nting
ting tto a shift of over
pointing
11 ah
41 M
trage the basis by issuing bonds in US dollars and swapping the $10 billion per quarter from euro to dollar.
23
proceeds back into euros, thus collecting the currency basis For a much more extensive analysis, see
ee Su
Sushko et al (2016).
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Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 345
The standard specification for the three-month basis—the tenor barometer of the imbalances in cross-currency flows hedged for
on which most of the empirical work has focused—is shown in currency risk, whereas the cost of short-term FX swaps is much
the first row of Table 17.1. The size of the basis is considered to more sensitive to risk premia and bank funding strains, particu-
be a function of counterparty risk (Libor-OIS spread), funding larly during crisis episodes (Graph 1).
liquidity (repo spreads) and market liquidity (currency market
Overall, the econometric evidence indicates that, while gener-
bid-ask spreads). This is in the spirit of, for instance, Mancini-
ally ignored, hedging demand played a role even before the
Griffoli and Ranaldo (2012) and Pinnington and Shamloo
widening of the basis from 2014, when market tensions were
(2016). The specification performs reasonably well: the coef-
subdued. No doubt, heightened counterparty risks did influence
ficients of the explanatory variables are all economically and
the basis in 2008–09 and again in 2011–12. But the demand for
statistically significant.
dollar hedging has been at work throughout.24 And it has con-
Once we add the quantitative indicator of hedging demand, tinued to play a significant role since.
the performance clearly improves (Table 17.1, second row). The
indicator is added on its own and interacted with the Libor-OIS
spread, as derived formally in Sushko et al (2016). In particular, CONCLUSIONS
the interaction of money market strains and hedging demand
pressures (column (c), in bold) matters and money market strains We have argued that the puzzling systematic and persistent
alone (column (a)) now no longer exert a significant impact. The violation of CIP since the GFC reflects the combination of FX
coefficient on the interaction term suggests that a 1% rise in the hedging demand and limits to arbitrage arising from lower
Libor-OIS spread combined with 1% higher demand for forward balance sheet capacity, in turn due to tighter management of
hedges is associated with a 45 basis point wider basis. This risks and associated balance sheet constraints. This explanation
result indicates that higher demand for hedges works together suggests that, even at the height of market tensions, hedging
with the market dislocations identified in previous research to demand played an important, but underappreciated, role. We
1
60
drive the basis. use BIS banking and debt securities statistics in combination
5
66
98 er
346 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Borio, C (2016): “More pluralism, more stability?”, speech at the Levich, R (2012): “FX counterparty risk and trading activity in
Seventh High-level SNB-IMF Conference on the International currency forward and future markets”, Review of Financial Eco-
Monetary System, Zurich, 10 May. nomics, 21, pp 102–10.
Borio, C and A Zabai (2016): “Unconventional monetary policies: Liao, G (2016): “Credit migration and covered interest parity”,
a re-appraisal”, BIS Working Papers, no 570, July. Harvard University, mimeo.
Bräuning, F and V Ivashina (2016): “Monetary policy and global Mancini Griffoli, T and A Ranaldo (2012): “Limits to arbitrage
banking”, June, mimeo. during the crisis: finding liquidity constraints and covered inter-
est parity”, Working Papers on Finance, no 1212, University of
Cetorelli, N and L Goldberg (2011): “Global banks and interna-
St Gallen School of Finance.
tional shock transmission: evidence from the crisis”, IMF Eco-
nomic Review, vol 59, no 1, pp 41–76. McCauley, R and P McGuire (2014): “Non-US banks’ claims on
the Federal Reserve”, BIS Quarterly Review, March, pp 89–97.
(2012): “Follow the money: quantifying domestic effects
of foreign bank shocks in the Great Recession”, American Eco- McGuire, P and G von Peter (2009): “The US dollar shortage in
nomic Review, vol 102, no 3, pp 213–18. global banking”, BIS Quarterly Review, March, pp 47–63.
Coffey, N, W Hrung and A Sarkar (2009): “Capital constraints, (2012): “The US dollar shortage in global banking and the
counterparty risk, and deviations from covered interest parity”, international policy response”, International Finance, June.
Federal Reserve Bank of New York, Staff Reports, no 393.
Pinnington, J and M Shamloo (2016): “Limits to arbitrage and
1
Domanski, D, H S Shin and V Sushko (2015): “The hunt for dura- deviations from covered interest rate parity”, Bank of Canada,
da,
a,
60
5
tion: not waving but drowning?”, BIS Working Papers, no 519, Staff Discussion Papers, 16-4.
66
98 er
1- nt
20
66 Ce
October.
Pozsar, Z and S Smith (2016): “Japanese banks, LIBOR
O and
LIBOR
LIBO an the
65 ks
06 oo
Du, W, A Tepper and A Verdelhan (2016): “Covered interest FX swap lines”, Credit Suisse Fixed Income Research,
eseaarch, Global
82 B
rate parity deviations in the post-crisis world”, May, available at Money Notes #7, August.
-9 ali
58 ak
Duffie, D (2016): “Why are big banks offering less liquidity to exposure and hedging in Australia”, Reserve
Reser Bank of Australia,
Reserv
bond markets?”, Forbes, 11 March. Bulletin, December, pp 49–57.
20
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Chapter 17 Covered Interest Parity Lost: Understanding the Cross-Currency Basis ■ 347
1
60
5
66
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1- nt
20
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65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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348 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● Discuss how asset-liability management strategies can ● Describe duration gap management and apply this
help a bank hedge against interest rate risk. strategy to protect a bank’s net worth.
1
● Describe interest-sensitive gap management and apply ● Discuss the limitations of interest-sensitive gap
605
this strategy to maximize a bank’s net interest margin. management and duration gap management.
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
Excerpt is Chapter 7 of Bank Management & Financial Services, Ninth Edition, by Peter S. Rose and Sylvia
a C. Hudgins.
H
20
99
349
risk. This type of coordinated and integrated decision making sources comparable to the control financial managers had long ong
ng
5
66
98 er
is known as asset-liability management (ALM). The collection exercised over their assets. The key control lever was price—the
ce—th
ce —the
1- nt
20
66 Ce
of managerial techniques known as asset-liability manage- interest rate and other terms offered on deposits and other oth
her
he
65 ks
borrowings to achieve the volume, mix, and cost desired. ed. For
esire Fo
82 B
handle such challenging events as business cycles and seasonal example, a lender faced with heavy loan demand d that
nd th at exceeded
hat ex
-9 ali
58 ak
1
Portions of this chapter are based upon Peter S. Rose’s article in The ings relative to its competitors, and funds would
ouuld flow
fl in. On the
Canadian Banker [6] and are used with the permission of the publisher. other hand, a financial institution flush with
h funds
fun but with few
20
99
350 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Funds Management
Strategy
The maturing of liability management Exhibit 18.1 Asset-liability management in banking and financial services.
techniques, coupled with more volatile
interest rates and greater risk, eventu-
ally gave birth to the funds management approach, which
dominates today. This view is a more balanced approach to 18.3 INTEREST RATE RISK: ONE
asset-liability management that stresses several key objectives: OF THE GREATEST MANAGEMENT
1. Management should exercise as much control as possible CHALLENGES
over the volume, mix, and return or cost of both assets and
liabilities in order to achieve the financial institution’s goals. No financial manager can completely avoid one of the toughest
and potentially most damaging forms of risk that all financial
2. Management’s control over assets must be coordinated
institutions must face—interest rate risk. When interest rates
with its control over liabilities so that asset management
change in the financial marketplace, the sources of revenue
and liability management are internally consistent and do
that financial institutions receive—especially interest income
not pull against each other, Effective coordination in man-
on loans and investment securities—and their most important
aging assets and liabilities will help to maximize the spread
source of expenses—interest cost on borrowings—must also
between revenues and costs and control risk exposure.
change. Moreover, changing interest rates also change the
3. Revenues and costs arise from both sides of the balance market value of assets and liabilities, thereby changing each
sheet (i.e., from both asset and liability accounts). Manage- financial institution’s net worth—the value of the owner’s invest-
ment policies need to be developed that maximize returns ment in the firm. Thus, changing interest rates impact both the
and effectively control costs from supplying services. balance sheet and the statement of income and expenses of
The traditional view that all income received by financial firms financial firms.
must come from loans and investments has given way to the
notion that financial institutions today sell a bundle of financial
Forces Determining Interest Rates
services—credit, payments, savings, financial advice, and the
like—that should each be priced to cover their cost of produc- The problem with interest rates is that although they are criti-
tion. Income from managing the liability side of the balance cal to most financial institutions, the managers of these firms
sheet can help achieve profitability goals as much as revenues simply cannot control either the level of or the trend in market
generated from managing loans and other assets. Many financial rates of interest. The rate of interest on any particular loan
firms carry out daily asset-liability management (ALM) activities or security is ultimately determined by the financial market-
through asset-liability committees (ALCO), usually composed of place where suppliers of loanable funds (credit) interact with
key officers representing different departments of the firm. demanders of loanable funds (credit) and the interest rate (price e
1
loanable funds demanded and supplied are equal, ass sho shown
own iin
98 er
1- nt
20
CONCEPT CHECK
66 Ce
Exhibit 18.2.
65 ks
ment? liability management? funds management? of the loanable funds (credit) market, butt each
eacch lending
len institu-
82
18.2. What factors have motivated financial institutions to tion is only one supplier of credit in ann international
inte
ternat
ernat market
-9
58
develop funds management techniques in recent years? for loanable funds that includes manyy thousands
thous
thous of lenders.
11
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 351
marketplace as demanders of loanable funds (credit) when The Measurement of Interest Rates
they offer deposit services to the public or issue nondeposit
IOUs to raise funds for lending and investing. But, again, When we use the term interest rates exactly what do we mean?
each financial institution, no matter how large it is, is only one How are interest rates measured?
demander of loanable funds in a market containing many thou- Most of us understand what interest rates are because we have
sands of borrowers. borrowed money at one time or another and know that interest
Thus, whether financial firms are on the supply side or the rates are the price of credit, demanded by lenders as compensa-
demand side of the loanable funds (credit) market at any given tion for the use of borrowed funds. In simplest terms the interest
moment (and financial intermediaries are usually on both sides rate is a ratio of the fees we must pay to obtain credit divided by
of the credit market simultaneously), they cannot determine the amount of credit obtained (expressed in percentage points
the level, or be sure about the trend, of market interest rates. and basis points [i.e., 1/100 of a percentage point]). However,
Rather, the individual institution can only react to the level of over the years a bewildering array of interest rate measures have
and trend in interest rates in a way that best allows it to achieve been developed.
its goals. In other words, most financial managers must be price For example, one of the most popular rate measures is the yield
takers, not price makers, and must accept interest rate levels as to maturity (YTM)—the discount rate that equalizes the current
a given and plan accordingly. market value of a loan or security with the expected stream of
As market interest rates move, financial firms typically face future income payments that the loan or security will generate.
at least two major kinds of interest rate risk—price risk and In terms of a formula, the yield to maturity may be found from
reinvestment risk. Price risk arises when market interest rates Expected cash flow Expected cash flow
rise, causing the market values of most bonds and fixed-rate Current market price in Period 1 in Period 2
= +
loans to fall. If a financial institution wishes to sell these finan- of a loan or security (1 + YTM)1 (1 + YTM)2
1
Sale or redemption
5
liabilities consists of finding ways to deal effectively with these where n is the number of years that payments occu
occur.
ur.. For
ur Fo exam-
58 ak
11 ah
352 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
$100 $100 $100 $1000 To convert a DR to the equivalent yield to maturity we can use
$950 = + + +
(1 + YTM)1 (1 + YTM)2 (1 + YTM)3 (1 + YTM)3 the formula
in Period 1 in Period 2
56
Price = + Filmtoid
66
98 er
(1 + YTM/k)1 (1 + YTM/k)2
1- nt
20
66 Ce
Expected cash flow and sale or redemption price What 2001 Australian drama finds the head of Centabank
Ceenta aban
ban
65 ks
+ g+
(1 + YTM/k)n * k
82 B
where k is the number of times interest is paid each year. Thus, the total Answer: The Bank.
11 ah
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 353
354 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 355
A well-run ALCO meets regularly (quarterly, monthly, or even Note how narrow this net interest margin (which is fairly close
more frequently) to manage the financial firm’s interest rate risk to the average for the banking industry) is at just 3.5 percent,
(IRR) and other risk exposures as well. The committee is expected which is not this bank’s profit from borrowing and lending funds
to have a firm grasp of the organization’s principal goals, usually because we have not considered noninterest expenses (such as
centered on the maximization of shareholder wealth, maintain- employee salaries, taxes, and overhead expenses). Once these
ing adequate profitability, and achieving sufficient capitalization. expenses are also deducted, the manager of this bank gener-
These are often stated as specific numerical targets (e.g., an ally has very little margin for error against interest rate risk. If
ROA of 1.5 percent and an equity-to-assets ratio of at least 10 management does find a 3.5 percent net interest margin accept-
percent). The AOL regularly conveys to the board of directors the able, it will probably use a variety of interest-rate risk hedging
firm’s financial condition plus suggestions for correcting identi- methods to protect this NIM value, thereby helping to stabilize
fied weaknesses. The committee lays out a plan for how the firm net earnings.
should be funded, the quality of loans that it should take on, and If the interest cost of borrowed funds rises faster than income
the proper limits to its off-balance-sheet risk exposure. The ALCO from loans and securities, a financial firm’s NIM will be
estimates the firm’s risk exposure to its net interest margin and squeezed, with likely adverse effects on profits.3 If interest rates
net worth ratios, develops strategies to keep that risk exposure fall and cause income from loans and securities to decline faster
within well-defined limits, and may employ simulation analysis to than interest costs on borrowings, the NIM will again be
test alternative management strategies. squeezed. In other words, yield curves do not usually move in
parallel fashion over time, so that the spread between borrow-
ing costs and interest revenues is never constant. Management
18.4 ONE OF THE GOALS OF INTEREST must struggle continuously to find ways to ensure that borrow-
RATE HEDGING: PROTECT ing costs do not rise significantly relative to interest income and
THE NET INTEREST MARGIN threaten the margin of a financial firm.
3
ln recent years, as noted by Alden Toevs [7], the net interest income
ncom
com
me of
66 Ce
U.S. banks has accounted for about 60 to 80 percent of theirr nett earn-
65 ks
Interest income Interest expense on ings. Toevs also found evidence of a substantial increase in n the e vola
volat
volatility
06 oo
°
from loans - deposits and other ¢
82 B
NIM = romin
interesting management strategy that became prominent nent n near the close
11 ah
of the 20th century and into the new century has be een to deemphasize
been
Net interest income interest rate–related sources of revenue and to empha
emph
emphasize noninterest
= (18.5)
Total earning assets e).
rate–related revenue sources (e.g., fee income).
20
99
356 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
For example, a financial firm can hedge itself against interest What happens when the amount of repriceable assets does
rate changes—no matter which way rates move—by making not equal the amount of repriceable liabilities? Clearly, a gap
sure for each time period that the then exists between these interest-sensitive assets and interest-
sensitive liabilities. The gap is the portion of the balance sheet
Dollar amount of repriceable Dollar amount of repriceable
affected by interest rate risk:
(interest@sensitive) = (interest@sensitive)
assets liabilities Interest@sensitive gap = Interest@sensitive assets
(18.7)
(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
1
Short-term securities issued Borrowings from the money Cash in the vault and deposits Demand deposits (which pay ay
5 60
by governments and private market (such as federal funds at the Central Bank (legal no interest rate or a fixed
fixe
66
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1- nt
Short-term loans made to Short-term savings accounts Long-term loans made at a Long-term savings
vingss and
06 oo
to mature)
58 ak
11 ah
securities (whose interest rates are ing fixed rates Buildings and financial
ial institution’s
in owners
adjustable frequently equipment
20
99
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 357
For example, a bank with interest-sensitive assets of $500 million A Relative IS GAP greater than zero means the institution is
and interest-sensitive liabilities of $400 million is asset sensi- asset sensitive, while a negative Relative IS GAP describes a
tive with a positive gap of $100 million. If interest rates rise, liability-sensitive financial firm. Finally, we can simply com-
this bank’s net interest margin will increase because the interest pare the ratio of ISA to ISL, sometimes called the Interest
revenue generated by assets will increase more than the cost of Sensitivity Ratio (ISR). Based on the figures in our previous
borrowed funds. Other things being equal, this financial firm will example,
experience an increase in its net interest income. On the other
ISA $150 million
hand, if interest rates fall when the bank is asset sensitive, this Interest Sensitivity Ratio (ISR) = = = 0.75
ISL $200 million
bank’s NIM will decline as interest revenues from assets drop
(18.11)
by more than interest expenses associated with liabilities. The
In this instance an ISR of less than 1 tells us we are looking at
financial firm with a positive gap will lose net interest income if
a liability-sensitive institution, while an ISR greater than unity
interest rates fall.
points to an asset-sensitive institution.
In the opposite situation, suppose an interest-sensitive bank’s
Only if interest-sensitive assets and liabilities are equal is a
liabilities are larger than its interest-sensitive assets. This bank
financial institution relatively insulated from interest rate risk. In
then has a negative gap and is said to be liability sensitive. Thus:
this case, interest revenues from assets and funding costs will
Liability@sensitive Interest@sensitive assets change at the same rate. The interest-sensitive gap is zero, and
= (18.9)
(negative) gap -Interest@sensitive liabilities 6 0 the net interest margin is protected regardless of which way
A financial institution holding interest-sensitive assets of $150 interest rates go. As a practical matter, however, a zero gap
million and interest-sensitive liabilities of $200 million is liability does not eliminate all interest rate risk because the interest rates
sensitive, with a negative gap of $50 million. Rising interest rates attached to assets and liabilities are not perfectly correlated
will lower this institution’s net interest margin, because the ris- in the real world. Loan interest rates, for example, tend to lag
ing cost associated with interest-sensitive liabilities will exceed behind interest rates on many money market borrowings. So
increases in interest revenue from interest-sensitive assets. interest revenues often tend to grow more slowly than interest
Falling interest rates will generate a higher interest margin and expenses during economic expansions, while interest expenses
probably greater earnings as well, because borrowing costs will tend to fall more rapidly than interest revenues during economic
decline by more than interest revenues. downturns.
Actually, there are several ways to measure the interest- Gapping methods used today vary greatly in complexity and
sensitive gap (IS GAP). One method is called simply the Dol- form. All methods, however, require financial managers to make
lar IS GAP. For example, as we saw above, if interest-sensitive some important decisions:
assets (ISA) are $150 million and interest-sensitive liabilities 1. Management must choose the time period during which the
(ISL) are $200 million, then the Dollar IS GAP = ISA - ISL net interest margin (NIM) is to be managed (e.g., six months
= $150 million - $200 million = -$50 million. Clearly, an insti- or one year) to achieve some desired value and the length
tution whose Dollar IS GAP is positive is asset sensitive, while a of subperiods (“maturity buckets”) into which the planning
negative Dollar IS GAP describes a liability-sensitive condition. period is to be divided.
1
560
66
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An Asset-Sensitive Financial A Liability-Sensitive 2. Management must choose a target level for the net inter-
nter-
ter-
1- nt
20
66 Ce
Firm Has: Financial Firm Has: est margin—that is, whether to freeze the margin roughly
rou
ughhly
65 ks
358 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
a profit that will help offset the margin losses that rising inter- n fixed
ffixe
edd
65 ks
est rates will almost surely bring in the coming week. Looking (non-rate-sensitive) liabilities * Volume off fixed
fixxeded
06 oo
82 B
over the remainder of the table, it is clear the institution will (non-rate-sensitive) liabilities]
s]
-9 ali
58 ak
fare much better over the next several months if market interest For example, suppose the yields on rate-sensitive
ensiti and fixed
te-se
ensitiv
11 ah
41 M
rates rise, because its cumulative gap eventually turns positive assets average 10 percent and 11 percent,
ce nt, respectively,
ent, r while
again. rate-sensitive and non-rate-sensitive
e liabilities
liabi
liab cost an average of
20
99
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 359
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
Marketable securities 200 $50 $80 $110 $460 900
Business loans 750 150 220 170 210 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 equipment — — — — 200 200
Total repriceable
(interest sensitive) assets $1,700 $310 $440 $ 480 $1,170 $4,100
Liabilities end Net
Worth
Checkable deposits $800 $100 — — — $900
Savings accounts 50 50 — — — 100
Money market deposits 550 150 — — — 700
Long-term time deposits 100 200 450 150 300 1,200
Short-term borrowings 300 100 — — — 400
Other liabilities — — — — 100 100
Net worth — — — — 700 700
Total repriceable
(interest-sensitive)
liabilities and net worth $1,800 $600 $450 $150 $1,100 $4,100
Interest-sensitive gap -$100 -$290 -$10 +$330 +$ 70
(repriceable assets –
repriceable liabilities)
Cumulative gap -$100 -$390 -$400 -$70 -0
margin will likely be rates rise rates rise rates rise rates fall rates fall
1 - nt
20
66 Ce
squeezed if
65 ks
06 oo
Suppose that interest yields on interest-sensitive assets currently average 10%, while interest-sensitive liabilities have an n average
averag
82 B
cost of 8%, In contrast, fixed assets yield 11% and fixed liabilities cost 9%. If interest rates stay at these levels, the bank’s
ank’s net
-9 li
58 ak
interest income and net interest margin measured on an annualized basis will be as follows:
11 ah
41 M
20
99
360 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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
8 percent and 9 percent, respectively. During the coming week However, if the market interest rate on rate-sensitive assets rises
60
5
the bank holds $1,700 million in rate-sensitive assets (out of an to 12 percent and the interest rate on rate-sensitive liabilities
iabil
abilities
ties
66
98 er
1- nt
20
asset total of $4,100 million) and $1,800 million in rate-sensitive rises to 10 percent during the first week, this liability-sensitive
ty-se
sensit
ensit
66 Ce
65 ks
liabilities. Suppose, too, that these annualized interest rates institution will have an annualized net interest income
incom
ncomme ofo only
06 oo
remain steady. Then this institution’s net interest income on an 0.12 * $1,700 + 0.11 * [4,100 - 1,700]
0]] - 0.10 * $1,800
82 B
-9 ali
$8
81 mmillion
11 ah
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 361
A useful overall measure of interest rate risk exposure is the Some financial firms shade their interest-sensitive gaps toward
cumulative gap, which is the total difference in dollars between either asset sensitivity or liability sensitivity, depending on
those assets and liabilities that can be repriced over a desig- their degree of confidence in their own interest rate forecasts.
nated period of time. For example, suppose that a bank has This is often referred to as aggressive GAP management. For
$100 million in earning assets and $200 million in liabilities example, if management firmly believes interest rates are going
subject to an interest rate change each month over the next to fall over the current planning horizon, it will probably allow
six months. Then its cumulative gap must be –$600 million— interest-sensitive liabilities to climb above interest-sensitive
that is: ($100 million in earning assets per month * 6) assets. If interest rates do fall as predicted, liability costs will
- ($200 million in liabilities per month * 6) = -$600 million. drop by more than revenues and the institution’s NIM will grow.
The cumulative gap concept is useful because, given any specific Similarly, a confident forecast of higher interest rates will trig-
change in market interest rates, we can calculate approximately ger many financial firms to become asset sensitive, knowing
how net interest income will be affected by an interest rate that if rates do rise, interest revenues will rise by more than
change. The key relationship is this: interest expenses. Of course, such an aggressive strategy cre-
ates greater risk. Consistently correct interest rate forecasting
Change in Overall change in Size of the
is impossible; most financial managers have learned to rely on
net interest = interest rate * cumulative gap
income (in percentage points) (in dollars) hedging against, not forecasting, changes in market interest
(18.13) rates. Interest rates that move in the wrong direction can mag-
nify losses. (See Table 18.2.)
For example, suppose market interest rates suddenly rise by
1 full percentage point. Then the bank in the example given Many financial-service managers have chosen to adopt a purely
above will suffer a net interest income loss of approximately defensive GAP management strategy:
If management anticipates an increase in interest rates, it may Some financial institutions have developed a weighted interest-
560
be able to head off this pending loss of income by shifting some sensitive gap approach that takes into account the tendency cyy of
66
98 er
1- nt
20
assets and liabilities to reduce the size of the cumulative gap interest rates to vary in speed and magnitude relative to eacheacch
h
66 Ce
65 ks
or by using hedging instruments (such as financial futures con- other and with the up and down cycle of business activity.
tivityy. The
ctivity Th
06 oo
tracts, to be discussed in Chapter 8). In general, financial insti- interest rates attached to assets of various kinds often
ofte
tenn change
cha
82 B
-9 al
tutions with a negative cumulative gap will benefit from falling by different amounts and at different speeds than many
man of the
m
58 ak
11 ah
interest rates but lose net interest income when interest rates interest rates attached to liabilities—a phenomenon
omeenon called
menon
41 M
rise. Institutions with a positive cumulative gap will benefit if basis risk.
20
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362 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Interest-sensitive assets 7 interest- Losses if interest rates fall because 1. Do nothing (perhaps interest rates will rise or
sensitive liabilities (asset sensitive) the net interest margin will be be stable).
reduced. 2. Extend asset maturities 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 6 interest- Losses if Interest rates rise because 1. Do nothing (perhaps interest rates will fall or
sensitive liabilities (liability sensitive) the net interest margin will be be stable).
reduced. 2. Shorten asset maturities or lengthen liability
maturities.
3. Decrease interest-sensitive liabilities or
increase interest-sensitive assets. 1
60
5
For example, suppose a bank has the current amount and interest rate sensitivity weight of 1.0—that is, we assume
sume the
ssume
66
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1- nt
20
distribution of interest-sensitive assets and liabilities shown in bank’s fed funds rate tracks market rates one for one.one. In this
t
66 Ce
65 ks
the table at the bottom of page 234 with rate-sensitive assets bank’s investment security portfolio, however, r, suppose
ppos there
sup
ppose
06 oo
totaling $200 million and rate-sensitive liabilities amounting to are some riskier, somewhat more rate-volatile e investments
tile inves
i
82 B
-9 ali
$223 million, yielding an interest-sensitive GAP of –$23 on its than most of the security interest rates reported
orted daily in the
repo
58 ak
11 ah
present balance sheet. Its federal funds loans generally carry financial press. Therefore, its averagee security
ecurit yield moves
sec
41 M
interest rates set in the open market, so these loans have an up and down by somewhat more than n the interest rate on
20
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 363
from higher market interest rates. Suppose the federal funds checkable deposits and savings accounts may have their inter- te
5
66
98 er
interest rate rose by 2 percentage points (+0.02). Instead of est rates adjusted up or down at any time. And the choice ce
1- nt
20
66 Ce
declining by - $0.46, this bank’s net interest income increases of planning periods over which to balance interest-sensitive
ens
nssitiv
ive
ve
65 ks
by $1.50. Clearly, management would have an entirely differ- assets and liabilities is highly arbitrary. Some itemss always
alw
ways
06 oo
82 B
ent reaction to a forecast of rising interest rates with the new fall between the cracks in setting planning periods,
iods, and
-9 ali
58 ak
weighted balance sheet than it would have with its original, they could cause trouble if interest rates moveove against
again the
again
11 ah
41 M
20
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364 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
AS A RISK-MANAGEMENT TOOL D =
t=1
(18.15)
Current Market Value or Price
In the preceding sections of this chapter we examined a key For example, suppose that a bank grants a loan to one of its
management tool—interest-sensitive gap management—that customers for a term of five years. The customer promises the
enables managers of financial institutions to combat the pos- bank an annual interest payment of 10 percent (that is, $100 per
sibility of losses to their institution’s net interest margin or year). The face (par) value of the loan is $1,000, which is also its
spread due to changes in market interest rates. Unfortunately, current market value (price) because the loan’s current yield to
changing interest rates can also do serious damage to another maturity is 10 percent. What is this loan’s duration? The formula
aspect of a financial firm’s performance—its net worth, the with the proper figures entered would be this:
value of the stockholders’ investment in the institution. Just 5
((18.16)
18.1
66
98 er
receive from its loans and security investments or the stream of As market interest rates change, the value of both h a finan-
th fi
65 ks
interest payments it must pay out to its depositors). In effect, cial institution’s assets and its liabilities will change,
angee, resulting
res
res
06 oo
82 B
duration measures the average time needed to recover the in a change in its net worth (the owner’s investment
vesttment in the
-9 ali
58 ak
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 365
The important feature of duration from a risk-management in an asset’s price and changes in market interest rates. It is a
5 60
value of financial instruments to changes in interest rates. The controlling the market risk in a portfolio of assets. An assetet or
ssset o
65 ks
percentage change in the market price of an asset or a liability portfolio bearing both a low duration and low convexityexity nor-
06 oo
82 B
is equal to its duration times the relative change in interest rates mally displays relatively small market risk.
-9 ali
366 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Because the dollar volume of assets usually exceeds the dol- (1 + i))
5
66
98 er
onn times
tim
mes the
t
66 Ce
∆i
65 ks
1 + i
82 B
-9 ali
4
As noted above, convexity is related to duration. Specifically, we can
58 ak
∆NW = J -DA * * AR - J -
-DDL * * LR
(1 + i) (1 + i)
41 M
relationship using
Convexity = (Duration) - (Change in duration/Change in interest rates). (18.22)
20
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 367
B. Plan the acquisition of earning assets and liabilities so that, as closely as possible,
Dollar@weighted - Dollar@weighted Total liabilities
* ≈ 0
asset duration liability duration Total assets
In words,
Change in Change in
Change in value -Average -Average
interest rate Total interest rate Total
of a financial institution’s = D duration * * T - D duration * * T (18.23)
(1 + Original assets (1 + Original liabilities
net worth of assets of liabilities
discount rate) discount rate)
For example, suppose that a financial firm has an average dura- Clearly, this institution faces a substantial decline in the value of
tion in its assets of three years, an average liability duration of its net worth unless it can hedge itself against the projected loss
two years, total liabilities of $100 million, and total assets of due to rising interest rates.
$120 million. Interest rates were originally 10 percent, but sud- Let’s consider an example of how duration can be calculated
denly they rise to 12 percent. and used to hedge a financial firm’s asset and liability portfolio.
In this example: We take advantage of the fact that the duration of a portfolio of
Change in the assets and of a portfolio of liabilities equals the value-weighted
+0.02 average of the duration of each instrument in the portfolio. We
value of = J -3 * * $120 million R
(1 + 0.10) can start by (1) calculating the duration of each loan, deposit,
net worth
1
60
+0.02
66
98 er
- J -2 * * $100 million R = -$2.91 million. market values of the instruments involved; and (3) adding g all
1- nt
20
(1 + 0.10)
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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368 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Real estate loans 40 million 2.25 years We would go through the same calculation for the remain-
Municipal bonds 20 million 1.50 years ing liabilities in this example, as illustrated in Table 18.4. This
institution has an average liability duration of 2.669 years,
substantially less than the average duration of its asset port-
Weighting each asset duration by its associated dollar
folio, which is 3.047 years. Because the average maturity of
volume, we calculate the duration of the asset portfolio as
its liabilities is shorter than the average maturity of its assets,
follows:
this financial firm’s net worth will decrease if interest rates rise
n Duration of Market value and increase if interest rates fall. Clearly, management has
a each asset in * of each asset positioned this institution in the hope that interest rates will fall
Dollar@weighted i=1
the portfolio in the portfolio in the period ahead. If there is a substantial probability inter-
asset portfolio =
Total market value est rates will rise, management may want to hedge against
duration
of all assets damage from rising interest rates by lengthening the average
(7 .49 years * $90 million in Treasury bonds maturity of its liabilities, shortening the average maturity of its
assets, or employing hedging tools (such as financial futures,
+ 0.60 year * $100 million in commercial loans options, or swaps, as discussed in the next chapter) to cover
this duration gap.
+ 1.20 years * $50 million in consumer loans
$914.10 million
5
$300 million an asset duration of three years and its total assets are $100 00 mil-
m
1- nt
20
66 Ce
lion while total liabilities are $92 million. Then management meentt will
= 3.047 years (18.24)
65 ks
3.261 years (or asset duration * total assets , total otal lia
ota liabilities
abilit
abiliti =
82 B
years).
rs).
58 ak
11 ah
41 M
20
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 369
DURATION GAP MANAGEMENT AT THE 14 months at the close of 2002. Fannie’s assets were rolling
WORLD’S LARGEST MORTGAGE BANK over into cash more than a year sooner than its liabilities. If
market interest rates had continued to fall, the value of Fan-
The world’s leading mortgage banking institution—the Fed- nie’s net worth would also have continued to decline as lon-
eral National Mortgage Association (FNMA), better known ger-term liabilities increased in value relative to shorter-term
as Fannie Mae—reports its duration gap on a monthly basis. assets. Investors in the financial markets reacted negatively to
Fannie is a crucial institution supporting the U.S. housing FNMA’s announcement of a widening negative duration gap
market. It issues notes and bonds to raise new capital and and its stock price fell for a time.
then uses the proceeds to purchase residential mortgages
from private lenders and to package home loans into pools Fannie strives to maintain a duration gap between negative
that support the issuance of mortgage-backed securities. 6 months and positive 6 months. By 2002 Fannie Mae had its
Fannie has contributed significantly to making more families duration gap in line with this objective—a negative 6 months.
eligible to receive loans in order to purchase new homes. By September 2007 its monthly duration gaps fell within the
-1 month to +1 month range and, in fact, was listed as zero.
As market interest rates plummeted early in the 21st century Fannie faced an uncertain future, however, in the wake of a
and the volume of home mortgage financings soared, FNMA serious global credit crisis and possible revocation of U.S.
experienced a significant shift in the average maturity of government support. (Fannie publishes its duration gap cal-
its assets and liabilities. Lengthening liabilities and shorter- culations on its website at www.fanniemae.com.)
term assets generated a negative duration gap of about
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 10.00% 7.490 Negotiable CDs $100 6.00% 1.943
securities
Municipal 20 6.00 1.500 Other time deposits 125 7.20 2.750
bonds
Commercial 100 12.00 0.600 Subordinated notes 50 9.00 3.918
loans
Consumer 50 15.00 1.200 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
1
560
= 3.047 years
65 ks
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370 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Management Interpretation
The positive duration gap of +0.60 year means that the bank’s net worth will decline if interest rates rise and increase if interest
rates fall. Management may be anticipating a decrease in the level of interest rates. If there is significant risk of rising market inter-
est rates, however, the asset-liability management committee will want to use hedging tools to reduce the exposure of net worth
to interest rate risk.
How much will the value of this bank’s net worth change for any given change in interest rates? The appropriate formula is as follows:
= -DA #
∆r #
A - J -DL #
Change in value ∆r #
LR,
of net worth (1 + r) (1 + r)
where A is total assets, DA the average duration of assets, r the initial interest rate, ∆r the change in interest rates, L total liabilities,
and DL the average duration of 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
(+0.02) (+002)
value of = -3.047 years * * $300 million - J -2.669 years * * $275 million R
(1 + 0.08) (1 + 0.08)
net worth
= - $16.93 million + $13.59 million = -$3.34 million
This institution’s net worth would fall by approximately $3.34 million if interest rates increased by 2 percentage points.
Suppose interest rates fall from 8 percent to 6 percent, what would happen to the value of the above institution’s net worth?
Again, substituting in the same formula:
Change in value (-0.02) (-0.02)
= - 3.047 years * * $300 million - J -2.669 years * * $275 million R
of net worth (1 + 0.08) 1 + .08
= $16.93 million - $13.59 million = + $3.34 million
In this instance, the value of net worth would rise by about $3.34 million if all interest rates fell by 2 percentage points.
The above formula reminds us that the impact of interest rate changes on the market value of net worth depends upon three cru-
cial size factors:
A. The size of the duration gap (DA - DL), with a larger duration gap indicating greater exposure of a financial firm to interest
rate risk.
B. The size of a financial institution (A and L), with larger institutions experiencing a greater change in net worth for any given
change in interest rates.
C. The size of the change in interest rates, with larger rate changes generating greater interest rate risk exposure.
Management 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 amounts of assets and liabilities (A and L) outstanding.
For example, suppose in the previous example the leverage-adjusted duration gap, instead of being + 0.60 year, is zero. If the
01
56
average duration of assets (DA) is 3.047 years (and assets and liabilities equal $300 and $275 million, respectively) this would
uld mean
66
98 e
*
duration (DA) (DL) Total assets
-9
gap
58
11
41
(Continued)
20
99
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 371
Change in
(-0.02) (+ 0.02)
value of = -3.047 years * * $300 million - J -3.324 years * * $275 million R
(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 * * $300 million - J -3.324 years * * $275 million R
(1 + 0.08) 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,
GAP MANAGEMENT
66
98 er
1- nt
liabilities will simply offset each other and net worth will remain
65 ks
where it is.
82 B
like the seemingly “wimpy” strategy of portfolio immunization task. It would be much easier if the maturityy off a loan
lo or security
loa
41 M
20
99
372 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
liability duration of 1.75 years. Its liabilities amount • Early in the history of banking managers focused principally
n ally
5
66
98 er
to $485 million, while its assets total $512 million. upon the tool of asset management—emphasizing ngg control
co
ontro
ontro
1- nt
20
66 Ce
Suppose that interest rates were 7 percent and and selection of assets to achieve institutionall goals
goals because
goa
oa be
65 ks
value of the Stilwater bank’s net worth as a result sions and government rules.
-9 ali
58 ak
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 373
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
1
5 60
66
98 er
1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
20
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374 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 What has been happening to the bank’s net interest
b. $95.75, 270 days margin? What do you think caused the changes you have
c. $98.75, 91 days observed? Do you have any recommendations for New
Comers’ management team?
Calculate the bank discount rate (DR) on each bill if
it is held to maturity. What is the equivalent yield to 8. The First National Bank of Dogsville finds that its asset
maturity (sometimes called the bond-equivalent or and liability portfolio contains the following distribution
coupon-equivalent yield) on each of these Treasury bills? 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
1
60
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 375
376 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
$1.5 billion. If interest rates began at 5 percent and then 18. Carter National Bank holds $15 million in government
suddenly climbed to 6 percent, what change will occur bonds having a duration of 12 years. If interest rates
in the value of Conway’s net worth? By how much would suddenly rise from 6 percent to 7 percent, what per-
Conway’s net worth change if, instead of rising, interest centage change should occur in the bonds’ market
rates fell from 5 percent to 4.5 percent? price?
14. A financial firm holds a bond in its investment portfolio
whose duration is 15 years. Its current market price is Internet Exercises
$975. While market interest rates are currently at 6 per-
cent for comparable quality securities, a decrease in inter- 1. At www.almprofessional.com you will find a network
est rates to 5.75 percent is expected in the coming weeks. devoted to articles and discussions of the asset-liability
What change (in percentage terms) will this bond’s price management field. Visit the site and find an article
experience if market interest rates change as anticipated? entitled “Principles for the Management of Interest Rate
Risk.” What are the major sources of interest rate risk
15. A savings bank’s weighted average asset duration is 8
according to this article?
years. Its total liabilities amount to $925 million, while
its assets total 1.25 billion dollars. What is the dollar- 2. If you would like to view the current yield curve go to
weighted duration of the bank’s liability portfolio if it has www.bloomberg.com/markets/rates/index.html. What
a zero leverage-adjusted duration gap? are the current yields on 3-month Ttreasury bills, 5-year
Treasury notes, and 30-year Ttreasury bonds? Describe
16. Blue Moon National Bank holds assets and liabilities
the shape of the yield curve.
whose average durations and dollar amounts are as
shown in this table: 3. If you want to learn more about duration, go to www
.bionicturtle.com/how-to/article/modified-vs-
Asset and Liability Items Avg. Duration Dollar macaulay-duration/ and read through this How-To learn-
(years) Amount ing segment. Define modified duration, and describe
(millions)
why it is useful.
Investment-grads bonds 15.00 $65.00 4. See if you can find the meaning of modified duration on
Commercial loans 3.00 400.00 the Web. Where did you find it, and what did you find?
Consumer loans (Hint: Try the website in Internet Exercise 3.)
7.00 250.00
Deposits 1.25 600.00 5. Duration gap management is a powerful analytical tool
for protecting net worth of a financial institution from
Nondeposit borrowings 0.50 50.00
damage due to shifting interest rates. Asset-liability
What is the weighted-average duration of Blue Moon’s managers have found this tool surprisingly resilient and
asset portfolio and liability portfolio? What is its robust even when its basic assumptions are not fully met.
leverage-adjusted duration gap? Go to www.ots.treas.gov/docs/4/422196.pdf, and
17. A government bond currently carries a yield to maturity see how bank regulators in the U.S. Treasury understand
of 6 percent and a market price of $1,168,49. If the bond duration gaps.
promises to pay $100 in interest annually for five years,
what is its current duration?
1
605
66
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1- nt
20
66 Ce
65 ks
06 oo
82 B
-9 ali
58 ak
11 ah
41 M
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Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 377
ANALYSIS OF INTEREST RATE SENSITIVITY find net interest income (NII) 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
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
1
with Peers. While the FDIC’s website is powerful in providing basicba icc data
dat
82 B
-9 ali
nd
concerning assets, liabilities, equity, income, and d expenses
exxpen
xpens for
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378 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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.
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 $23.5 billion for 2010. This
sensitive gap by multiplying the Relative IS gap by average indicates that BB&T is asset sensitive and its exposure to inter-
est rate changes increased during 2010. Using a one-year time
assets.
frame, we may explore the effects on net interest income from
C. Write one paragraph discussing the interest rate risk expo- changes in market interest rates using the one-year Interest Sen-
sure for your BHC, Is it asset or liability sensitive at the sitive Gap for 2010 and the following equation:
conclusion of each year? What are the implications of the Change in NII = (Change in interest rate) * ($ 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 2010 information.
Chapter 18 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques ■ 379
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.
1
60
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11 ah
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380 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
● 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.
1
560
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65 ks
06 oo
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11 ah
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Excerpt is Chapter 13 of Asset Management: A Systematic Approach to Factor Investing, by Andrew Ang.
g.
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381
Harvard Management Company (HMC), the funds manager of buy my interest back.
5 60
MENDILLO: Great.
1- nt
20
FUNDS MANAGER: Here, I think it’s worth you know, now, today
tod
toda
65 ks
06 oo
1
This is based on “Liquidating Harvard,” Columbia CaseWorks MENDILLO: Then why would I sell it?
58 ak
ID #100312.
11 ah
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2
Financial Update to the Council of Deans, December 2, 2008, from
3
Faust and Forst. Nina Munk, “Rich Harvard, Poor Harvard,” Vanity
nity F
Fair, August 2009.
20
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382 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
But in truth Harvard was desperate. Markets can be illiquid because one investor has superior
knowledge compared with other investors. Fearing they’ll
The reaction to Faust and Forst’s cost-cutting memo was swift
be fleeced, investors become reluctant to trade. When
and sharp. Faculty, students, and alumni were incredulous. Alan
asymmetric information is extreme—all the products are
Dershowitz, a famous professor at Harvard Law School, said:4
lemons, and no one wants to buy a lemon—markets break
“Apparently nobody in our financial office has read the story in
down.5 Many liquidity freezes are caused by these situa-
Genesis about Joseph interpreting Pharaoh’s dream. . . . You know,
tions. The presence of asymmetric information also causes
during the seven good years you save for the seven lean years.”
investors to look for nonpredatory counterparties, so infor-
All the short-term decisions for Harvard leaders and Mendillo mation is a form of search friction.
at HMC were painful: slashing budgets, hiring freezes, and the
5. Price impact
postponement of the university’s planned Allston science com-
plex. Asset-liability management for Harvard University had Large trades will move markets.
failed. In the longer term, was the endowment model with illiq- 6. Funding constraints
uid, alternative assets still appropriate? 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
19.3 ILLIQUID ASSET MARKETS to credit is impaired, investors cannot transact in illiquid
asset markets.
Sources of Illiquidity
Vayanos and Wang (2012) provide a taxonomy of how illiquidity Characteristics of Illiquid Markets
arises due to market imperfections:
Illiquid asset markets are characterized by many, and sometimes
1. Clientele effects and participation costs
all, of the market imperfections on this list. I refer to these
Entering markets can be costly; investors often must spend effects as “illiquidity.” On the basis of this reasoning, all assets
money, time, or energy to learn their way around and gain are at least somewhat illiquid—even the large-cap equities that
the necessary skills. In many large, illiquid asset markets, trade many times every second—but of course some assets are
only certain types of investors with sufficient capital, exper- much more illiquid than others. Illiquidity manifests as infrequent
tise, and experience can transact. trading, small amounts being traded, and low turnover. Inter-
2. Transaction costs vals between trades in illiquid markets can extend to decades.
Table 19.1, adapted from Ang, Papanikolaou, and Westerfield
These include commissions, taxes, and, for certain illiquid
(2013), lists average intervals between trading and turnover for
assets, the costs of due diligence, title transfers, and the
several asset classes.6 First, note that . . .
like, as well as the bread-and-butter costs incurred for trad-
ing. It also includes fees paid to lawyers, accountants, and
Most Asset Classes Are Illiquid
investment bankers. Academics sometimes assume that
investors can trade whenever they want as long as they pay Except for “plain-vanilla” public equities and fixed income,
(sometimes a substantial) a transaction cost, but this is not most asset markets are characterized by long periods,
1
60
always true because of . . . sometimes decades, between trades, and they have very very
5
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3. Search frictions
65 ks
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6
See Ang, Papanikolaou, and Westerfield (201
(2013)
13) fo
for additional refer-
41 M
4
Quoted by Munk, N., “Rich Harvard, Poor Harvard,” Vanity Fair, ences behind the numbers in Table 19.1 andd othe
other references in this
August 2009. section.
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low turnover. Even among stocks and bonds, some subas- fine art and jewelry. This rises to 20% for high net worth individ-
set classes are highly illiquid. Equities trading in pink-sheet uals in other countries.7
over-the-counter markets may go for a week or more without The share of illiquid assets in institutional portfolios has
trading. The average municipal bond trades only twice per increased dramatically over the past twenty years. The National
year, and the entire muni-bond market has an annual turnover Association of College and University Business Officers reported
of less than 10%. In real estate markets, the typical holding that, in 2011, the average endowment held a portfolio weight of
period is four to five years for single-family homes and eight more than 25% in alternative assets versus roughly 5% in the
to eleven years for institutional properties. Holding periods early 1990s. A similar trend is evident among pension funds. In
for institutional infrastructure can be fifty years or longer, and 1995, they held less than 5% of their portfolios in illiquid alterna-
works of art sell every forty to seventy years, on average. Thus tives, but today the figure is close to 20%.8
most asset markets are illiquid in the sense that they trade
infrequently and turnover is low. Liquidity Dries Up
Many normally liquid asset markets periodically become illiquid.
Illiquid Asset Markets Are Large
During the 2008 to 2009 financial crisis, the market for com-
The illiquid asset classes are large and rival the public equity mercial paper (or the money market)—usually very liquid—expe-
market in size. In 2012, the market capitalization of the rienced “buyers’ strikes” by investors unwilling to trade at any
NYSE and NASDAQ was approximately $17 trillion. The price. This was not the first time that the money market had
estimated size of the U.S. residential real estate market is frozen: trading in commercial paper also ceased when the Penn
$16 trillion, and the direct institutional real estate market is Central railroad collapsed in 1970. In both cases, the money
$9 trillion. In fact, the traditional public, liquid markets of market needed to be resuscitated by the Federal Reserve, which
stocks and bonds are smaller than the total wealth held in stepped in to restore liquidity.
illiquid assets.
During the financial crisis, illiquidity also dried up in the repo mar-
ket (which allows investors to short bonds), residential and com-
1
Illiquid assets dominate most investors’ portfolios. For individu- auction rate security market (a market for floating rate municipal
icipall
1- nt
20
66 Ce
als, illiquid assets represent 90% of their total wealth, which is bonds). The last example was one of the first markets to o become
beccome
ome
65 ks
06 oo
7
See “Profit or Pleasure? Exploring the Motivations Behin
Behind
nd Tr
Tre
Trea-
58 ak
capital. There are high proportions of illiquid assets in rich inves- sure Trends,” Wealth Insights, Barclays Wealth andd Inve
estme
Investment
11 ah
41 M
tors’ portfolios, too. High net worth individuals in the United Management, 2012.
States allocate 10% of their portfolios to “treasure” assets like 8
See Global Pension Asset Study, Towers Watson,
son, 2
2011.
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384 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
19.4 ILLIQUID ASSET REPORTED The only way to completely remove the effect of survivorship
bias is to observe the entire population of funds. Unfortunately,
RETURNS ARE NOT RETURNS
in illiquid asset markets we never observe the full universe.
As Faust and Forst note in their memo to Harvard’s Coun- We can gauge the impact of survivorship bias with mutual funds,
cil of Deans, the true illiquid asset losses were greater than which are required to report their returns to the Securities and
the reported ones, which leads us to an important corollary. Exchange Commission because they fall under the 1940 Invest-
Reported illiquid asset returns are not returns. Three key biases ment Act. This allows us to see the whole mutual fund universe,
cause people to overstate expected returns and understate the at least when the funds become registered, and to compute the
risk of illiquid assets: effect of survivorship bias. Survivorship bias knocks at least 1%
1. Survivorship bias, to 2% off the estimates of expected returns of mutual funds if
we fail to include dead funds in our sample. However, industry
2. Infrequent sampling, and
often bases its conclusion only on funds in existence at a given
3. Selection bias. point in time. When we separately compare defunct and live
In illiquid asset markets, investors must be highly skeptical of funds, the survivorship effect can go above 4%. Take these as
reported returns. 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
Survivorship Bias
1
we only rarely count their failures. This makes true illiquid asset
06 oo
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returns worse than the reported data. Jorion and Goetzmann (1999) argue that survivorship
vors
orsshiip bia
bias partly
-9 al
that smoking is bad for you. We’re going to run our tests only investments have prospered.
10
on a sample of smokers that have puffed cigarettes for at least See Ang, Rhodes-Kropf and Zhao (2008).
08).
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The true daily returns are plotted in Panel B of Figure 19.1. To illustrate the Geltner-Ross-Zisler unsmoothing process,
These are much more volatile than the ones in Panel B. Prices go denote the true return at the end of period t as rt, which is
below 0.7 and above 3.0 in Panel B with daily sampling, whereas unobservable, and the reported return as r*t , which is observable.
the range of returns in Panel A is between 1.0 and 2.5 with quar- Suppose the observable returns follow
terly sampling. The volatility of quarterly returns, computed from
(19.1)
(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. where f is the autocorrelation parameter and is less than one in
absolute value. Equation (19.1) is an AR(I) process, where “AR”
For a full comparison, Panel C plots both the quarterly and daily
stands for autoregressive and the “1” denotes that it captures
sampled returns and just overlays Panels A and B in one picture.
autocorrelation effects for one lag. Assuming the observed
Infrequent sampling has caused the volatility estimate using the
returns are functions of current and lagged true returns (this is
quarterly sampled returns to be too low. The same effect also
called a “transfer function” or an “observation equation” in the
happens with betas and correlations—risk estimates are biased
parlance of engineers), we can use Equation (19.1) to invert out
downward by infrequent sampling.11
the true returns. If the smoothing process only involves averag-
ing returns for this period and the past period, then we can
Unsmoothing Returns filter the observed returns to estimate the true returns, rt, from
observed returns, r*t using:
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 (19.2)
too smooth, and we need to tease out the true, noisier returns. Equation (19.2) unsmooths the observed returns. If our assump-
This process is called unsmoothing or de-smoothing, and the
1
first algorithms to do this were developed by David Geltner implied by Equation (19.2) should have zero autocorrelation. on.
n.
66
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1- nt
20
returns and produces true returns that are close to IIDD (or
or no
not
06 oo
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See Geltner (1993) and Graff and Young (1996) for infrequent obser-
forecastable). Note that the variance of the true retu
returns
turrns is higher
etu
turn
82 B
estimates that betas are understated by a factor of 0.5 for real estate
11 ah
returns. This is not a “small sample” problem, which goes away when
41 M
386 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
3 3
2.5 2.5
2 2
1.5 1.5
1 1
0.5 0.5
0 0
Panel C
Daily vs Quarterly Sampling
3.5
2.5
1.5
0.5
0
1
605
Figure 19.1
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41 M
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13 papers.
This literature includes both repeat-sales methodologies (see
5
66
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17
Goetzmann (1992)) and constructing indexes using only transactions We want an ARMA(p, q) model, which captures the effect of p lagge lagg
lagged
ged
ed
1- nt
20
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(see Gatzlaff and GeItner (1998) and Fisher, GeItner, and Pollakowski no
ovattions
autocorrelated terms (the “AR” effect for p lags) and where innovations ions
(2007)). Some of these methods adjust for the different characteristics
65 ks
of individual homes in creating these indices, like whether an apartment returns. The latter are referred to as moving average terms ms (t
(th
he “M
(the “MA”
82 B
or a house is for sale, whether it is close to the water or far, or whether effects for q lags). Both GeItner (1991) and Ross and Zisler (199
(1991) con-
-9 ali
58 ak
the house has two stories or one. These are called hedonic adjustments. ).. Ok
sider richer time-series processes than just an AR(1). Oku
kunev
unev and White
Okunev
11 ah
These methods have been applied to create indexes in other illiquid evellop u
(2003) and Getmansky, Lo, and Makarov (2004) develop unsmoothing
41 M
markets, like art (Goetzmann (1993) and Moses and Mei (2002)), stamps algorithms to hedge fund returns with higher-ordererr auto
autocorrelation
(Dimson and Spaenjers (2011)), and wine (Krasker (1979) and Masset and corrections.
20
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388 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
20 20
10 10
0 0
06–78 02–81 11–63 08–86 05–89 02–92 11–94 07–97 04–00 01–03 10–05 07–08 04–11
–10 –10
–20 –20
–30 –30
–40 –40
Unsmoothed Returns Raw Data (Smoothed)
Figure 19.2 Smoothed and unsmoothed real estate returns.
Estate Investment Fiduciaries (NCREIF), which constructs an Buildings tend to be sold when their values are high—otherwise,
institutional property index from data reported by its mem- many sellers postpone sales until property values recover. This
bers.18 Because this is an appraisal index, NCREIF real estate causes more transactions to be observed when the underlying
returns are highly autocorrelated. From March, 1978 to real estate values are high.
December, 2011, the first-order autocorrelation of NCREIF
In private equity, selection bias is acute. In buyout funds, com-
returns is 0.78. The raw reported data is shown in the solid
panies are taken public only when stock values are high. Many
line. I graph unsmoothed returns in the squares applying the
venture capital investments are structured over multiple rounds.
filter of Equations (19.1) and (19.2). All returns are at the quar-
Better-performing companies tend to raise more money in more
terly frequency.
rounds. The venture capitalist tends to sell a small company, and
Unsmoothing produces a dramatic effect. The minimum the transaction is recorded, when the company’s value is high.
reported return during the real estate downturn in the early Distressed companies are usually not formally liquidated, and
1990s is - 5.3% during the quarter ending December 1991. The these “zombie” companies are often left as shell companies.
corresponding unsmoothed return is -22.6%. During the finan- When observing old companies without recent transactions, it is
cial crisis, NCREIF returns reached a low of -8.3% in December not clear whether these companies are alive and well or whether
2008. The unsmoothed return during this quarter is -36.3%. they are zombies.
The volatility of the raw NCREIF returns is 2.25% per quarter,
To illustrate the selection bias problem, consider Figure 19.3,
whereas the volatility of the unsmoothed returns is 6.26% per
which is adapted from Korteweg and Sorensen (2010). Panel A
quarter. This approximates the volatility of stock returns, which is
shows the full universe of returns of an illiquid asset marked by
around 7.5% per quarter. Correlation (and hence beta) estimates
dots. These returns (on the y-axis) are plotted contemporaneous
are also affected by unsmoothing: the correlation of raw NCREIF
with market returns (on the x-axis). In the full universe, there is
returns with the S&P 500 is 9.2% and this rises to 15.8% once
no alpha, and the intercept of the line summarizing the relation-
the unsmoothing correction is applied.
ship between the illiquid asset and the market goes through
1
the origin (this line is called the security market line (SML; seeee
e
5 60
Selection Bias Chapter 1). The slope of the SML is the beta of the illiquid
iquiid asset
lliquid ass
as
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18
Unsmoothing corrections produces similar effects in other illiquid
41 M
markets. Campbell (2008), for example, estimates that unsmoothing the black dots are reported. An estimated
maated SML fitted to these
increases the volatility of art market returns from 6.5% to 11.5%. observed returns yields a positive alpha
alph when the true alpha
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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
Figure 19.3
underlying valuations are high, will produce return estimates
1
60
that are overly optimistic and risk estimates that are biased
5
66
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19
58 ak
See also Cochrane (2005) for selection bias models applied to venture inability to access capital immediately. They
eyy also
alsso com-
co
11 ah
capital and Fisher et al. (2003) for real estate. Korteweg, Kräussl, and
41 M
Verwijmeren (2012) find that correcting for selection bias decreases the pensate investors for the withdrawal of liquidity
dity during
uiidity
Sharpe ratio of art from 0.4 to 0.1. illiquidity crises.
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390 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
There are four ways an asset owner can capture illiquidity 1. Illiquidity biases.
premiums: As previous sections show, reported data on illiquid assets
1. By setting a passive allocation to illiquid asset classes, like cannot be trusted. The various illiquidity biases—survivorship,
real estate; sampling at infrequent intervals, and selection bias—result in
the expected returns of illiquid asset classes being overstated
2. By choosing securities within an asset class that are more
using raw data.
illiquid, that is by engaging in liquidity security selection;
2. Ignores risk.
3. By acting as a market maker at the individual security
level; and Illiquid asset classes contain far more than just illiquidity risk.
Adjusting for these risks makes illiquid asset classes far less
4. By engaging in dynamic strategies at the aggregate portfo-
compelling. The NCREIF real estate index (despite the arti-
lio level.
ficial rosiness of its raw returns) is beaten by a standard 60%
Economic theory states that there should be a premium for equity and 40% bond portfolio. The average hedge fund
bearing illiquidity risk, although it can be small.20 In models and private equity fund, respectively, provide zero expected
where illiquidity risk has small or no effect on prices, illiquidity excess returns. In particular, after adjusting for risk, most
washes out across individuals. A particular individual may be investors are better off investing in the S&P 500 than in a
affected by illiquidity—illiquidity can crimp his consumption or portfolio of private equity funds.
affect his asset holdings (as in the asset allocation model with
3. There is no “market index” for illiquid asset classes.
illiquidity risk that I present below)—but other agents will not be
constrained, or they trade at different times. Different agents No investor receives the returns on illiquid indexes. An
share risk among themselves, which mutes the impact of illiquid- asset owner never receives the NCREIF return on a real
ity. Thus in equilibrium the effects of illiquidity can be estate portfolio, for example. The same is true for most
negligible.21 hedge fund indexes and private equity indexes. In liquid
public markets, large investors can receive index market
Whether the illiquidity risk premium is large or small is an empir- returns and pay close to zero in fees. In contrast, NCREIF
ical question. is not investable as it is impossible to buy all the underly-
ing properties in that index. Since all asset owners own
Illiquidity Risk Premiums across considerably fewer properties than the thousands included
in NCREIF, they face far more idiosyncratic risk. While this
Asset Classes
large amount of idiosyncratic risk can boost returns in some
Figure 19.4 is from Antti Ilmanen’s (2011) wonderful book, cases, it can also lead to the opposite result. Returns to illiq-
Expected Returns, and plots average returns on illiquidity esti- uid asset investing can be far below a reported index.
mates. The average returns are computed from (reported) data 4. You cannot separate factor risk from manager skill.
over 1990 to 2009. The illiquidity estimates represent Ilmanen’s
Tradeable and cheap index funds in bond and stock mar-
opinions. Some private equity investments are more liquid than
kets allow investors to separate systematic returns (or factor
certain hedge funds, and some infrastructure investments are
returns) from management prowess. In illiquid markets, no
much less liquid than private equity, so it is hard to pigeon-hole
such separation is possible: investing in illiquid markets is
these asset classes in terms of illiquidity. Nevertheless, Figure 19.4
always a bet on management talent. The agency issues in
seems to suggest a positive relation between how illiquid an asset
illiquid asset markets are first-order problems. Agency prob-
class is and its expected return. Figure 19.4 represents “con-
lems can, and often do, overwhelm any advantages that an
ventional” views among most market participants that there is a
illiquidity risk premium may bring.
1
60
(1968). See summary articles by Hasbrouck (2007) and Vayanos and ail.22 But
as Ang, Goetzmann, and Schaefer (2011) detail. B w while
06 oo
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Wang (2012).
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21 22
58 ak
For models of this kind, see Constantinides (1986), Vayanos (1998), Nevertheless, there are common componentsents in
in illiq
illiquidity conditions
11 ah
Gârleanu (2009), and Buss, Uppal, and Vilkov (2012). In contrast, Lo, ond mark
across asset classes: when U.S. Treasury bond m
markets are illiquid, for
41 M
Mamaysky, and Wang (2004) and Longstaff (2009), among others, argue orly. S
example, many hedge funds tend to do poorly. See, for example, Hu,
that the illiquidity premium should be large. Pan, and Wang (2012).
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99
16 Venture
Capital
14
Emerging Market Debt Buyouts
12 Hedge Funds
Small Cap Equities
Emerging Market Equity Timber
10
High Yield bonds
Global Infrastructure Fund of Funds
8 US Real Estate
US Fixed Income
Global Sovereigns
6 Commodities
Global REITS
Cash Deposits Developed Market Equity
4
0
Most Liquid Increasing Illiquidity = > Most Illiquid
Figure 19.4 Asset class returns vs illiquidity.
there do not seem to be significant illiquidity risk premiums original maturities of twenty to thirty years and notes originally
across classes, there are large illiquidity risk premiums within carry maturities of one to ten years. But after ten years, a Trea-
asset classes. 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.
Illiquidity Risk Premiums within Asset During the financial crisis Treasury bond prices with the same
Classes maturity as Treasury notes had prices that were more than 5%
Within all the major asset classes, securities that are more illiq- lower—these are large illiquidity effects in one of the world’s
uid have higher returns, on average, than their more liquid coun- most important and liquid markets.25
terparts. These illiquidity premiums can be accessed by dynamic
factor strategies which take long positions in illiquid assets and Corporate Bonds
short positions in liquid ones. As illiquid assets become more Corporate bonds that trade less frequently or have larger bid–
liquid, or vice versa, the investor rebalances. ask spreads have higher returns. Chen, Lesmond, and Wei (2007)
find that illiquidity risk explains 7% of the variation across yields
U.S. Treasuries of investment-grade bonds. Illiquidity accounts for 22% of the
A well-known liquidity phenomenon in the U.S. Treasury market variation in junk bond yields; for these bonds, a one basis point
is the on-the-run/off-the-run bond spread. Newly auctioned rise in bid–ask spreads increases yield spreads by more than two
Treasuries (which are “on the run”) are more liquid and have basis points.26
higher prices, and hence lower yields, than seasoned Treasuries
(which are “off the run”).23 The spread between these two types Equities
of bonds varies over time reflecting liquidity conditions in Trea- A large literature finds that many illiquidity variables predict
sury markets.24 returns in equity markets, with less liquid stocks having higher
returns.27 These variables include bid–ask spreads, volume, vol-
1
turn
ume signed by whether trades are buyer or seller initiated, turn-
5
the 2008 to 2009 financial crisis. Treasury bonds and notes are
66
98 e
1- nt
20
identical, except that the U.S. Treasury issues bonds with over, the ratio of absolute returns to dollar volume (commonly
monlly
monly
66 Ce
65 ks
06 oo
82 B
25
See Musto, Nini, and Schwarz (2011).
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23
The on-the-run bonds are more expensive because they can be used
58 ak
as collateral for borrowing funds in the repo market. This is called “spe- 26
See also Chapter 9, Bao, Pan, and Wang (2011), ),, Lin,, Wan
Wang, and Wu
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392 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
Perhaps the reason is limited integration across asset classes. Many asset owners cannot collect illiquidity risk premiums by
There are significant impediments to switching capital and building high-frequency trading systems, nor would they wish to
investment strategies seamlessly even across liquid stock and enter this business (directly or indirectly). But there is a way large
bond markets.30 Investors put asset classes into different silos asset owners can do a low-frequency version of market making.
1
28
Sorting stocks on all these variables results in spreads in average
1- nt
20
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31
higher than average (normalized) volume, for example, tend to have See Merton (1987), Duffie (2010), and Shleifer and
nd Vishny
Vi
V (1997),
82 B
lower future returns as shown by Gervais, Kaniel, and Mingelgrin (2001). respectively.
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29 32
See Aragon (2007) and Sadka (2010), respectively. O’Hara (1995) provides a summary of theoretical
eorettical
ical m
models of market
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30 making.
See Kapadia and Pu (2012) for evidence of lack of integration across
33
stock and bond markets. See Zhang (2010).
20
99
their fund’s portfolio is sold to another private equity firm. the effects of adverse selection. DFA provides some exam--
5
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34
See Keim (1999) and the Harvard Business School case study,
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35 37
An academic study of this market is Kleymenova, Talmor, and From the introduction to Luytens (2008) written
n by Andre
A
Andrew Sealey
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394 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
40
See the literature on index reconstitution effects summarized by Ang,
41
Goetzmann, and Schaeffer (2011). Parts of this are based on Ang (2011) and A
Ang and Sorensen (2012).
20
99
42
Chapter 4 discusses extensions of Constantinides (1986) to double
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the bands.
65 ks
43
For some illiquid assets, investors may not be even willing to trans-
below the Long-Run Average Holding g
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act immediately for one cent; some investments do not have liability
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limited at zero. For example, on June 30, 2008, a real estate invest-
In the presence of infrequent trading, illiquid assetett wealth
wea can
11 ah
ment by CalPERS was valued at negative $300 million! See Corkery, M.,
41 M
C. Karmin, R. L. Rundle, and J. S. Lublin, “Risky, Ill-Timed Land Deals Hit vary substantially and is right-skewed. Suppose e the optimal hold-
se
CalPERS,” Wall Street Journal, Dec. 17, 2008. ing of illiquid assets is 0.2 when the liquidity
ty event
eve arrives. The
20
99
396 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
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 0.11
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
1
60
In a mean-variance model, two assets with different Sharpe Large, long-term investors often cite their large amounts
am
amo
mou
ounts of
65 ks
06 oo
ratios and perfect correlations produce positions of plus or capital and their long horizons as rationales foror investing
nvesti in
inv
in
82 B
minus infinity. This is a well-known bane of mean-variance illiquid assets. Size and patience are necessary
ssaryy but not sufficient
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models, and professionals employ lots of ad hoc fixes, and conditions for illiquid asset investing; these
hesee conditions
con simply
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41 M
arbitrary constraints, to prevent this from happening. This does aren’t adequate justifications in themselves.
elves. Since illiquid asset
elves.
not happen when one asset is illiquid—there is no arbitrage. classes do not offer high risk-adjusted
ed returns,
ret
re the case for
20
99
45
“About HSPH: Endowment Funds: What Are Endowmentt Fund Fun
Funds?”
ds?”
65 ks
d.edu
u/ab
u/abo
Harvard School of Public Health, http://www.hsph.harvard.edu/about/
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46
See Hansmann (1990).
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44 47
Quoted by Stewart, J. B., “A Hard Landing for University Endow- “Q&A. Modest Proposal. An Economist Asks, Doesoes H
Harvard Really
ments,” New York Times, Oct. 12, 2012. Need $15 Billion?” New York Times, Aug. 2, 1998.
98.
20
99
398 ■ Financial Risk Manager Exam Part II: Liquidity and Treasury Risk Measurement and Management
48 49
Kevin Carey, “The ‘Veritas’ About Harvard,” Chronicle of Higher Brown et al. (2013) show that most universities do the same thing:
Education, Sept. 28, 2009. they hoard endowments when bad times come.
1
560
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58
11
41
20
99
INDEX
sample interest-sensitivity analysis (GAP Management), 360–362 liquidity transformation by banks, 20–21
65 ks
asset management strategy, 350 balance sheet expansion since 2000, 316
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401
402 ■ Index
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.I.T.
off-balance-sheet financing, 160–161 environments, both normal and stressed, 50
1
Depository Trust and Clearing Corporation (DTCC), 159 risk identification and, 47, 49
99
Index ■ 403
404 ■ Index
Index ■ 405
406 ■ Index
asset-liability committee (ALCO), 181 on-balance sheet funding liquidity risk management
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Index ■ 407
O
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industry practices, 51
20
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408 ■ Index
Recommendations for Securities Settlement Systems (RSSS), 121 stress testing assumptions, 181
5
66
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Index ■ 409
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
1
60
resiliency, 38
5
66
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slippage, 38
Z
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20
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tightness, 38
65 ks
410 ■ Index